From time to time clients ask us whether they should “protect” their trademarks from their company’s liabilities by setting up a separate trademark holding company. Often they have heard about tax savings or read something online suggesting that any company with substantial trademark assets to protect ought to be segregating them into a separate corporate entity. Except in exceptional circumstances, however, the trademark holding company is a bad idea.
Trademark holding companies were originally devised by lawyers as tax-saving devices — specifically to reduce an operating company’s corporate franchise tax liabilities in the state or states of operation. (Corporate franchise taxes are the taxes a corporation pays to a state for the privilege of doing business there.) Theoretically, the savings could be substantial. The holding company is typically set up in Delaware or Nevada, where there is no corporate income tax on intangibles (like trademarks). The parent company transfers its trademarks to the holding company, which then licenses them back in return for a royalty. The royalty is then treated as an expense to the operating company and tax-free income for the holding company. This sleight of hand may still work in some jurisdictions, but in many places, the courts have already caught on.
No Tax Savings in New York.
Under New York law, trademark holding companies have been consistently disregarded as a means of reducing taxes. The lead case regarding tax liability is Sherwin-Williams Co. v. Tax Appeals Tribunal, 2004 NY Slip Op 07737 [12 AD3d 112] October 28, 2004. There, the New York Court of Appeals (New York State’s highest court) upheld a determination that Sherwin-Williams (an Ohio corporation) was required to report the income earned by its trademark holding company (a Delaware corporation) formed for the purpose of holding some 500 Sherwin-Williams domestic trademarks. The establishment of the holding company and the licenses back to the parent company, the court said, lacked any valid business purpose apart from tax avoidance.
Sherwin-Williams argued that it formed the holding company to: (1) improve quality control oversight with regard to its many licensees and franchisees; (2) enhance its ability to enter into third-party licensing arrangements at advantageous royalty rates; (3) insulate its trademarks from the parent company’s liabilities; and (4) have flexibility in preventing a hostile takeover. To accomplish those purposes, the holding company established separate office space in Delaware and named as President an individual who had no previous association with the parent company. The tax tribunal and New York courts found these reasons unpersuasive. Not only did the parent company call the shots on management of the trademarks, but the President of the trademark holding company was a person who had no prior experience as a trademark manager. Thus the deduction for royalties that Sherwin-Williams’ operating company paid to its subsidiary holding company was disallowed and the combined income of both entities — the operating company and the holding company — was found subject to New York state corporate franchise tax.
The Sherwin-Williams case is only the most recent New York case to reach this conclusion regarding the reduction of tax liability via trademark holding companies. How would Sherwin-Williams have fared in a lawsuit in which it was sued for trademark infringement or in which the operating company was sued for breach of contact by a licensee or by a consumer for product liability?
Limitations on Liability.
Sherwin-Williams argued to the New York courts that it formed its trademark holding company in part to “insulate the trademarks from the parent’s liabilities,” but the court found ample reason to find the two companies were simply alter egos — at least from the standpoint of tax liability – including the fact that control over the quality of the Sherwin-Williams’ goods came from the parent company, rather than its subsidiary. That finding would not bode well for other types of claims. Automobile Insurance Co. of Hartford v. Murray, Inc., 04-CV-770A (LGF), a 2008 decision from the U.S. District Court, Western District of New York, bears this out. In that case, a lawnmower manufacturer that was sued for product liability attempted to defend itself on the basis that its trademark holding company was the actual owner and licensor of the trademark and therefore the wrong party had been sued. The court examined the organization and function of the holding company, however, and determined that it was formed “with no other business purpose … except to hold and license” the operating company’s trademarks. Consequently, the operating company was found to be the “de facto” or “actual” licensor.
Indeed, in most situations it is doubtful that a trademark holding company would be effective at protecting anything. The operating company/”licensee” will not be able to insulate itself from trademark infringement claims of its subsidiary holding company / “licensor.” Any such lawsuit would almost of necessity be brought against both companies, since both would have played a part in the alleged infringement. Nor is the trademark holding company/”licensor” likely to get away with pointing to its “licensee” (which is usually the licensor’s parent company!) as the sole party liable for breaches of contract or product liability. As one of the leading experts on trademark law has said, “in general, it is accurate to conclude that there is a very substantial risk that a trademark licensor … will be held liable for the torts of licensees…” McCarthy § 18:74 under the theory that the the licensee is a related company. This is especially true where the two companies share board members, management and/or office space. Notwithstanding Murray, where only the operating company was sued, it is the customary practice for attorneys when filing suit to include as many different entities and individuals as could be liable or capable of paying a judgment. In short, whether the claim is asserted against the operating company or its holding company, piercing the corporate veil would not be difficult.
The only possible protection that a holding company might afford to the trademark is an instance in which the operating company is sued for reasons unrelated to its licensing and business activities — for example, if the operating company defaulted on a mortgage or lease, or was sued for some kind of tortious (non-product-related) conduct — but even there, if the operating company’s assets were insufficient to satisfy the judgment, the trademarks might still be reachable as assets of the operating company.
Legal Pitfalls of Licensing through Trademark Holding Companies
In deciding whether to pierce the corporate veil of a trademark holding company, the courts will consider a number of factors, including whether the two companies have common directors or officers; whether the parent corporation owns all or most of the stock in the subsidiary; whether the parent finances the subsidiary; whether the subsidiary has any business with any entities other than the parent; whether the subsidiary has any assets other than those conveyed to it by the parent; and whether employees, officers and directors of the parent (and not the holding company) are the ones controlling the quality of the goods sold under the marks owned by the holding company. In principal, setting up a holding company is easy. But forming and operating one that will be recognized by the courts as an independent entity is time-consuming and expensive. And there is no bulletproof formula for success. In the cases cited above, the holding companies had different management, their own offices, and multiple licensees (i.e., various sources of income), but still failed in their purported objectives. A trademark holding company owned by a parent operating company is by its very nature suspect, but an “independent” holding company owned personally by the owners of a parent operating company is no better. In addition to these problems, there is the legal risk that a trademark holding company just might put a company’s trademarks at risk.
Although trademark holding companies are common, not only have they not been fully endorsed by the courts, but they have also caused damage to trademark owners. Not long ago, one of our clients sued two trademark infringers. The client’s trademarks are owned by a holding company (established by predecessor counsel, not us). One of the defenses mounted by the other side in a countersuit for invalidity is that the licensor holding company doesn’t exercise sufficient control over its licensees. Rather, they argued, control is exercised by the holding company’s parent corporation and the holding company has therefore made a “naked license.” The remedy for a naked license is for the court to declare that the trademark in question was abandoned by the trademark owner. In CNA Financial Corp. v. Brown, 922 F. Supp. 567 (M.D. Fla. 1996), reconsideration den. by 930 F. Supp. 1502 (M.D. Fla. 1996), aff’d, 162 F.3d 1334 (11th Cir. 1998), a court did just that. CNA lost its trademark because the court found that it did not actually control the quality of the services offered by its licensees, but only controlled how the marks themselves were used. (The issue in our client’s case was never addressed by the court, as the case was subsequently settled in our client’s favor.)
This is not the only risk. A holding by a court that an operating company is the de facto or actual licensor of the trademark, as in the Murray case cited above, opens the door to the corollary conclusion that the holding company’s trademark applications and maintenance filings in the PTO were fraudulent, since the holding company may not be the true owner of the trademark. That would be an additional ground for cancellation of trademark registration.
There are still other complications, including how a court or the PTO will view a transfer of a trademark to a holding company, without a transfer of the accompanying “goodwill.” Under U.S. law, trademarks cannot be assigned “in gross” but must be assigned together with the business (i.e., the goods and services) represented by the trademarks. In other words, because the “goodwill” is created by the business, a trademark cannot exist independently of it. A transfer of a trademark to a holding company may thus be considered an assignment in gross, which is voidable and subjects the trademark to cancellation. Indeed, if the holding company does no business other than licensing, it may be very difficult to claim that any goodwill at all is associated with the legal owner of the mark.
These latter issues have not been directly addressed either by the courts or the PTO. However, the risk of losing one’s trademarks by transferring them to a U.S. holding company, when weighed against some very speculative benefits, hardly seems worth it.
(In a future posting, I will deal with a slightly different scenario: where the trademark holding company is located outside the United States.)
Blogger and Consumer Endorsements of Commercial Goods: Is Your Company in Compliance with FTC Guidelines?
Whether on your company’s website, Facebook, Twitter or third party blogs, endorsements of your products are subject to FTC guidelines issued in 2009.
General Considerations, 16 CFR § 255.1
FTC rule and guidelines require that before a company publishes an advertisement of a product — and this applies to all advertising, online or off — it must have a “reasonable basis” for each claim being made about the product. Both advertisements which make claims about the efficacy of a product (e.g., “you will achieve noticeable results in a few weeks”), and statements by bloggers and consumers attesting to that efficacy (e.g., “I used the product and felt results within a few days!”) are subject to the rule.
“Reasonable basis” means that the company must have objective evidence to support each claim. For medicine, remedies, vitamins, food supplements, reparative cosmetics and diets, “objective evidence” means “competent and reliable scientific evidence,” i.e., studies conducted by qualified persons, using methods that are generally accepted as scientifically valid. Furthermore, any claim regarding the results of using a product must be based on what consumers may generally expect. The matter obviously gets quite tricky when, for example, a study reveals a wide range of outcomes, particularly with regard to varying body types, skin types, ages, etc. But the FTC guidelines provide no further guidance on what will pass the test. The onus, if the FTC comes knocking, will be on the company.
If a claim is not supported by “objective evidence,” the company must conspicuously (i.e., not in fine print) state what the “generally expected results” of the product are, but even these generally expected results must, according to the FTC, be supported by objective evidence. Testimonials from satisfied customers are not considered objective or adequate evidence to support a claim about a product. Moreover, the FTC does not distinguish between claims made (1) directly by your company; (2) via consumer testimonials which appear on your company’s websites, blogs, Facebook pages, etc., or any other website at your company’s behest; and (3) by bloggers if the blogger has been provided with the product by the company, or reviews the product at the company’s request, or receives any kind of compensation, monetary or otherwise. In all three cases, the claims must be supported by objective evidence. Claims which are not supported by objective evidence may be considered “deceptive” by the FTC.
Rules Applicable to Consumer Endorsements, § 255.2
As noted above, the FTC makes no distinction between consumer and blogger endorsements. They carry the same burdens and are treated as statements by the company whose product is being endorsed. Where a blogger makes a claim about the efficacy or curative properties of a product, the Company may be held responsible by the FTC even if the claim appears only on the blogger’s blog. Companies must therefore be aware of what bloggers (with whom they have been in contact) write and must take steps to correct claims which are not what consumers will generally achieve and are not supported by objective evidence. The FTC, by the way, disfavors the use of disclaimers such as “the results attested to by [the endorser] are not typical” or “may not be achieved by you.” FTC cites research on these disclaimers demonstrating that they have no effect on consumer expectations. However, the FTC doesn’t rule out the possibility that such a disclaimer might be sufficient in some circumstances. It just doesn’t say what those circumstances are.
There is a further rule which companies must heed for advertisements which contain consumer endorsements. Whenever an endorser represents that s/he uses a product, the company may run the advertisement only during the time the endorser actually uses, and continues to use, that product and to have the same opinion about it. (Companies have the obligation to contact the endorser from time to time to find out.) Dated testimonials in a section devoted to consumer comments is likely the best way to sidestep this potential problem –that is, where endorsement are conspicuously dated, there is no implication that product use is either current or ongoing. Videoclips with endorsements should also be conspicuously dated. Companies should ensure that the bloggers they contact also conspicuously date their product reviews.
§§ 255.1 and 255.2 contain several examples which are useful in understanding how the rules are applied:
- A brochure for a baldness treatment consists entirely of testimonials from satisfied customers who say that after using the product, they had amazing hair growth and their hair is as thick and strong as it was when they were teenagers. The advertiser must have competent and reliable scientific evidence that its product is effective in producing new hair growth. The ad will also likely communicate that the endorsers’ experiences are representative of what new users of the product can generally expect. Therefore, even if the advertiser includes a disclaimer such as, “Notice: These testimonials do not prove our product works. You should not expect to have similar results,” the ad is likely to be deceptive unless the advertiser has adequate substantiation that new users typically will experience results similar to those experienced by the testimonialists.
- An advertisement for a cholesterol-lowering product features an individual who claims that his serum cholesterol went down by 120 points and does not mention having made any lifestyle changes. A well-conducted clinical study shows that the product reduces the cholesterol levels of individuals with elevated cholesterol by an average of 15% and the advertisement clearly and conspicuously discloses this fact. Despite the presence of this disclosure, the advertisement would be deceptive if the advertiser does not have adequate substantiation that the product can produce the specific results claimed by the endorser ( i.e. , a 120-point drop in serum cholesterol without any lifestyle changes).
- An advertisement for a weight-loss product features a formerly obese woman. She says in the ad, “Every day, I drank 2 WeightAway shakes, ate only raw vegetables, and exercised vigorously for six hours at the gym. By the end of six months, I had gone from 250 pounds to 140 pounds.”The advertisement accurately describes the woman’s experience, and such a result is within the range that would be generally experienced by an extremely overweight individual who consumed WeightAway shakes, only ate raw vegetables, and exercised as the endorser did. Because the endorser clearly describes the limited and truly exceptional circumstances under which she achieved her results, the ad is not likely to convey that consumers who weigh substantially less or use WeightAway under less extreme circumstances will lose 110 pounds in six months. (If the advertisement simply says that the endorser lost 110 pounds in six months using WeightAway together with diet and exercise, however, this description would not adequately alert consumers to the truly remarkable circumstances leading to her weight loss.)The advertiser must have substantiation, however, for any performance claims conveyed by the endorsement (e.g., that WeightAway is an effective weight loss product).
If, in the alternative, the advertisement simply features “before” and “after” pictures of a woman who says “I lost 50 pounds in 6 months with WeightAway,” the ad is likely to convey that her experience is representative of what consumers will generally achieve. Therefore, if consumers cannot generally expect to achieve such results, the ad should clearly and conspicuously disclose what they can expect to lose in the depicted circumstances ( e.g., “most women who use WeightAway for six months lose at least 15 pounds”).
If the ad features the same pictures but the testimonialist simply says, “I lost 50 pounds with WeightAway,” and WeightAway users generally do not lose 50 pounds, the ad should disclose what results they do generally achieve ( e.g., “most women who use WeightAway lose 15 pounds”).
- A skin care products advertiser participates in a blog advertising service. The service matches up advertisers with bloggers who will promote the advertiser’s products on their personal blogs. The advertiser requests that a blogger try a new body lotion and write a review of the product on her blog. Although the advertiser does not make any specific claims about the lotion’s ability to cure skin conditions and the blogger does not ask the advertiser whether there is substantiation for the claim, in her review the blogger writes that the lotion cures eczema and recommends the product to her blog readers who suffer from this condition. The advertiser is subject to liability for misleading or unsubstantiated representations made through the blogger’s endorsement. The blogger also is subject to liability for misleading or unsubstantiated representations made in the course of her endorsement.
Material Connections, § 255.5
This section of the regulations requires that companies disclose any material fact that might influence a blogger’s opinion about the product. This applies both to compensation, the promise of compensation, employment by the company (as when an employee posts on a board anonymously, touting his company’s products) and claims that an opinion is candid when it isn’t. “Compensation,” in this context, does not need to be monetary for the disclosure requirement to be triggered. The promise of publicity or some non-monetary reward for a favorable review is also “compensation.”
Again, the FTC provides some nuanced examples:
- An actual patron of a restaurant, who is neither known to the public nor presented as an expert, is shown seated at the counter. He is asked for his “spontaneous” opinion of a new food product served in the restaurant. Assume, first, that the advertiser had posted a sign on the door of the restaurant informing all who entered that day that patrons would be interviewed by the advertiser as part of its TV promotion of its new soy protein “steak.” This notification would materially affect the weight or credibility of the patron’s endorsement, and, therefore, viewers of the advertisement should be clearly and conspicuously informed of the circumstances under which the endorsement was obtained.
- Assume, in the alternative, that the advertiser had not posted a sign on the door of the restaurant, but had informed all interviewed customers of the “hidden camera” only after interviews were completed and the customers had no reason to know or believe that their response was being recorded for use in an advertisement. Even if patrons were also told that they would be paid for allowing the use of their opinions in advertising, these facts need not be disclosed.
- An infomercial producer wants to include consumer endorsements for an automotive additive product featured in her commercial, but because the product has not yet been sold, there are no consumer users. The producer’s staff reviews the profiles of individuals interested in working as “extras” in commercials and identifies several who are interested in automobiles. The extras are asked to use the product for several weeks and then report back to the producer. They are told that if they are selected to endorse the product in the producer’s infomercial, they will receive a small payment. Viewers would not expect that these “consumer endorsers” are actors who were asked to use the product so that they could appear in the commercial or that they were compensated. Because the advertisement fails to disclose these facts, it is deceptive.
- A college student who has earned a reputation as a video game expert maintains a personal weblog or “blog” where he posts entries about his gaming experiences. Readers of his blog frequently seek his opinions about video game hardware and software. As it has done in the past, the manufacturer of a newly released video game system sends the student a free copy of the system and asks him to write about it on his blog. He tests the new gaming system and writes a favorable review. Because his review is disseminated via a form of consumer-generated media in which his relationship to the advertiser is not inherently obvious, readers are unlikely to know that he has received the video game system free of charge in exchange for his review of the product, and given the value of the video game system, this fact likely would materially affect the credibility they attach to his endorsement. Accordingly, the blogger should clearly and conspicuously disclose that he received the gaming system free of charge. The manufacturer should advise him at the time it provides the gaming system that this connection should be disclosed, and it should have procedures in place to try to monitor his postings for compliance.
- An online message board designated for discussions of new music download technology is frequented by MP3 player enthusiasts. They exchange information about new products, utilities, and the functionality of numerous playback devices. Unbeknownst to the message board community, an employee of a leading playback device manufacturer has been posting messages on the discussion board promoting the manufacturer’s product. Knowledge of this poster’s employment likely would affect the weight or credibility of her endorsement. Therefore, the poster should clearly and conspicuously disclose her relationship to the manufacturer to members and readers of the message board.
The FTC can subpoena companies and hold them accountable for violating FTC guidelines. It can issue cease and desist orders, require corrective advertising and impose civil penalties. By all accounts, FTC enforcement is focused on products which are ingested (particularly supplements) and products which claim to cure conditions or diseases (especially cancer). The use of consumer and blogger endorsements which make claims not substantiated by objective evidence is common practice in the health supplements and cosmetics industries, but “everybody does it” is not a defense to an FTC action.
The FTC is not particularly proactive, but responds primarily to consumer complaints. Still, any proceeding — administrative or civil — can be an expensive process and is best avoided by following the guidelines carefully and in good faith.