Borrowers as Distributors of Trademarked Inventory

Reprinted from The Secured Lender, April 2015.

In today’s world of off-shore manufacturing, an asset-based lender’s portfolio of borrowers most likely includes entities that purchase finished goods for resale.  Some of these borrowers may purchase goods on the open market.  Others may be authorized distributors of a manufacturer (the “supplier”) who supplies goods bearing the supplier’s trademark (the “Trademarked Inventory”).  In such cases, the parties’ relationship typically is memorialized in a distribution agreement, which agreement may contain an express grant of a license to use the supplier’s trademark in connection with the marketing, promotion and sale of the Trademarked Inventory.  Lending against Trademarked Inventory involves questions of trademark law and contract interpretation.  It is important for the lender to understand whether applicable law or the underlying contract restricts the borrower’s ability to sell the Trademarked Inventory if the agreement is terminated.  The lender should consider any limitations that may exist when it evaluates whether it will extend loans against the value of the Trademarked Inventory.[i]

Trademark Law.  The Lanham Act[ii] is the applicable federal law governing federally registered trademarks.  One of the primary objectives of the Lanham Act is to protect trademark owners against third parties creating confusion among consumers regarding the origin of a product bearing a registered trademark.[iii]  However, such protections have limits.  Case law interpreting the Lanham Act provides that a trademark owner’s right to control the sale of licensed products ceases after a “first sale” of “genuine goods” has occurred.

First Sale.  The “first sale” doctrine provides that the trademark owner’s right to control the distribution of a product bearing its trademark does not extend beyond the first sale of its product.  In other words, “a purchaser who does no more than stock, display, and resell a producer’s product under the producer’s trademark violates no right conferred upon the producer by the Lanham Act.”[iv]  This limitation preserves competition, which would otherwise be stymied if the trademark owner could dictate the terms of subsequent resales of a trademarked product.

Genuine Goods.  A reseller of goods bearing a trademark owner’s trademark can avail itself of the first sale doctrine only if the goods are “genuine.”  In the distributor context, questions can arise as to whether goods are “genuine” if they have been repackaged or otherwise modified prior to resale.  Courts addressing the issue examine whether the goods sold by the reseller are “materially different” from the goods sold by the trademark owner.  Materiality is not based on the size or number of changes.  Instead, the analysis is a fact-based, case-by-case examination that aims to determine whether the changes generate consumer confusion about the source and quality of the goods in question.[v]  For example, the removal of batch codes or other markings from packaging could be sufficient to find that the packaged goods are not genuine.[vi]  In addition, repacking the Trademarked Inventory or splitting the Trademarked Inventory into smaller lots or components could also be deemed to render the goods to be materially different.[vii]

Due Diligence.  The lender should first review the underlying distribution agreement to determine whether the first sale doctrine shields the borrower from claims of trademark infringement.  The passage of title is a logical reference as to when a first sale has occurred.[viii]  Ideally, the terms of the agreement set forth when title to the Trademarked Inventory passes from the supplier to the borrower.  Assuming that title passes no later than the time the Trademarked Inventory is received by the borrower, the supplier would be hard-pressed to assert that a first sale has not occurred upon the borrower’s receipt of the Trademarked Inventory.

A lender’s due diligence should also include confirming whether the Trademarked Inventory purchased by the borrower is altered in any manner prior to its resale.  Any physical modification of the Trademarked Inventory should raise a potential “red flag,” as the fact-specific analysis used to determine whether the Trademarked Inventory is genuine could prevent a lender from having a clear answer whether the borrower’s actions might support a claim of trademark infringement.

Severe consequences can result if a first sale has not occurred or the borrower’s actions are found to result in the sale of materially different goods.  A court could order injunctive relief prohibiting further sales of the Trademarked Inventory.  If the Trademarked Inventory constituted primary collateral supporting the lender’s asset-based loans, an injunction could transform the lender’s secured loan to an unsecured loan.

Holding Out as an “Authorized” Distributor.  Distribution agreements may also contain a license authorizing the use of the trademark owner’s trademarks in connection with the marketing, sale and promotion of the Trademarked Inventory.  Although the contract’s language regarding the license will vary by agreement, the provisions typically require that the licensee cease using the trademarks upon termination of the distribution agreement and that the licensee return all promotional material to the trademark owner.  A license of this type raises the question whether the termination of the license restricts the borrower’s ability to sell the goods.

Although a license may assist the borrower in its conduct as an authorized distributor, the termination of the license (and the rights granted pursuant to it) should not prevent the borrower from continuing to sell the Trademarked Inventory on the grounds of trademark infringement.  As noted earlier, once a “first sale” has occurred, the first sale doctrine dictates that the borrower should be able to resell freely the Trademarked Inventory in an unaltered state without restriction.

The license allows the borrower to use the supplier’s trademark to hold itself out as the supplier’s authorized distributor in its promotional material.  In this limited context, the borrower should alter its promotional material and cease to represent itself as an authorized distributor.  The failure to do so could constitute both a breach of contract as well as trademark infringement based on possible confusion among consumers regarding the supplier’s perceived endorsement of the borrower as a seller of the Trademarked Inventory.[ix]

 Due Diligence.  In addition to the passage of title and trademark license considerations noted previously, the lender’s review should also include an examination of the distribution agreement provisions regarding the agreement’s term and the parties’ rights upon termination.  Restrictions on post-termination sales can arise as a result of an agreement between the parties.  Understanding what restrictions exist, if any, will assist the lender in evaluating whether the Trademarked Inventory is a suitable asset against which the lender can advance loans.

Contract Review:  Distribution agreements come in all shapes and sizes.  In their most basic form, distribution agreements will address (a) the goods subject to the agreement, (b) the borrower’s distribution territory, and (c) the circumstances under which the agreement can be terminated by either the borrower or the supplier.  More detailed distribution agreements may also address (i) potential minimum purchase obligations or performance standards to which the borrower must adhere, (ii) the supplier’s right or obligation to repurchase (or the borrower’s right to require the supplier to repurchase) the Trademarked Inventory upon the expiration or termination of the agreement, and/or (iii) the borrower’s ability to sell the Trademarked Inventory after termination or expiration.

When reviewing the possible contract terms, the lender should consider:

1. Distribution Territory: Is the stated distribution territory consistent with the lender’s liquidation plan?  If it is not, then the lender may need to adjust its advance rates if its recovery would be adversely impacted by limits placed on the markets into which the Trademarked Inventory can be sold.
2. Contract Termination: Does the distribution agreement contain minimum purchase requirements or must the borrower satisfy financial covenants?  If so, has the borrower satisfied those requirements and covenants historically and what is the likelihood of satisfying them in the future?  A track record of poor performance may raise the possibility that the supplier could terminate the contract during the term of the lender’s financing to the borrower.
3. Repurchase Obligation/Right: Is the supplier obligated (or does it have the right) to repurchase the Trademarked Inventory upon termination or expiration of the license?  If so, how is the purchase price calculated and could the payment be reduced by amounts owing by the borrower to the supplier?  Repurchase obligations can be an effective method for a lender to unwind its relationship with the borrower after a default.  However, the purchase price should not be lower than the lender’s advance rate against the Trademarked Inventory. The lender should also monitor the amount of payables owing to the supplier to determine what effect, if any, the supplier’s right to offset amounts could have on the net purchase price to be paid by the supplier in the event it repurchases any Trademarked Inventory.
4. Post-Termination Sales: Does the distribution agreement expressly permit the borrower to sell the Trademarked Inventory after termination or expiration of the agreement?  If so, does the agreement set forth a specific time period during which sales may occur?  If post-termination sales are permitted within a stated period, the lender should confirm that its liquidation timetable is no longer than the allotted period, otherwise its ability to realize on the collateral could be adversely impacted.

What if the agreement is silent regarding post-termination sales?  A number of courts have examined this issue when the prospective seller is a manufacturer – not a distributor – of Trademarked Inventory.  Several federal court decisions have held that silence regarding post-termination sales should be interpreted to prohibit post-termination sales of previously manufactured goods.[x]  The general focus of these decisions is that a “first sale” has not occurred when a manufacturer is involved, and that allowing future sales by the manufacturer would be akin to a de facto extension of the license, the effect of which would be to render the license’s termination date irrelevant.

An important distinction exists when the borrower is a distributor of the Trademarked Inventory, and not a manufacturer.  A first sale would have already occurred from the supplier to the borrower.  Any trademark license from the supplier to the borrower would likely be in connection with the borrower holding itself out an authorized distributor of the supplier.  As a result, silence regarding post-termination sales should not preclude future sales so long as the borrower ceases to refer to itself as an authorized distributor, removes such references from its marketing materials, and otherwise complies with the post-termination requirements under the distribution agreement.[xi]

Agreement between Supplier and Lender.  The lender may still have a sound credit basis to lend against the Trademarked Inventory even if the distribution agreement contains unfavorable terms regarding post-termination sales or the supplier’s rights after termination.  The lender can address such terms or adverse rights by pursuing an agreement directly with the supplier.  Although the scope of the lender’s agreement will depend on the terms of the underlying distribution agreement, common components of such an agreement with the supplier include:

1. Acknowledgment and Consent: The supplier’s acknowledgement of, and consent to, the borrower’s grant of a security interest to the lender in the borrower’s rights under the distribution agreement and the Trademarked Inventory.
2. Term: The supplier’s agreement that the lender has the right to sell the Trademarked Inventory after termination of the distribution agreement.
3. Territory: The supplier’s agreement regarding the territory into which the Trademarked Inventory may be sold.
4. Notice and Cure Right: The supplier’s agreement to provide notice to the lender of any default by the borrower under, or termination by the supplier of, the distribution agreement, and the lender’s right to cure the default, if the lender elects to do so.
5. Repurchase Right: The supplier’s agreement to repurchase the Trademarked Inventory.  The lender may also want to specify the methodology used to calculate the purchase price and to obtain the supplier’s agreement to pay the purchase price directly to the lender without offset of any amounts owing by the borrower to the supplier.

Whether a lender can obtain the supplier’s agreement on all or some of these points will depend on a number of factors, including the relative negotiating power of the borrower and the supplier as well as the potential costs and delays associated with pursuing an agreement.  The lender should first examine the borrower’s business to confirm whether the borrower is merely a purchaser and reseller of the Trademarked Inventory.  The lender should then review the distribution agreement to confirm whether the agreement limits the borrower’s right to sell the Trademarked Inventory after termination, or grants the supplier the right to repurchase the Trademarked Inventory under circumstances that undermine the loans that the lender may have made against the value of the Trademarked Inventory.  If such limits or adverse rights exist, the lender has the option to pursue an agreement directly with the supplier to address those concerns to the lender’s satisfaction.

[i] It is unclear whether a lender’s right to sell the Trademarked Inventory is derivative of the borrower’s right.  The most conservative approach for the lender is to assume that its right is derivative, and make a decision regarding lending against such inventory accordingly.

 [ii] 15 U.S.C. § 1401 et seq. (2006).                         

[iii] Bel Canto Design, Ltd. v. MSS HiFi, Inc., 837 F. Supp. 2d 208, 222-23 (S.D.N.Y. 2011).

 [iv] Sebastian Int’l, Inc. v. Longs Drug Stores Corp., 53 F.3d 1073, 1074 (9th Cir. 1995), cert. denied, 516 U.S. 914 (1995).

[v] Societe Des Produits Nestle, S.A. v. Casa Helvetia, Inc., 982 F.2d 633, 638 (1st Cir. 1992).

 [vi] See, e.g., Davidoff & CIE, SA v. PLD Int’l Corp., 263 F.3d 1297, 1242 (11th Cir. 2001) (removal of batch code from bottom of fragrance bottle created a material difference where removal left a small etching on bottle);  John Paul Mitchell Sys. v. Pete-N-Larry’s Inc., 862 F. Supp. 1020, 1027 (W.D.N.Y. 1994) (removal of batch codes from bottles constituted a material difference where removal left noticeable marks on the bottles and erased certain printed information).  But see Graham Webb Int’l Ltd. P’ship v. Emporium Drug Mart, Inc., 916 F. Supp. 909, 916 (E.D. Ark. 1995) (removal of batch codes from hair care products did not constitute infringement where bottle was not visibly altered).

 [vii] Enesco Corp. v. Price/Costco Inc., 146 F.3d 1083, 1087 (9th Cir. 1998) (repacking of porcelain figurines without disclosing they had been repackaged constituted trademark infringement); Softman Products Co., LLC v. Adobe Systems, Inc., 171 F.Supp. 2d 1075, 1093 (C.D. Cal. 2001) (repackaging of Adobe-brand software in manner that omitted registration card and invalidated software support constituted a material difference).

 [viii] Italverde Trading, Inc. v. Four Bills of Lading, 485 F. Supp. 2d 187, 210 (E.D.N.Y. 2007); McDonald’s Corp. v. Shop at Home, Inc., 82 F. Supp. 2d 801, 812 (M.D. Tenn. 2000).

[ix] Bel Canto Design, 837 F. Supp. 2d at 221-222 (S.D.N.Y. 2011); Stormor, a Division of Fuqua Indus., Inc. v. Johnson, 587 F. Supp. 275, 280 (W.D. Mich. 1984).

 [x] See, e.g., Bill Blass, Ltd. v. SAZ Corp., 751 F.2d 152 (3d Cir. 1984); Ryan v. Volpone Stamp Company, 107 F. Supp. 2d 369 (S.D.N.Y. 2000).

[xi] See, e.g., Citizens of Humanity, LLC v. Costco Wholesale Corp., 89 Cal. Rptr. 3d 455, 464-65 (Cal. App. 2009) (manufacturer’s ability to preclude post-termination sales by distributor must be based on contractual restrictions, not trademark law), disapproved on other grounds, Kwikset Corp. v. Superior Ct. of Orange Cty., 120 Cal. Rptr. 3d 741 (Cal. 2011).