Taming the Five-Ton Elephant

The series of articles on private labeling that appeared in Electrical Wholesaling over the past few months alerted electrical distributors to the risks and benefits of private labeling. In our research for these articles, electrical distributors, end users and electrical manufacturers voiced their concerns about this risk. This article highlights the legal issues related to private labeling so an electrical distributor can make a more an educated decision prior to engaging in private labeling. It's not intended to give specific legal advice, and instead is intended to highlight general legal issues that may affect the decision to private label.

An electrical distributor considering private labeling has three categories of legal stakeholders to consider: the manufacturer of its private-labeled products; purchasers and end users of the products; and the general public and government. A prudent electrical distributor will take the legal actions necessary to reduce or eliminate its legal risk to each stakeholder category. The legal risks of most concern to electrical distributors include:

• Product liability for injury or property damage allegedly caused by a defective product.

• Liability for patent or trademark infringement.

• Liability for counterfeiting.

Product liability is a major business concern. According to insurance consulting firm Tillinghast in a recent Fortune article, the 49,743 product liability lawsuits filed in 2006 cost businesses (and their insurance companies) $261 billion. The issue is of great concern in the electrical industry. Surveys conducted by Allen Ray Associates, Kennedale, Texas, and Channel Marketing Group, Raleigh, N.C., consistently show the risk of product liability lawsuits is one of the main concerns of distributors contemplating private labeling.

Product liability is a legal action based on an allegedly defective product. Under current law in virtually every state, an injured party can bring a lawsuit against any corporation in the “chain of distribution” of the product, from the original manufacturer to the retailer and every party in between. It doesn't matter that a distributor may have obtained a product in a sealed box and sold it in a sealed box; that company is potentially liable to the injured party (the “plaintiff”) based on the legal doctrines of product liability.

Over the years, the doctrine has been modified and altered by the courts and legislatures. For example, the Texas legislature passed a statute requiring manufacturers to defend distributors sued in product liability actions unless the manufacturer can prove the distributor altered the product in a way that caused harm to the plaintiff. Other states have adopted similar measures, most less sweeping than the Texas law.

The key element in a plaintiff's claims against the distributor, manufacturer, retailer or other company is the concept of “product identification.” The plaintiff must be able to allege the product that caused harm was manufactured, distributed and sold by the defendants. Keep in mind that the standard for making an allegation in a lawsuit is very low. If the slightest possibility exists that the distributor defendant may have distributed the particular product, that's usually enough to allow for the filing of a lawsuit. If a distributor is identified based on company sales receipts to the end-user, it may not matter that the customer was also buying similar or even identical product from other unnamed distributors.

In a recent contractor survey conducted by Allen Ray Associates and Channel Marketing Group, 11 percent of respondents have faced product-liability issues for products they have installed. Over 70 percent of the time, these cases included a distributor. Respondents said they determined which distributor sold them the product through invoices, purchase orders, the name on a product, knowledge of purchasing history and delivery receipts. In essence, alleging distributor involvement can be a low hurdle. The concept behind this broad-based liability is that the plaintiff should not have to sort out who was at fault in manufacturing, designing, selling or (potentially) altering the product. That should be left to the defendants to determine amongst themselves through agreement or through a legal procedure to shift the costs to the appropriate party. In 90 percent of the cases, the plaintiff's main claim is that the design of the product itself is defective and, as a result, the manufacturer (who designed the product) should bear the burden of proving that the product design was not defective.

When most manufacturing was done in the United States, the plaintiff would typically sue every participant in the chain of distribution and the U.S. manufacturer would then assume the defense for all downstream parties. This arrangement might take place after the suit was filed by agreement of the defendants or it might take place before any claim was made if the manufacturer agreed to include the distributor as an “Additional Insured” on the manufacturer's product liability insurance policy.

When a manufacturer is offshore or bankrupt, however, things are complicated. If an offshore manufacturer has no U.S. operations, it may not be subject to suit in the United States. Manufacturers based in China or India, in particular, are notoriously hard to serve with suit papers. The same result applies to bankrupt U.S. manufacturers. A bankrupt company is all but invulnerable to lawsuits.

If the offshore manufacturer or bankrupt U.S. manufacturer cannot be served with suit papers, then the plaintiff brings the claims against the viable U.S. parties, typically the distributor. Distributors have a hard time defending against defective design or manufacture claims when design and manufacturing were done by the offshore manufacturer. Things become more complicated for a private labeler (read distributor). The plaintiffs often argue that the private labeler is an “apparent manufacturer” and therefore responsible not only for the product design and manufacture but also the warnings and package instructions.

When the plaintiff makes this type of claim, then the actual manufacturer, whether based in the U.S. or offshore, may refuse to take over the defense of the private-label distributor. The manufacturer will argue that the plaintiff is making a claim directly at the private label itself, not just the product design.

Reducing the Risk of Product Liability

Contract

The best way for a private labeler to reduce the risk of product liability is to include an enforceable indemnification-and-defense provision in the private-label contract. That sounds simple but is, in practicality, fairly complicated.

First, the indemnification-and-defense provision must be enforceable. This means the manufacturer must have ongoing U.S. operations, either as a U.S.-based company or an offshore company with a U.S. subsidiary. If the U.S. subsidiary is expected to provide the product-liability defense, then it should be specifically named in the private-label contract. As previously mentioned, if the private-label product manufacturer is bankrupt or offshore with no U.S. subsidiary able to provide the defense, then the private-label distributor becomes the target defendant.

The indemnification and defense provision must provide both indemnity (payment of an adverse jury award) and defense (the costs of attorneys needed to defend the company.) This latter cost is often higher than the indemnity cost. Most indemnity-and-defense provisions in private-label contracts are not well drafted. They typically use boilerplate language that makes it too easy for a manufacturer to refuse to indemnify or defend. For example, the standard boilerplate indemnity provision does not mention defense costs. It simply provides for indemnity in the event of an adverse verdict. The distributor is left to cover its own attorney fees in a case that may drag on for years. Then, if the distributor decides it is cheaper to settle than fight, the indemnity provision does not reimburse the distributor for its settlement payment (because indemnity requires a jury award, not a settlement). Lastly, the standard boilerplate indemnity clause does not require the manufacturer to step in and defend at the start of the case. The manufacturer has the leeway to wait until it's established that the distributor did not alter the product in a way that caused harm to the plaintiff.

A properly drafted indemnification-and-defense provision allows the distributor to turn over the case to the manufacturer as soon as it's filed. Then, the distributor can let the manufacturer provide the attorneys and indemnity needed to protect the distributor.

Insurance

A second, less effective, way for a private-label distributor to limit product liability risk is to require that the manufacturer list the distributor as an “Additional Insured” on the manufacturer's product-liability insurance policy. This is a less effective method than a well-written contractual indemnity-and-defense clause for several reasons:

• Manufacturers fail to follow through with the commitment to add the distributor as an additional insured, sometimes inadvertently, other times overtly.

• The manufacturer's policy may limit or exclude the risk of product-liability lawsuits.

• The manufacturer may change insurers and not include, or forget to include, the distributor on a later policy.

• The product-liability lawsuit may allege a distributor's independent negligence and the insurer may deny coverage based on that allegation.

• The “additional insured” coverage will often be deemed excess or secondary to the distributor's (primary) product-liability coverage and, consequently, the manufacturer's insurer will refuse to provide a defense unless the distributor's carrier exhausts its policy or goes into receivership.

For a distributor offering private-label products, all of these difficulties are compounded by the possibility that the manufacturer's carrier may expressly exclude private-label product liability, especially if the manufacturer is a name-brand manufacturer.

Legal process

The third and least effective way for a private-label distributor to limit product liability risk is to make a claim for indemnity (or contribution) in court. These legal procedures only provide a distributor limited recourse against the manufacturer for some portion of an adverse jury award. They typically do not provide for reimbursement of attorneys fees. The prudent distributor will protect itself against the risk of product liability at the outset, when it negotiates with the private-label manufacturing source. After that point, it may be too late.

Liability for Patent and Trademark Infringement

Distributors offering private-label brands typically develop unique labels and trademarks for their products. In doing so, the distributor will need to insure that its planned trademark and labeling do not infringe on existing marks and needs to register its trademarks and labels with the United States Patent and Trademark Office to insure maximum protection from infringement.

Private-labeling distributors should be extremely careful, and thorough, in searching for existing trademarks and packaging. The starting point for trademark search is the United States Patent and Trademark Office's database. This database identifies registered trademarks and labeling using a standard search engine. This is not enough, however.

Just because a trademark is not listed in the United States Patent and Trademark Office database does not mean it's not being used somewhere in the country. If a business is using a trademark and has been using it for a period of time, that business may have obtained a common-law trademark. Like a common-law marriage, a common-law trademark is recognized in the law if it's in place for a reasonable period of time and if the business treats the trademark as its own.

If a distributor chooses a trademark already covered by a common-law trademark, then the distributor may be liable for trademark infringement. A distributor should conduct a full trademark search — which generally requires the assistance of a trademark attorney — to be certain that its proposed trademark does not infringe on an existing registered or unregistered trademark.

The risk of trademark infringement is substantial. If a distributor launches its private-label brand and that label is later determined to infringe on an existing trademark, then the distributor will likely have to pay damages and its marked inventory may have to be destroyed or re-labeled.

Worse yet, trademark-infringement claims typically are not covered under standard insurance policies. Once the distributor selects a trademark and begins private labeling, the company needs to insure that the private-label manufacturer does not misuse the trademark. Standard practice is to allow the private-label manufacturer a limited license to print the trademark on the distributor's products and no other products. This insures the integrity of the trademark. A distributor must also manage the risk of patent infringement. Like product-liability claims, patent-infringement claims can be brought against any party in the chain of distribution of the product. A distributor can and should insist that the manufacturer bear the risk of patent-infringement lawsuits. The best way to handle that risk is through contractual indemnity — the same way product liability risk is handled.

Product Liability & Counterfeiting

Some opponents of private labeling warn that a distributor offering private-labeled products could be liable for “counterfeiting.” Technically, this is an inaccurate criticism of private labeling. “Counterfeiting” is defined as “ the act of producing or selling a product with a sham trademark that is an intentional and calculated reproduction of the genuine trademark.” Consequently, private labeling is, by definition, not counterfeiting. Those who warn of “counterfeiting” are actually warning of patent infringement. The manufacture and sale of a product (whose design and operation of which is covered by a patent or patent application held by another company) could create the risk of patent infringement. As discussed above, a distributor must be vigilant about the patent status of the products it intends to purchase from the private-label manufacturer and should place the burden of defending patent infringement lawsuits on the shoulders of the manufacturer.

The Five-Ton Elephant of private labeling is in the room, and it won't walk away anytime soon. Any electrical distributors who want to ride this elephant must take the legal steps to ensure their rights are protected and their risks are minimized. Only by first taking these steps can private labeling be a profitable ride for an electrical distributor.

Robert Redmond is a partner in the Litigation Section at Williams Mullen, Richmond, Va., and co-chairs the firm's Complex Litigation Team. He focuses on national mass tort and product liability defense with a specialty in defending distributors. He can be reached at (804) 783-6439 or [email protected].

Allen Ray is a principal of Allen Ray Associates, Kennedale, Texas. Allen Ray Associates helps companies improve profitability through effective pricing strategies and streamlining business processes through effective e-Business utilization using customized research. Allen can be reached at (817) 704-0068 or [email protected].

David Gordon is a principal of Channel Marketing Group, Raleigh, N.C., which develops strategic planning and marketing strategies for manufacturers and distributors. He can be reached at (919) 488-8635 or [email protected].