Clarifying gray market gray areas

INTRODUCTION

In 1988, for example, an estimated seven to ten billion dollars in goods entered the U.S. market through such channels,(1) which commonly are referred to as gray markets. Although they are not illegal in most cases, gray markets create complications for licensed dealers and the companies that supply them. It is not surprising, therefore, that literature on this topic has proliferated.(2) Yet this literature is as gray as the phenomenon itself. Gray markets (“parallel imports”) are frequently ill-defined, and the problems they purportedly cause often are not clearly articulated or verified. Moreover, the literature is rife with specialistic interpretations of gray markets that fail to accurately describe this phenomenon in a holistic, prescriptive fashion.(3)

This paper attempts to mitigate that failure by integrating various perspectives on gray markets. In addition, this paper describes the emerging trade environment affecting these markets. Consideration of the competition laws in the European Community, as well as Japan’s historical trade behavior and industry structure, demonstrates that global free trade is unlikely to characterize the emerging environment, and it is unsound for the United States to predicate its public policy approach to gray markets on the existence of free trade.

This article supports formation of a North American Common Market based on provisions of the emerging North American Free Trade Agreement (NAFTA), and it supports an altered view of the goals of American antitrust laws. The formation of a common market will preserve some of the benefits of free trade for the United States on a limited regional basis, while revised interpretation of American antitrust laws will aid American firms that compete with traders from Japan and Europe.

UNDERSTANDING GRAY MARKETS

A Transactional View of Gray Markets

In most of the current literature on the gray marketing, gray marketing is defined generically as the distribution of genuine products outside the manufacturer’s authorized channels.(4) This general definition masks the multiplicity of transactional forms that gray, markets assume. One authority, for example, describes five transactional forms and also notes that gray markets can occur both domestically and internationally.(5) In the former case, a retailer or distributor makes unauthorized sales to other retailers to take advantage of volume discounts

In the first scenario, a manufacturer in one country, such as the United States, exports goods to distributors in a foreign country, who re-export some of the goods back to the United States. In the second case, imports from a foreign country enter the United States through both authorized channels (such as a sales subsidiary) and unauthorized channels. The latter can occur when an authorized distributor in the product’s country of origin sells to importers in the United States without the manufacturer’s permission. Finally, a foreign manufacturing affiliate of an American firm or the affiliate’s distributors may directly export some of their goods back to the United States, even though they had agreed to serve only markets other than the United States.

In addition to these transactional forms, parallel imports occur in a number of relational forms. For example, the authorized channel may be a subsidiary of the foreign firm

Emergence of the Gray Market Problem

Profit, of course, is the primary motivation for the development of gray markets. Gray markets are particularly likely to emerge when (1) a supply of the goods is available in another country

Though these goods do confer benefits — notably increased consumer welfare through lower prices and increased product choice — they are considered problematic by manufacturers and by authorized distributors. In particular, the intrabrand competition resulting from gray market imports can impede efforts to meet interbrand competition, especially from foreign firms. As the Japanese experience suggests, companies’ competitive strength in international markets is enhanced by the ability to restrict competition in the domestic market.

Additionally, parallel imports may negatively affect brand image, a major concern of consumer products companies. These companies fear that consumers will be disappointed if products purchased from unauthorized outlets do not function as promised or are not properly serviced.(8) Similarly, manufacturers and authorized dealers fear that the availability of products in discount stores will tarnish their prestige image and devalue the trademark.(9)

The case of IBM personal computers (pc’s) demonstrates this point. Typical gray market distributors do not provide warranties that cover repairs, but because IBM is touted for its high-quality service, the company response center continues to receive calls from gray-market purchasers. In an effort to preserve its goodwill and reputation for service, IBM refers such customers to shops that perform both in and out-of-warranty repairs.(10)

Though this strategy preserves the benefits of IBM warranties for legitimate purchasers, it creates an incentive for the expansion of gray markets. Rather than paying a high markup for an IBM pc from an authorized dealer, whose warranty likely contains many services that will never be used, consumers have an incentive to purchase at unauthorized dealerships and pay for services only as they, need them. Indeed, IBM will even recommend a repair shop where the high-quality services synonymous with its name can be purchased piece-meal.(11)

As this vignette suggests, gray markets are likely to lead to strained manufacturer-dealer relations, which is another reason that such markets are considered problematic. In 1984, for instance, Caterpillar’s equipment dealers on the east coast of the United States were barraged by $600 million in construction equipment manufactured in Europe. As this equipment was being sold by unauthorized dealers at prices substantially below the U.S. list price, authorized dealers lost sales and became increasingly frustrated with Caterpillar. Consequently, some authorized dealers considered entering the gray market themselves.(12)

Since gray markets are difficult to track, they can have significant effects on companies’ marketing strategies and their profit performance.(13) Forecasting sales becomes difficult, as do merchandising activities and price setting.(14) In addition, parallel imports may decrease domestic employment as increased competition in a particular market forces authorized dealers, who often bear significant costs related to the maintenance of goodwill, to curtail employment or leave the business.

THE LAW OF GRAY MARKET

The Early Cases

As gray markets have evolved, so have the legislation and court cases defining them. Indeed, over a century ago, in 1886, the first American court case on gray markets was decided. In that case(15), the plaintiff, Appolinaris Co., Ltd., had entered an exclusive agreement to distribute a Hungarian producer’s merchandise in the United States. After that agreement was concluded, however, the defendant, Scherer, began sourcing goods bearing the same trademark from an authorized German producer and distributing them in the United States.(16)

When the plaintiff sued on the basis of trademark infringement, the court ruled in favor of the defendant, arguing that because the products were genuine and were legitimately marked, no infringement had occurred. In rendering this judgment, the court established the doctrine of universality, under which trademarks were viewed merely as an indication of origin, not of established goodwill or other intangibles. This doctrine remained the guiding principle in gray market cases for forty years, until the United States Supreme Court adjudicated A. Bourjois v. Katzel.(17)

In that case, the facts were similar to those in the Appolinaris case. A French manufacturer sold its face powder business and trademark in the United States to the Bourjois Company. Since exchange rates favored importation to the United States at the time — the dollar had gained strength against the franc — Katzel, an independent distributor, purchased the same face powder directly from the French manufacturer and began selling it in packages similar to those used by the United States trademark owner.

Like the Appolinaris Company, the Bourjois Company sued Katzel on the basis of trademark infringement, alleging that significant resources had been expended to develop goodwill. Expressing the unanimous decision of the Court to enjoin the parallel imports, Justice Holmes asserted that the powder “was sold and could only be sold with the goodwill of the business that the plaintiff bought.”(18) In rendering this decision, the Court implicitly replaced the doctrine of universality with that of territoriality, which recognizes that a trademark is not only a designator of product origin but also the embodiment of the goodwill developed by the owner. This doctrine is still recognized and has been extended to the realm of international trade.(19)

Section 526 and Customs Cases

The Katzel case is significant not only because it resulted in the establishment of the doctrine of territoriality, but also because it led to the enactment of legislation prominent in the regulation of gray markets. One such piece of legislation is Section 526 of the Tariff Act of 1930(20), which explicitly forbids the importation of goods of foreign manufacture bearing an American company’s trademark without the trademark owner’s permission. Despite the apparent stringency of this legislation, its effectiveness in curbing parallel imports is limited by the United States Customs Service’s implementing regulations.(21)

Evidently concerned about the potential for monopolistic manipulation of Section 526, Customs has established an Affiliation Exception.(22) As expressed in section 133.21 of Customs’ importation regulations, the restrictions set forth do not apply when the foreign and domestictrademark or trade name owners are parent and subsidiary companies

or are otherwise subject to common control …. (23) This regulation is based on the premise that a company can not infringe its own trademark,(24) and may be viewed as a tool for preventing multinational companies from engaging in monopolistic price discrimination.

The 1987 case, NEC Electronics v. CAL Circuit ABCO(25), exemplifies this point. In that case, NEC Electronics (USA), a wholly owned subsidiary of the NEC Corporation (Japan), sued CAL Circuit ABCO for purchasing computer chips in Japan and selling them in the United States at prices substantially lower than those charged U.S. customers by NEC Electronics. Arguing that NEC Electronics and the NEC Corporation were “commonly controlled” (because a majority of the directors from the former were also directors of the latter), the court ruled that the right to control the goods was “exhausted” after they were first sold — whether in Japan, by the NEC Corporation, or in the United States, by NEC Electronics. In justifying the decision, the court stated, in part:

If NEC-Japan chooses to sell abroad at lower prices than those it could obtain for the identical product here, that is its business. In doing so, however, it cannot look to United States trademark law to insulate the American market or to vitiate the effects of international trade. This country’s trademark law does not offer NEC-Japan a vehicle for establishing a worldwide discriminatory pricing scheme simply through the expedient of setting up an American subsidiary with nominal title to its mark.(26)

In addition to the Affiliation Exception, U.S. Customs has specified two other exceptional cases in Section 133.21. One case is the Authorized Use Exception, which permits goods manufactured abroad bearing a trademark applied with the American owner’s permission to enter the United States.(27) A second exception is made when both the foreign and United States trademark are owned by the same enterprise.(28)

The United States Supreme Court decision in K-mart Corp. v. Cartier, Inc.(29) generally supports these exceptions to Section 526. This decision is noteworthy because the basic issue was Customs’ interpretation of the Tariff Act of 1930. That is, the plaintiffs, the Coalition to Preserve the Integrity of Trademarks (or COPIAT) and others, made the statutory construction argument that Customs’ regulations were not consistent with the legislative intent expressed in Section 526. The Court disagreed, distinguishing three types of gray market imports, which it called cases.(30)

Case one involves unrelated purchases, such as those that occur when an American firm buys a foreign manufacturer’s trademark and distribution rights for use in the U.S. market. If, as in the Katzel case discussed previously, a third party also tries to import the same goods, Customs will strictly enforce Section 526, and the goods will be barred. The doctrine of territoriality is the rational for this decision.(31)

In case two, the American company shares an affiliate relationship with the foreign firm that owns the trademark. As demonstrated by the NEC case discussed earlier, the United States affiliate is also considered an owner of the same trademark. That is, the trademark is said to be under “common control.” Consequently, if an independent third party purchases goods in the country where the parent firm operates and exports them to the United States, the goods will be admitted by Customs.(32)

The Authorized Use Exception is the third case distinguished by the Court. As noted above, Customs’ interpretation of Section 526 has allowed goods manufactured in foreign locations with the American mark owner’s permission to enter the United States, even if the American firm had intended for the goods to be sold outside the United States. Disagreeing with Customs regarding this practice, the Court reasoned that the language of Section 526 was clear and unambiguous on this point: allowing such goods to enter the United States was not consistent with the intent of this legislation. Thus, such imports are now barred.(33)

Application of Trademark Law in Gray Market Cases

As the court decisions discussed above indicate, plaintiffs often sue on the basis of trademark infringement in an effort to enjoin parallel imports. The criteria by which such suits are adjudicated are delineated in sections 32 and 43(a) of the Lanham Act.(34) Section 32 protects companies from parties attempting to use a mark that is a reproduction, counterfeit, copy or colorable imitation of the company’s registered trademark and is likely to deceive or cause confusion or mistake. Section 43(a), in contrast, focuses on the product itself.

According to this section, which specifies a “false designation of origin exception,” a gray market product may be banned if it differs substantively from the trademark owner’s. Thus, the owner of a United States trademark may be able to halt gray market imports of nearly identical goods, provided that the owner can show that the imports differ substantively such that they are not associated with the goodwill created by the American trademark owner.(35)

In evaluating cases under the Lanham Act, the courts typically draw on the notion of equivalence. That is, they ask “Are parallel imports truly equivalent to those distributed by the trademark owner?” In Original Appalachian Artworks, Inc. v. Granada Electronics, Inc.(36) (Appalachian), for example, the court had to decide whether Cabbage Patch dolls produced abroad under a restrictive license were equivalent to those produced in the United States. To do so, the court carefully examined various issues, such as the fact that customers do not merely buy their dolls, but actually adopt them by completing the certificate that accompanies the product. Moreover, owners receive a birthday card for their dolls a year after the adoption date. Since the adoption papers for the gray market dolls were in Spanish, these dimensions of the product could not be furnished, the court argued, ruling in favor of Appalachian Artworks, Inc.

Other Laws Used to Combat Gray Markets

Though the Tariff Act of 1930 (specifically Section 526) and the Lanham Act are the major pieces of legislation affecting gray markets, other laws apply.(37) Copyright infringement, for example, may be a more viable option to prevent gray marketing if it appears likely that the plaintiff will be unable to prove that the likelihood of confusion is sufficiently high to warrant a ruling of trademark infringement. As in the case of trademarked goods, copyright law (specifically, section 106(3) of the Copyright Act(38)) reserves for the owner of the right control of the first public distribution of the work. Moreover, even if the product itself is not under copyright, if a part of it, such as the label or instructions, is under copyright, action may still be possible.

In the case where copyright infringement is not a viable option, trademark dilution may be. Although “likelihood of confusion” has become a prerequisite to recovery under trademark law (the Lanham Act), action may be possible on grounds of trademark dilution even if there is no competition or likelihood of confusion. In cases where a trademark functions not as a source of goods valued by the consumer, but as a source of value itself, a remedy for injury may be justified.

In more unusual cases, fraud theory may be used to stymie gray marketers. For instance, in Johnson & Johnson Products, Inc. v. DAL International Trading Co.(39), the plaintiff alleged that it was fraudulently induced to sell goods to the defendant, who promised to distribute them only in Poland, but later resold some of them in the United States.

PERSPECTIVES ON GRAY MARKET MANAGEMENT

This section seeks to assess the effectiveness of the various approaches to combatting gray markets, drawing on both legal and strategic perspectives. Neither perspective alone is satisfactory, although both views offer insights that can and will be integrated into an overall theory.

Legal Views

The current scholarly legal literature suggests a state of confusion and controversy.(40) Some commentators urge that policy should be shaped around the assumption that market forces and free trade will best serve the common good. For example, one view argues that Congress should completely repeal Section 526 of the Tariff Act and replace it with a labeling law that would notify customers of the differences between the domestic trademarked good and its graymarket cousin.(41) The United States government’s commitment to free trade is cited as a primary rational for this recommendation.(42) Another asserts that “the bottom line [in deciding between a thorough redrafting of section 526 or an affirmation of section 133.212 should not be a question of administrative interpretation but of increased competition and consumer satisfaction.”(43) This view assumes that the forces of supply and demand will result in the lowest prices to consumers.

Other legal scholars concentrate on the inadequacy of the Lanham Act and Section 526. One view recommends that Congress re-examine Section 526 and consider factors other than the relationship between enterprises involved in gray market transactions, as the California Gray Market Goods Act(44) does. Under this act, a retailer of graymarket goods must post a conspicuous label disclosing matters such as the applicability of the manufacturer’s warranty, the absence of English instructions, and non-conformity to United States product standards, such as different broadcast frequencies for communications equipment.(45)

Yet another perspective on gray market regulation argues for an interpretation of the Lanham Act to require the plaintiff to demonstrate a material difference in the goods before gray market sales will be enjoined.(46) This suggestion is based on the opinion that the courts have generally been too hasty in barring sales of gray market goods. The application of a material-difference rule would protect both trademark owners and consumers, while simultaneously preserving the benefits of free competition conferred by gray markets.(47)

Despite their many differences, these authors’ recommendations share a common deficiency: they all assume that the United States should maintain its commitment to free markets and free trade. The emergence of the European Community, whose member countries trade freely only with one another, challenges this perception of desirable trade policy. It is unlikely that gray market goods will enter the European Community to any extent, even though member countries will continue to have free access to the American market. Japan poses a similar challenge. Historically closed to free trade,(48) Japan appears to be opening in response to external pressure. Nevertheless, it is unlikely that gray markets will proliferate due to the manner in which industry is organized and business is transacted.

Many American legal scholars fail to consider the interaction of various laws and the need for greater cooperation between the Customs Service, Congress, the courts, and industry. The recent experience of Sushi Boy in Japan is a didactic example. When the California-based company initially began exporting sushi to the Japanese market, it confronted trade officials who tried to ban it based on rice content. These officials argued that because Japan has a ban on rice imports, and the exported sushi contains rice, it could not enter the Japanese market. Later, when the Japanese courts were pressured into allowing the sushi to enter, Sushi Boy discovered to its chagrin that its products were left languishing in cold storage as the Farm Ministry decided what to do with them.(49)

Reactive Strategic Responses to Gray Markets

In contrast to the legal perspective, which attempts to balance both corporate and consumer concerns, the strategic perspective focuses exclusively on the corporation. Managers examine how gray markets erode corporate profits and attempt to devise strategies for curbing these markets.(50) This section describes some of those strategies, such as pricing products destined for international markets in dollars.

By pricing in dollars, companies effectively eliminate price differentials, a common cause of gray markets mentioned earlier. For example, if a traveler from the United States were flying to Mexico, he would save money by purchasing his return ticket in Mexico using pesos. As the peso is likely to have depreciated during the traveler’s stay while the peso price of a ticket remains temporarily unadjusted, he will spend fewer dollars to return to America. Pricing the ticket in dollars regardless of where it is bought would greatly reduce the incentive for gray market activities.(51)

Alternatively, the airline could cut dollar prices to offset the effects of the peso depreciation. Indeed, aggressive price cutting is a common strategy for combatting gray marketers.(52) But it is a risky strategy as well, for customers may perceive the price reduction as permanent if it persists, and gray market broker may claim that the price reduction was implemented to eliminate competitors.(53)

Unlike price cutting and pricing in dollars, both strategies aimed at eliminating gray market activities, participation in the market is a coping strategy. In a participation strategy, for example, U.S. dealers avoid dilution of their U.S. market shares by selectively offering discounts to match gray market prices when selling to important customers, while simultaneously charging the usual price to other customers. This policy can preserve profit margins, but may be viewed as an endorsement of the quality of gray market goods if consistently applied. Consequently, participation should be used only as an expedient, until more effective strategies can be devised.(54)

One such strategy is termination of authorized distributors who participate in or contribute to gray markets. Frequently, implementation of this strategy requires systems for identifying goods sourced from these markets. The identification problem is illustrated by the experience of Lotus Development Corporation. Lotus spent $10,000 on a system to label products and monitor sales that involved purchasing Lotus software from unauthorized dealers. Lotus then eliminated the authorized dealers from whom the gray market distributors were purchasing.(55) Recently, this strategy has been reinforced by the Supreme Court’s validation of the Colgate doctrine, under which corporations may announce sales terms in advance and terminate dealers who do not abide by them.(56)

Proactive Strategic Responses to Gray Markets

Though dealer termination may effectively curb gray market sales, it is reactive in nature. Because reactive measures may conflict with long-term strategic objectives, firms should consider proactive strategies.(57) These strategies are aimed at preempting the development of gray markets, rather than merely treating the symptoms of the problem. Consequently, they are part of the corporation’s long-term planning process.

As part of this process, the corporation should devise plans for differentiating its products and services. By segmenting international markets carefully and custom designing products and services for each segment, the firm will likely be able to stymie the gray marketer sourcing from other market segments. As these products will not embody the same features or offer the same services as the product custom-designed for the segment, customers may be reluctant to buy.(58) Moreover, such product differentiation increases the likelihood that a trademark-infringement suit will succeed.

To determine whether such a differentiation strategy is succeeding, timely information is vital. Yet it appears that many corporations do not collect information well. For example, commenting about their research on distribution channels, several business scholars have noted: “[M]anagers were often woefully uninformed about the magnitude or channel dynamics of gray markets for their goods.”(59) These same scholars also remark that traditional sources of market information such as salespeople and distributors may be unreliable. Therefore, the company must carefully devise information systems to acquire necessary data on gray markets.

The most common means of acquiring these data is through the use of warranty registration cards. By secretly encoding these cards to identify the original distributor, companies can identify the source of gray market goods and take remedial action, such as termination.(60) Companies also can adjust prices to impede the development of gray markets. Though manufacturers’ volume discounts help ensure that minimum efficient scales of production can be achieved and maintained, indiscriminately offering discounts on broad ranges of volumes provides an open invitation to gray marketers. To stymie these would-be profiteers, manufacturers should not base prices on production costs — a practice that typically results in the setting of broad volume ranges for discounts — but should, instead, closely tie unit prices to order volumes.(61)

Finally, companies should strongly consider lobbying for legislative and judicial changes. As indicated earlier, the U.S. Customs Service’s interpretation of major gray market laws is excessively lenient, and the recent Supreme Court ruling, K mart Corp. v. Cartier, Inc., has affirmed them.(62) More importantly, gray market legislation is unrealistic: it is based on a view of free trade that does not reflect current conditions in world markets. Indeed, current administrative interpretation of gray market and related antitrust laws exposes American corporations to pressures that foreign companies do not face as a result of their policies and market structures.

THE AMERICAN GRAY MARKET CONTROVERSY IN GLOBAL PERSPECTIVE

American firms operate in an era of restricted trade and monopolistic markets. The Japanese government, for example, has actively intervened in key industries, restricting imports and thwarting foreign competitors. This country does not practice free trade, but a form of neo-mercantilism that has resulted in some of the most monopolistic industries in the world. The European Community is less likely to be as monopolistic as Japan, but still does not wholeheartedly embrace the notion of free trade.

The United States of Europe

When the formation of the European Community (EC) is complete, Europe will behave like a protectionistic United States, encouraging pan-European trade but restricting trade with other nations.(63) Thus, while American firms will continue to confront gray market competition from European affiliates and licensees, gray-market goods from the United States and other markets will be taxed to the point that they are no longer competitive. In this respect, gray market goods confront the same obstacles as goods passing through authorized channels and portend a future of increased trade friction.

This friction is likely to characterize extra-EC trade only, however. Within the EC, trade relations among countries are likely to become increasingly amicable over time, driven by the harmonization of trade-related regulations and a Community-wide currency. These factors account for the fact that gray markets are not problematic in the American economy. The existence of a common currency, in which all products are priced, eliminates price differentials that are a frequent cause of gray market activities. Thus, when the ECU (European Currency Unit) becomes widely used in the Community, gray market activities are likely to wane. Moreover, the harmonization of commercial laws and the removal of non-tariff barriers within the Community will result in a trade environment similar to that faced by American states, where federal constitutional principles, augmented by uniform trade law, provide a level playing field for domestic interstate trade.

Within a free trade zone, such as the United States or the emerging EC, no company enjoys an unfair advantage over another in profiting from gray markets by virtue of its state of residence. In contrast, for example, if state A were able to erect formidable trade barriers while state B maintained a relatively open market, state A would be in a better position to profit from gray-market activities. Firms in state A could easily return-ship goods purchased at a volume discount back to high-margin state B or transship from a third state. But state B firms may not be able to return ship or transship goods to state A to profit from higher prices due to state A’s non-tariff barriers. American law impedes the development of such inequitable trade opportunities and, in the EC, the harmonization of trade regulations, along with tax harmonization and Community-wide subsidy leveling, will undoubtedly have the same effect.

Currently, however, gray markets are a problem in Europe.(64) The extreme case of the European pharmaceutical industry, in which gray-market activities proliferate, verifies this statement. Over 10% of Britain’s market, for example, is supplied by parallel imports for some brands of pharmaceuticals, while the share taken by such imports is believed to be even higher in the Netherlands.(65)

The cause of these gray market activities is undoubtedly price differentials, which result from the practice of negotiating pharmaceutical prices on a country-by-country basis. In Portugal, for example, drugs are purchased at 68% of the average price for the EC, while in the Netherlands, prices are 30% greater than the average. In some cases, a particular pharmaceutical product costs ten times as much in one country as in another.(66)

Though it is becoming increasingly difficult to maintain these price differences, prices are likely to become uniform in the near future. Thus, to minimize gray-market activities and erosion of profits, “price corridors” may be used. To establish a “price corridor,” a firm 1) computes the optimal price for the product in each country separately

EC Laws Affecting Gray Markets

The EC’s objectives as a common market are “to promote throughout the Community a harmonious development of economic activities, a continuous and balanced expansion, an increase in stability, an accelerated raising of the standard of living and closer relations between the States belonging to it.”(68) As a means of achieving those goals, Community members have developed the competition policy in articles 85 and 86 of the EC Treaty.(69) Though are similar in purpose and content to United States antitrust laws, EC competition policy differs in an important respect: Article 85, which prohibits agreements that restrict trade, permits the exemption of arrangements that do not eliminate competition and which ultimately provide benefits to consumers.(70) Thus, in some instances, agreements in restraint of trade are deemed appropriate in the EC.

For example, selective distribution agreements may be acceptable in competitive markets. The Court of Justice permits manufacturers to impose restraints that allow retailers to appropriate the full value of their investments.71 Similarly, the exclusive licensing of intellectual property is permissible over a limited territory, provided such exclusivity does not severely restrain competition. This view is similar to the rule of reason applied by United States courts: if interbrand competition is likely to increase as a result of a restrictive license, the arrangement is unlikely to infringe section 1 of the Sherman Act.72

Supplementing article 85 of the EC Treaty is the Community’s New Trade Policy Instrument (73) dating from 1984. Like section 301 and the U.S. Trade Act of 1974, amended by the Omnibus Trade and Competitiveness Act of 1988,(74) the New Instrument provides a means for industries to obtain redress from unfair foreign trade practices. Under this law, a private party can file a complaint if three conditions are met. First, there must be evidence that the disputed practice transgresses international law or generally accepted rules. Second, the practice must be demonstrably harmful or threatening to a Community industry. Third, the complaining party must be acting on behalf of the threatened industry.

Ironically, despite the Community’s concern about being treated fairly by trading partners, this trading block appears unwilling to reciprocate equitable behavior. For example, the EC has been a target of numerous 301 investigations (76) and has also reinterpreted GATT provisions to increase trade at non-EC members’ expense.(77) Evidently, members of the Community are only interested in free trade with each other.

Neo-Mercantilist Japan

Japan has historically practiced a form of neo-mercantilism, which developed from early European trade practices. From the 16th until the 19th century, mercantilism was the dominant trade theory among European economic philosophers, who believed that countries should run surpluses with their trading partners. The gold received from partners to settle the deficit could then be used by the government to invest in armies and consolidate its power. Frequently, major powers like Great Britain and France exploited their colonies to achieve surpluses. Great Britain, for example, forced colonies like Sri Lanka to export primary materials and then used them to manufacture goods. The resulting goods were sold to the colonies, perpetuating an exploitative trade cycle.(78)

Neo-mercantilism is similar to traditional mercantilism in its focus on trade surpluses. In the case of neo-mercantilism, however, the goal is not gold accumulation but a particular socio-economic objective, such as economic development.(79) During its postwar development, Japan has embraced mercantilistic practices, importing raw materials and processing them into goods that are then exported. Indeed, as recently as 1985, manufactured imports accounted for only 31% of Japan’s total imports, and from 1960 until 1985, these imports represented only 2% of domestic manufacturing.(80)

Recently, United States trade with Japan has improved,(81) partially due to gray markets and other unconventional marketing channels.(82) However, it is unlikely that trade will ever be “fair” in a Western sense or that gray markets will significantly challenge Japanese companies, for two reasons. First, the structure of Japanese industry in general and distribution channels in particular will stymie gray markets. Second, Japanese strategies involve low-cost production in areas that would normally lead to competition from parallel imports. As one author expressed it, “Cartel principles are likely to dominate business in Japan for a long time to come …. [A] company that waits quietly for Japan to guarantee free trade will be waiting for a long, long time.”(83)

Distribution keiretsu exemplify this point.(84) These entities represent manufacturers’ efforts to control products, accessories and services, and prices, as goods flow from factories to consumers. By paying dealers 25% of the retail margin on sales, subsidizing advertising and inventory management, Matsushita, for example, successfully impedes interbrand competition. Toshiba, Hitachi, Sanyo, Mistubishi and Sony also maintain distribution keiretsu, which are legal in Japan and exist in a large variety of industries(85) Thus, while parallel imports of genuine goods are legal in Japan(86), they can still be effectively stymied.

More generally, lenient regulation of monopolies, cartels, and anti-competitive agreements in Japan hinders all imports, gray market products and legitimate market products alike. As one commentator notes, approximately 70% of the shares of public companies in Japan are held by “friendly” or affiliated firms due to the keiretsu structure of many Japanese industries.(87) Since the percentage of imports in domestic consumption is inversely related to the number of keiretsu firms in an industry (88), it is not difficult to understand why, competition from imported goods is not problematic for most Japanese firms.

Though Japan has had a fair trade commission since the end of World War II, neither antitrust laws nor the commission itself has been a major element in Japanese trade law.(89) Price fixing, for example, is still legal for certain cosmetics and over-the-counter drugs, and has until very recently also been common among breweries.(90) Furthermore, fines for anti-competitive behavior are paltry compared to those levied in the United States, no doubt because the cartel-rife construction industry is a generous contributor to the Liberal Democratic Party that rules Japan.(91) Though some progress is being made with respect to the regulation of trust activities(92), the keiretsu system appears permanent.(93)

Extending this system abroad, Japanese investment strategy strives to eliminate price differentials, a major cause of gray market activity. Rather than license independent manufacturers in cheap-labor countries, who may export the trade-marked goods back to Japan, Japanese firms invest directly in newly industrialized Asian countries. Industries involved in such investment include consumer electronics and watches.(94) These investments not only explain why figures on growing manufactured imports by Japan are misleadingly optimistic, but also provide another means of restricting gray markets.

The North American Free-trade Agreement

Like the EC, the United States, Canada and Mexico appear to be moving toward the creation of a common market through trilateral negotiations. These negotiations are intended to create a North American Free Trade Area (95)

Moreover, unlike many EC nations, whose trade relations have historically been antagonistic, United States-Canadian relations have been relatively friendly. Thus, these two nations’ recent free-trade agreement is likely to succeed. The case of Mexico, though more difficult due to this nation’s comparatively low economic development(97), is also promising. If the United States and Canada nurture the Mexican economy, a North American Common Market may result.(98) Indeed, because of the United States’ experience with interstate trade, and the small number of nations involved, “integration” is likely to be a much less painful process than it currently is for members of the EC.

To achieve such integration, the United States, Mexico and Canada must first conclude a free trade agreement that will simultaneously (1) preserve the FTA already concluded with Canada, (2) provide for a trilateral FTA ensuring market access, and (3) articulate provisions to which other countries could be bound in the future, among other things.(99) The resulting free-trade area would have the largest GDP in the world. In 1990, for example, Canada, Mexico and the United States’ aggregate GDP was $6.2 trillion, which is over $220 billion greater than that of the EC.(100) Since the U.S. economy is approximately ten times as large as Canada’s and roughly twenty-two times that of Mexico, the United States will exert a dominant influence on these trading partners.(101)

A POLICY PRESCRIPTION

Gray market goods continue to flood American ports, and strategic efforts by corporations to stem the tide have been disappointing.(102) This situation is the consequence not only of the inappropriate enforcement of gray market laws, but also of a general approach to trade and industrial regulation that forces American firms to compete against foreign rivals on unfair terms. American firms must tolerate the Japanese keiretsu’s restraint of gray market good in Japan, and face the EC’s efforts to erect external trade barriers against “authorized” and gray market imports alike. America, in the meantime, continues to embrace free-trade principles.

The days of free trade, however, are over. If the United States is to remain competitive, the government must heed this message of parallel imports. In anticipation of the EC’s expected course of action, for example, the United States government should develop all of North America as a common market. Such a market would increase U.S. policy makers’ bargaining power with the EC and Japan and would also serve as a buffer against adverse trade actions they might take.

In addition, the United States government also should consider antitrust and trade law policies that are pro-competitive rather than pro-competition. Trade policy should nurture important national industries until they are developed, even if doing so requires the restriction of foreign competition or vigorous action against imports. The pro-competition policy traditionally espoused by the United States has geared its laws and trade infrastructure to the creation of a maximally competitive environment, under the erroneous assumption that such competition benefits the nation.

To end competition from parallel imports in the American market, U.S. policy makers must work more closely with industry, as in Japan. Cooperatively, both parties must define industries and technologies of the future, devising specific plans for nurturing them. In this context, trade laws, antitrust legislation and administrative agencies would be tools for the achievement of trade competitiveness, which is the appropriate superordinate goal.

It is instructive to compare the United States and Japanese economies one last time, with specific reference to the computer industry. In the late 1950s, the Japanese Ministry of International Trade and Industry (MITI) identified the computer industry as a pillar of future competitiveness. It imposed tariffs and arbitrary regulations to restrict imports and foreign investments and forced IBM to license its technology cheaply in exchange for permission to produce in Japan. MITI also allocated large sums of money among firms for research and development, tying the allocation to performance. If a company failed to commercialize products or became complacent, both funding and the opportunity to participate in government-sponsored projects were revoked.(103)

The Japanese computer industry and its many sister industries have developed into world leaders as a result of such pro-competitiveness policies, which are unmistakably protectionistic. Yet the protectionist measures taken are intended to achieve the goal of increased competitiveness and do not preclude healthy levels of competition. Domestic firms in Japan compete with each other ruthlessly,(104) even as they cooperate with the government to eliminate foreign firms. A firm that exhibits signs of complacency is exposed to the discipline of market forces.

In 1987 American policy makers permitted the formation of the Semiconductor Manufacturing Technology (Sematech) consortium.(105) Comprised initially of fourteen American electronics companies who provide 50% of the consortium’s funding, Sematech is intended to restore American industry’s competitiveness in manufacturing the equipment used to make integrated circuits.(106) Though this consortium is still relatively young, it has already achieved “impressive results in a short time” according to the market-research firm Dataquest.(107) Among these results are the construction of a world-class facility in record time, and the recent introduction of Microscan II, a device which promises to surpass the current chip-printing ability of Japanese machinery. Most important, however, the Sematech consortium has demonstrated symbolically that American companies, like their Japanese counterparts, can both cooperate and compete simultaneously.(108),

Despite this accomplishment, American firms’ cooperation is still not driven by superordinate goals conceived in conjunction with and supported by policy makers. Thus, laws often are inappropriate and do not advance these goals. And where they do advance appropriate goals, administrative interpretation may reduce their effectiveness, as the experience with gray market policy suggests.

Adding to this problem is the belief that protectionism and monopoly are antithetical to increased competitiveness. Unlike the Japanese government, the United States government protects industries only after they become uncompetitive.(109) Such a policy implicitly rewards complacency. Thus, unlike in Japan, where the higher current prices resulting from protectionism are more than offset by future increases in national income and international purchasing power, higher prices for American goods merely perpetuate corporate inefficiency.

The best approach to the gray market problem is not protectionistic legislation

As a starting point, agreements among competitors to fix prices horizontally and restraint prices vertically should be subject to case-by-case analysis, and considered illegal per se. If they are the only viable means of effectively controlling gray market activities or are deemed necessary to combat formidable cartels, price fixing and vertical price restraints should be sanctioned on a limited basis.

The courts should also broaden their view of market power in evaluating firms’ activities. Currently, firms that possess 70% or more of the relevant market are regarded as having monopoly power under Section 2 of the Sherman Act and may be prosecuted if they use this power unlawfully.(111) In today’s global market place, such a definition of market power is unrealistic. An American firm with a large U.S. market share may have a paltry global market share or may have only limited access to important markets like Japan. Thus, this firm’s monopoly power will be limited with respect to the foreign competitors that freely access the U.S. market from a protected domestic market.

American antitrust law may be useful in opening the Japanese market and challenging keiretsu.(112) Under the Foreign Trade Antitrust Improvement Act of 1982,(113) a foreign firm’s offshore activities may be actionable under U.S. antitrust law if the firm operates a subsidiary or affiliate in the United States. Suspect activities include those in foreign markets that hinder U.S. export opportunities and those that reduce output or raise prices in the American market.(114) Use of this law to challenge unfair competitive threats would create an environment more conducive to the management of gray markets. Then the survival of firms will depend not on costly protectionism, but on demonstrated strategic prowess.

CONCLUSION

This article has taken a comparative approach to identifying means of managing gray-market imports. By examining emerging competition law in the EC and reviewing Japan’s historical trade behavior and industry structure, it has sought to draw a holistic picture of gray markets, from which two general policy recommendations emerge. First, the United States government should continue to strengthen ties with Canada and Mexico and ultimately form a common market with them. Second, American courts should fundamentally reconsider laws that restrict American companies’ ability to compete against foreign firms. In so doing, policy makers must shift orientation from a pro-competition to a pro-competitive posture, which paradoxically implies more lenient treatment of American firms’ “anti-competitive” behavior. Though perhaps antithetical to the idealistic notions of equitable competition synonymous with the American market, this option is the only realistic one. The sooner policy makers wake up to this new reality, the better. (1) Frank V. Cespedes et al., Gray Markets: Causes and Cures, 66 Harv. Bus. Rev. 75 (July-Aug. 1988). (2) See discussion infra part IV.A. for a summary of the relevant legal literature. See S. Tamer Cavusgil and Ed Sikora, How Multinationals Can Counter Gray Market Imports, 23 Colum. J. World Bus. 75 (Winter 1988)