As the Wall Street Journal is already reporting, today eBay sustained an important win in its long-running dispute with Tiffany over counterfeit goods sold through its marketplace.  (The full opinion is available here.)

I wrote about this case as my leading example of the legal problems that appear at the border between physical life and digital life, both in “The Laws of Disruption” and a 2008 article for CIO Insight.

To avoid burying the lede, here’s the key point:  for an online marketplace to operate, the burden has to be on manufacturers to police their brands, not the market operator.  Any other decision, regardless of what the law says or does not say, would effectively mean the end of eBay and sites like it.

Back to the beginning.  Tiffany sued eBay over counterfeit Tiffany goods being sold by some eBay merchants.  The luxury goods manufacturer claimed eBay was “contributorily” liable for trademark infringement—that is, for confusing consumers into thinking that non-Tiffany goods were in fact made by Tiffany.

The problem of counterfeit items has been a long-standing problem for electronic commerce, and as one of the largest and first online marketplaces it’s little surprise that eBay has found itself so often in the cross-hairs of unhappy manufacturers.  While the company has generally won these lawsuits, it lost an important case in France at about the same time the trial court in the Tiffany case ruled it its favor in 2008.

(A related problem that was explicit in the French case is that luxury goods manufacturers are unhappy in general with secondary markets given the tight—sometimes illegal—control they exert over primary channels.  Electronic commerce doesn’t respect local territories, fixed pricing and regulating discounting, perhaps the bigger headache for companies such as Tiffany’s.)

The struggle for courts is to apply traditional law to new forms of behavior.  Many of the opinions in these cases tie themselves in knots trying to figure out just what eBay actually is—is it a department store, where a variety of goods from different manufacturers are sold?  Is it a flea market, where merchants pay for space to sell whatever they want?  Or is it a bulletin board at a local grocery store, where individuals offer products and services?

Of course eBay is none of these things.  But courts must apply the law they have, and the case law for trademark infringement is based on these kinds of outdated classifications.  In the “common law” tradition, judges decide cases by analogy to existing case laws.  That means when there isn’t a good analogy to be found, the law is often thrown into confusion for a long period of time while new analogies get worked out.  Disruptive technologies create such discontinuities in the law, particularly for common law.

At the heart of these decisions is a question of control.  The more the marketplace operator controls the goods that are sold, the more likely they will be found liable for all manner of commercial misconduct.  (Tiffany also sued for false advertising, for example, claiming that eBay ads placed on Google searches promising Tiffany goods at low prices on its site were false, given that some of the goods were counterfeit.  Of course some of the goods were NOT counterfeit.)

A department store operator has complete control over the source of merchandise, and so would be held liable for selling counterfeits.  A bulletin board host has no control, and so would not be held liable.  Flea market operators sit somewhere in between, and depending on the extent and obviousness of the counterfeiting that takes place, operators are sometimes held liable along with the counterfeiters themselves.

The eBay marketplace sits somewhere between the two extremes.  On the one hand, eBay can and does have the ability to review the text of listings prior to their posting, and provides extensive service to merchants including listing services, postage and packaging, and payment management through PayPal.  It can and does respond to complaints by buyers of misrepresented goods (condition and source, e.g.) and by trademark holders who are given extensive tools to review listings to check for counterfeits.  And it charges the sellers for these services—indeed, that is the source of its revenue.

On the other hand, eBay never has physical possession of the goods that are sold through its marketplace—indeed, it never sees them.  That’s an essential feature of the company’s success—eBay couldn’t handle millions of listings in a limitless range of categories if merchants actually sent the goods to eBay during the course of an auction, the way high-end auctioneers such as Sotheby’s and Christie’s would do.

EBay (or buyers for that matter) can’t inspect the goods (other than through photos and text descriptions) prior to purchase, and even if it could the company doesn’t have the expertise to evaluate authenticity and condition of everything from buttons to Rolex watches to cars.  That’s why eBay’s buyer feedback system is so important to the efficient operation of the marketplace.

In today’s decision, the Second Circuit Court of Appeals in New York mostly affirmed the trial court’s holdings.  It agreed that for eBay to be liable for the trademark infringements of its misbehaving sellers, the company had to have actual knowledge of their activities and still continue doing business with them.

There was substantial evidence to the contrary—including direct policing by eBay as well as the tools provided to manufacturers to review and flag suspicious listings.  As the court noted, eBay has plenty of incentives to ensure counterfeit goods stay off the site—for unhappy buyers mean the loss of liquidity and the loss of any competitive advantage.

Tiffany objected to the fact that the eBay tools put the burden on trademark holders rather than marketplace operators to ensure the authenticity of the goods.  But the court agreed with eBay that such is indeed the burden of a trademark, a valuable and exclusive right given to manufacturers to encourage the creation of consistent and quality goods and services.  Since eBay acted on actual knowledge of infringement and could not be said to have willfully ignored the illegal behavior of some merchants, the company had fulfilled its legal obligation to trademark holders.

The opinion is, as to be expected, largely a discussion of legal precedent and the law of trademark.  That, after all, is the role of an appellate court—not to retry the case, but to review the trial judge’s findings in search of legal error.  The decision by the appellate court will serve as a powerful precedent for eBay and other e-commerce sites in the future.  (Tiffany says it may appeal to the U.S. Supreme Court, but it’s unlikely for many reasons that the Court would take the case.)

One important feature of the case that is not discussed directly in the appellate decision, however, is worth highlighting.  Though courts rarely say so explicitly, an important factor in deciding cases has to do with the practical limits of the remedy requested by a plaintiff, in this case Tiffany’s.  Given what eBay already does to police counterfeit goods, it’s hard to see what Tiffany’s actually wanted the company to do—that is, what it wanted the courts to order eBay to do had it won the lawsuit.

For aside from money damages, the purpose of a lawsuit and the reason the taxpayers fund the legal system is that court decisions let everyone know what behaviors are acceptable and which are not–and how to correct those that are not.  Had eBay lost, they would have had to pay damages, but more to the point the loss would have sent a message to them and others to change their behavior to avoid future damage claims.

So would would a loss have signaled?  In essence, eBay would have had either to agree not to sell any Tiffany goods (a limit other brands would have demanded as well) or to verify and authenticate all items before allowing them to be listed on the site.  That would have been the only way to satisfy Tiffany’s that their view of the law was being followed.

That remedy, though theoretically possible, would have meant the end of eBay and sites like it (including Amazon Marketplace).  It would in essence have said that any auction or other third-party sales model other than the high-end Sotheby’s or Christie’s approach is inherently illegal.  For there would have been nothing left to distinguish eBay’s low-cost approach to buying and selling—all of the efficiencies would have been eaten up by the need to authenticate before the auction began.

Such a remedy would have been economically inefficient—it would, to use Ronald Coase’s terminology, have introduced a great deal of unnecessary transaction costs.  For most of the items on eBay are accurately described, and for them the cost of authentication would be a waste.  eBay practices in essence a post-auction model of authentication.  If the buyer doesn’t agree with the description of the item once they receive it, eBay will correct the problem after the fact.

That’s much more efficient, but it does introduce cost to brand holders such as Tiffany’s.  A buyer who gets a counterfeit good may think less not only of the seller and of eBay but also of Tiffany’s.  Worse, the buyer who doesn’t realize they’ve received a counterfeit good may attribute its poorer quality to Tiffany’s, another form of damage to the mark.

The court’s decision implicitly weighs these costs and concludes that eBay’s model is, overall, the more efficient use of resources.  The brand owner can always sue the eBay sellers directly, of course, and can use the tools provided by eBay to reduce the number of bad listings that get posted in the first place.  Those enforcement costs, the court implies, are less than the authentication costs of Tiffany’s proposed remedy.  Faced with two possible outcomes, the court chose the more economically efficient.

Under the “law and economics” approach to legal decision-making, that finding would have been made explicit.  Some appellate judges, including Richard Posner and Frank Easterbrook, would have actually done the math as best they could from the record.

In any case, the finding seems economically sound.  Meanwhile, the law is still struggling mightily to catch up to reality.