Lenders, Don’t Get Caught With Your Pants Down: The Case for Trademark Due Diligence

A recent decision by the North Carolina Court of Appeals spotlights the risks faced by lenders who finance trademarked goods that violate third-party trademark rights, and underscores the importance of performing thorough intellectual property diligence in loan transactions.

In Variety Wholesalers, Inc. v. Prime Apparel, LLC (2011 WL 6036084), a supplier (Quick Response) sold fabric on credit to a manufacturer (Prime). Prime used the fabric to make pants for a wholesale customer (Variety). However, the pants featured a trademark (“Newport Bay”) owned by Quick Response, which had not authorized Prime to use the mark. Prime invoiced Variety for the pants, but before Variety could pay, Quick Response demanded that Variety pay Quick Response instead because Prime’s use of the Newport Bay mark was unauthorized. Variety filed an action in state court to determine whom it should pay, and deposited the amount of the payment with the court. Prime’s lender (CIT) intervened in the case, claiming that because of its perfected security interest in Prime’s accounts receivable, it was entitled to the deposited funds. Quick Response filed claims against Prime for trademark infringement and violation of North Carolina’s unfair trade practices law.

Prime failed to defend itself, and the trial court entered a default judgment in favor of Quick Response. In separate rulings, the trial court dismissed CIT’s claims and ordered that the deposited funds be paid over to Quick Response as damages. CIT appealed.

The Court of Appeals affirmed the trial court’s ruling. Its opinion contains scarce legal analysis, but the Court of Appeals seems to have adopted the trial court’s conclusion that Prime’s infringement of the Newport Bay trademark completely wiped out any interest of Prime and CIT in the pants and the proceeds from their sale to Variety. Therefore, Prime had no property that could be assigned as security to CIT, so CIT’s security interest was void.

The decision is difficult to understand based on the legal issues presented, but may reflect the court’s desire for a fair result based on the unusual facts of the case. Variety had apparently already resold the pants to retailers, so it would have been impossible to stop the flow of goods into the marketplace and return them to Prime. Variety thus owed payment for the pants, and unsure of whom to pay, deposited the funds into court. As between Prime and Quick Response, and in view of Prime’s failure to defend itself, it’s understandable that the court would find in favor of Quick Response. However, the opinion doesn’t clarify how the court determined that Quick Response was entitled to damages in an amount equal to the entire payment, rather than a portion; nor does the opinion explain why Prime’s use of an infringing mark should destroy its ownership interest (and, therefore, CIT’s security interest) in the entire product bearing the mark, as well as all proceeds of sale. After all, a pair of pants without a label is still a pair of pants, so it must be worth something. (We note that although this last point might be persuasive to a court, it hasn’t been shown to be effective with teenage girls.)

Nevertheless, the court’s ruling highlights the importance of careful intellectual property diligence in lending transactions, particularly the financing of goods bearing trademarks. Before entering into this type of transaction, a lender should consider taking the following steps with respect to its borrower’s use and registration of trademarks:

• The lender should conduct a thorough review of the borrower’s policies, practices and documentation relating to the use of trademarks. In particular, the lender should review all existing trademark registrations and renewal status, licensing and marketing agreements, policies and procedures regarding the adoption and use of trademarks, promotional and marketing materials, and any prior searches and legal opinions relating to the use and registration of the trademarks.
• The lender should also conduct a search of the United States Patent and Trademark Office online trademark database and any applicable state trademark database (many of which are searchable online), to determine ownership and status of registered trademarks and the existence of any exclusive licenses or security interests that could affect the borrower’s rights to use the trademarks.
• In the event that documentation supporting a borrower’s use of a trademark is unavailable because the trademark is unregistered, or if the lender wants a greater level of assurance regarding the borrower’s rights to use a trademark, the lender can arrange additional research to help determine whether any other parties have an interest in the trademark or whether the borrower’s use is vulnerable to third-party infringement claims. Such research might involve engaging a trademark attorney to review the results of a comprehensive search of federal and state records and other commercial and proprietary databases.

Although it is sometimes difficult to evaluate the strength of a borrower’s trademark rights in relation to third-party rights, careful attention to due diligence should provide a lender with greater certainty regarding potential threats to the value of its collateral.

The holding in Variety Wholesalers represents an aggressive remedy that should be of great concern to any lender in North Carolina that finances the manufacture or sale of goods bearing a trademark. In order to evaluate and address the risks presented by the decision, lenders in these transactions should consider engaging experienced finance and intellectual property counsel to assist with due diligence efforts.