Legal Question in Business Law in California

"Legal?" Sure. Breach of proper business practices? Yes. Your fault for letting it happens through lack of checking serial numbers or other evidence of purchase? 'Fraid so. Your remedy is to invoice the distributor for the customer service and sue if he doesn't pay, issue a cease and desist letter to cancel his authorization to sell your product, and institute security and verification procedures to prevent this from happening in future.

I basically agree. "Legal" is a term capable of different meanings. To most lawyers, "illegal" probably means something that is criminal, and punishable by fine or incarceration, such as murder and jaywalking, and possibly the term could be stretched to include torts such as civil fraud and trespass. However, attorneys tend not to think of breaches of contract or unethical conduct as illegal, even if the injured party has a remedy - which will usually just be money damages. There is probably a remedy, at least in theory, against someone receiving a service to which it is not entitled as a consequence of being a customer. Probably some restitutionary remedy based on "unjust enrichment" or "quantum meruit," and these theories could be useful as threats to the competitor and its clients, but it's probably not worthwhile to take legal action in a U.S. court at this time.