Distributors have long been an essential component of the American sales channel. These intermediaries between the manufacturer and the consumer play several critical roles in the sales process, including warehousing, shipping, promotions, and sales to retailers.i Their ingrained relationships with regional or national chains are often the catalyst for a brand’s success.
For as long as there have been distributors, however, there has been distributor leakage. This can be as simple as a distributor employee pilfering product samples for his own use, or as devastating as cargo thieves heisting truckloads of products from a rest stop. Whatever the method, distributor leakage can be costly for brands in a variety of ways.
Exacerbation through ECommerce
While distributor leakage has been historically problematic, never has it impacted manufacturers and brands like it does today. The ECommerce era has changed the game. Particularly troublesome is the proliferation of vast online marketplaces that allow unauthorized third-party retailers (“TPRs”) to peddle products without concern for product sourcing. While products leaked from distributor warehouses were once relegated to back-alley sales, today these diverted products can be offered to consumers across the globe with a few clicks of the mouse.
Indeed, in February 2018, the United States General Accounting Office issued a report highlighting the problems TPRs are causing within online marketplaces offered by trusted brands such as Amazon.com, Walmart.com, eBay.com, and NewEgg.com.ii Consumers often believe that orders placed from these well-known websites are fulfilled and shipped by the sites themselves. Often, however, those orders are fulfilled by TPRs. As a matter of fact, in the fourth quarter of 2017, over one-half of all products sold via Amazon.com were sold by TPRs, not Amazon.iii
Not all TPRs are illegitimate. Some have been explicitly authorized by manufacturers to sell certain products. Many TPRs, however, are not so authorized and are receiving the products they sell through illicit channels such as distributor leakage.iv Because these retailers are typically receiving these products far below the normal wholesale price, they are selling them online far below the Manufacturer’s Advertised Price (“MAP”). The fall-out from these sub-MAP sales is discussed further in Part II of this Paper.
The Mom & Pop Myth
There is a popular perception among manufacturers that TPRs are small-time operators practicing part-time retail arbitrage from their kitchen tables. While those TPRs undoubtedly exist, a far more dangerous species of TPR is started to emerge – and thrive.
Perhaps the best example is a company called Pharmapacks, operating out of Queens, New York. Having shifted from a brick-and-mortar, local pharmacy to a mega online retailer, Pharmapacks made some fascinating business decisions along the way. Of particular note is the company’s decision not to focus on brand-building, logos, or name-brand recognition. Rather, Pharmabacks is building its empire by obtaining products cheaply and then reselling them as a TPR on Amazon. To succeed at this, the company uses a proprietary algorithm that helps them win the buy box more often than not.v
Far from a mom & pop TPR, Pharmapacks hit $160 million in revenue in 2016.vi Key to its success, of course, is the company’s ability to obtain products at wholesale prices far below market. How do they do this? For one thing, they rely on a distributor called Quality King, which happens to be known as the “largest and most successful [product] diverter in the world.”vii (For purposes of this Paper, “distributor leakage” and “product diversion” are used interchangeably.)
Quality King executives are cagey at best about the sources of their products. Nonetheless, they’ve been pulling in over $2 billion a year since at least 2009.viii By 2014, they had reached #147 on Forbes’ “Largest Private Companies in America” list and were generating over $3.2 billion in annual revenue.ix Generally speaking, the product diversion industry has become so lucrative that it has its own lobbyists in Washington, D.C., as well as a cadre of specialized lawyers who defend diverters against frequent lawsuits.x
Significantly, Pharmapacks is not alone in its reliance on distributors like Quality King, which is frequently alleged to obtain products from a host of shady sources. Indeed, household names such as Costco, Target, CVS, and Kroger have all been accused of relying on product diverters to stock their shelves.
In Part I of this Paper, we will discuss the myriad of ways that distributor leakage/product diversion occurs. Part II, as noted, will explore why leakage is a problem for manufacturers and brands, particularly in the ECommerce era. Finally, Part III will focus on strategies and tactics manufacturers can employ to put a stop to the problem.
PART I: HOW DOES DISTRIBUTOR LEAKAGE HAPPEN?
Given that product diverters are generating billions of dollars annually, where and how are they getting the products they sell? Often, the answer lies with “legitimate” distributors. As noted in the Introduction, there are a variety of ways products can leak from the distributor warehouse into illicit sales channels. Some of these methods are simple, one-off events. More sophisticated diverters, however, are resorting to organized crime and other atrocities to obtain their wares. In this Part, we explore some of the most common distributor leakage schemes.
One of the most obvious ways products escape from distributor warehouses is through employee theft. In fact, employees are a problem at all points along the sales channel. At retail, for example, employee theft is responsible for nearly half of all business lossesxi and has proven to be a greater detriment to employers than shoplifting or organized crime.xii
Distributorships are also susceptible to theft by employees. The opportunities are vast: sales staff can convert product samples for their own use, truck drivers can pilfer products on their way to and from the warehouse, and managers can often appropriate products for resale without much oversight.
In one well-publicized case, the manager of a wine distributorship in Connecticut made off with nearly $250,000 worth of wine over the course of a year.xiii He then sold that wine to retailers outside of the distributor’s exclusive network. He and his accomplices were only caught when astute consumers noticed the wines being sold in new locations.
Manufacturers have long been frustrated over this state of affairs, believing they have little control over the employees of their distributors. While they are correct that they cannot exert control over distributor personnel, they can take measures to lessen this significant risk. Those measures, discussed in detail within Part III, can mean the difference between distributor leakage and product security.
Distributors have a reputation for biting off more than they can chew. Frequently, they will negotiate for lower prices from manufacturers in exchange for high-volume orders. If they fail to sell through all that product, however, they will do whatever it takes to get it off their shelves. Sometimes, that means selling that extra inventory to unauthorized channels – even if that is a direct breach of their contract with the manufacturer.xiv
Distributors don’t make money when products languish in their warehouses. Consequently, the risk of getting caught making sales to unauthorized channels is often outweighed by the need to free up valuable warehouse real estate.
Another common scheme occurs when an unauthorized retailer goes directly to the distributor and asks to purchase a product that the distributor isn’t supposed to sell to them. Often, the retailer will offer unbelievably favorable terms, such as prepayment and high-volume orders.xv For the distributor, this is almost too good to be true – immediate revenue and the opportunity to order product that is guaranteed to sell. Again, the risk of getting caught by the manufacturer pales in comparison to the lure of instant profit.
Significantly, this scheme also happens at the retail level. An unauthorized purchaser will ask an authorized retailer to order products for delivery to their place of business. The unauthorized purchaser will pay for the products and offer an additional cash payment for the authorized retailer’s trouble.xvi While this may violate the retailer’s contracts with the manufacturer and/or the distributor, cash often trumps the risk of getting caught.
Cargo theft can take many forms. From organized crime rings stealing entire trucks at gunpoint to trailers being stolen off trucks at rest stops, the FBI estimates that cargo theft costs U.S. shippers and trucking companies over $30 billion per year. Cargo theft can also occur at the distributor level, however.
One of the most common heists is known as the “fictitious pickup.” In this scheme, thieves masquerade as legitimate carriers, pull up to the distributor warehouse, and drive off with a shipment intended for another company.xvii By the time the original carrier arrives at the warehouse, the products are long gone. These are not inconsequential events. The average loss resulting from a fictitious pickup is more than $140,000 per occurrence.xviii
Of all the distributor leakage methods discussed in this Paper, the U-boat strategy requires the most devious intent on the part of the distributor. In this scheme, the distributor orders large quantities of product from a manufacturer, under the guise that the products are intended for a foreign market (products for foreign markets often sell for quite a bit less than their domestic counterparts). The distributor picks up the products and places them onto a ship.xix
That ship, however, will never reach a foreign port. Rather, it will quickly return to the United States, where the products will then be sold far below the market rate in domestic outlets.xx Distributors that operate at this level have also come up with documentation scams which help them get the products back through customs without a hitch.xxi
PART II: WHY IS DISTRIBUTOR LEAKAGE A PROBLEM?
Ultimately, distributor leakage results in financial losses for manufacturers and distributors. But are there other problems, aside from loss, that stem from product diversion? The answer to that question is a resounding “yes.”
This is especially true in the ECommerce era, where product diverters (and their customers) can move products globally by operating as TPRs for mega-retailers such as Amazon and Walmart.xxii In this Part, we detail some of the major problems that stem from distributor leakage, as well as the exacerbation of those problems by TPRs.
Any time a product is diverted from its intended sales channel, there is a possibility it will become unsafe for consumer use. This problem is particularly true with nondurable goods – things like food, pharmaceuticals, hair care products, and other cosmetics. This is because these types of products typically need to be shipped and stored under certain conditions to maintain integrity. Additionally, once they are in the hands of diverters, these products are often expired, diluted or otherwise compromised.xxiii
Product diverters don’t care about product safeguards. They’ve been known to ignore refrigeration mandates, water down products to increase profits, and buy lots of expired (i.e., worthless) goods for the express intent of resale.
The problem is especially troubling in the hair care industry, where products manufactured exclusively for sale in salons end up everywhere from eBay to major brick-and-mortar grocery shelves.xxiv The problem is so vast that it has prompted brands like Redken to publish extensive anti-diversion policies on their websites.xxv Redken also publishes its salon-exclusive sales channel in advertisements and on product packaging.xxvi
Despite these efforts, Redken products can be purchased almost anywhere. This reality is startling, given that the company itself admits that diverted products “could cause irritation or even infection.”xxvii
One of the principle problems with TPRs who have obtained products through distributor leakage is that once they sign up to sell those products in an online venue, the competition for sales is fierce. On Amazon, for example, TPRs are competing with potentially thousands of other retailers (and Amazon itself) for product sales. On any given day with respect to any given product, only one seller can “win the Buy Box” (i.e., be the seller picked to consummate a sale once the consumer clicks the “Add to Cart” button). Roughly 80% of all sales on the site go to the Buy Box winner.xxviii
On Amazon, a complicated algorithm determines who wins the Buy Box – with low price being a key consideration. The Walmart Buy Box, by contrast, goes to whomever is selling a product at the lowest price — period.xxix Both venues are structured this way in an effort to attract the dollars of cost-conscious consumers. Unfortunately, manufacturers, brands, and authorized retail partners are getting hurt along the way.
When TPRs obtain the products they sell online via surreptitious means (such as distributor leakage), they have almost certainly paid far less than the wholesale price paid by authorized retailers. Consequently, they are able to offer products for sale online at sup-MAP pricing. They can also continually lower prices to compete for the coveted Buy Box.
This practice has a cascading effect. As online sales prices drop, brick-and-mortar retail outlets feel strong pressure to price match. Indeed, many stores that have price-matching guarantees are seeing profits dwindle as they struggle to compete with popular websites. As pricing pressure increases with these authorized retailers, they, in turn, demand pricing breaks from manufacturers. As this cycle perpetuates, the only parties consistently realizing healthy margins are the TPRs themselves.
As one industry-watcher put it, “The problem is when you start trying to compete on price. You are suddenly running around like headless chickens and you don’t make any money. We have seen businesses that have tried [to compete] go under.”xxx In fact, it has been posited that long-time brick-and-mortar sports retailer, Sports Authority, was forced out of business precisely because it couldn’t keep up with online pricing.xxxi
When a singular force like distributor leakage causes problems as serious as unsafe products and price erosion, a third disaster is sure to follow – brand dilution. It is easy to see how products that cause harm to consumers will also cause harm to the underlying brand. But what does price erosion have to do with brand reputation? Everything.
First, some brands are priced at a certain level so the manufacturer can maintain a reputation for quality. Studies have repeatedly shown that if products are sold too cheaply, consumers will perceive them to be cheaply made.xxxii This is one of the main reasons manufacturers set MAP policies and insist that authorized retailers honor them. When TPRs violate MAP, those hard-earned reputations can be quickly eroded.
To add insult to injury, TPRs are also notoriously bad at doing things like honoring money-back guarantees or providing customer service. Unfortunately, the majority of consumers who purchase products through TPRs on Amazon and other online marketplaces have no idea that they’re buying from someone other Amazon. They presume that by using a well-known retail giant, they will be getting the same level of consumer safeguards they would get if they purchased from an authorized brick and mortar retailer. Not so.
Perhaps unfairly, the ire over these poor consumer experiences tends to fall squarely on the brand, rather than the TPR. Spend an hour reading through negative consumer reviews on Amazon and you’ll see what we mean. Creating a bad consumer experience doesn’t tend to hurt TPRs so much as it hurts the brands they sell.
PART III: HOW TO STOP THE LEAKS
In light of the grave consequences that can stem from distributor leakage, it is imperative that manufacturers create comprehensive strategies for dealing with the issue. Not surprisingly, the best strategies employ both preventative and enforcement measures. In this Part, we’ll discuss what can be done to prevent distributor leakage, as well as tactics for halting a leakage problem that already exists.
Preventing Distributor Leakage
According to industry insiders, “if a brand does not have tight control of its distribution, it can be quite hard to control the price … Tight control means ‘eliminating product diversion, gray market selling, reimportation of products, etc.’ – avoiding anything that makes it easier for sellers to shop up on Amazon offering your product at discount.”xxxiii That sounds like a great idea, but how does a brand go about it? Below are some of the most effective methods for controlling distribution.
• Distributor Due Diligence
Before even hiring a distributor, a manufacturer should create a detailed list of questions about each potential distributor’s business practices. With respect to employees, ask whether the distributor performs employee background checks, random drug testing, or regular employee reviews. Do they have a written zero-tolerance policy when it comes to employee theft?
On the security side, determine whether they have security cameras, both inside and outside the facility. Is security video backed-up and stored off-site? Additionally, survey the physical security measures that are in place such as fencing, locking systems, lighting, etc. Finally, examine the technology they use to track and schedule shippers and carriers. Some of the newer technologies are quite effective at deterring schemes like fictitious pickups.
It also never hurts to ask about their loss history. How many insurance claims has the distributor filed relating to theft? Relatedly, ask what sort of due diligence the distributor uses in retaining carriers. What do they know about the independent drivers who transport products from place to place?
It is also critical to ask for references from within your industry. Talk to other manufacturers outside the reference list to determine the distributor’s general reputation for truthfulness and safety. The more questions you ask, the less likely you are to encounter leakage problems in the future.
• Contractually Supported Anti-Diversion Policies
Even though companies like Redken continue to be plagued by product diversion despite well-publicized anti-diversion policies, it does not mean such policies are without utility. The key, of course, is to make sure all policies relating to the sales channel (MAP policies, anti-diversion policies, zero-tolerance policies) are expressly incorporated into contracts with distributors.
In doing this, manufacturers are stockpiling ammunition for lawsuits against distributors, should that become necessary. Key terms to any contract with a distributor include consent to an immediate injunction upon discovery of leakage, and (if allowable within the relevant jurisdiction) liquidated damages for diversion activities.xxxiv
The hope, of course, is that these provisions act as a preventative measure to avoid distributor leakage all together. To aid in that goal, these sorts of terms should be expressly discussed by executives during contract negotiations.
• Obtain Trademarks & Participate in Gating Programs
Most manufacturers have a good understanding of the importance of trademarks in protecting things like logos, designs, and slogans. From a legal perspective, trademarks give companies the right to bring civil action against those who seek to infringe on their marks – including those who have obtained products through illicit means (such as product diverters).
On the online marketplace side, however, trademarks hold an additional significance. Amazon.com, in particular, offers brand registry and brand gating programs that are ostensibly aimed at helping manufacturers fend off unauthorized TPRs operating on its site.
Brand gating is touted by Amazon as, among other things, a way to expedite “reports of suspected intellectual property rights violations” on its site.xxxv Brand registry, while still in the early stages, allows manufacturers to stamp products as “genuine” in an effort to promote authorized sales.
Similar programs are almost certain to crop up on other popular online retail sites as TPRs continue to proliferate. Significantly, however, these programs are unavailable without valid, registered trademarks in place.
• Alert the Public to Anti-Diversion Policies & Authorized Networks
As the Connecticut wine heist illustrated, consumers can (and will) actively participate in putting a stop to surreptitious sales. In order to do that, of course, they have to know what they’re looking for. Fortunately, there are many ways to communicate with the public about a manufacturer’s intended sales channel.
The classic example comes from the hair care industry. Products are clearly labeled with slogans such as “Intended for sale in salons only.” In conjunction with such phrases, brands can provide links to websites that warn of the risks of buying from an unauthorized retailer (product safety concerns, unavailability of money-back guarantees, etc.). Given that most Americans are shopping with smart phones in-hand, consumers can instantaneously obtain all the information they need to avoid purchasing from an unauthorized TPR.
Additionally, brand websites and product brochures should provide lists of authorized distributors and retailers, as well as any known unauthorized TPRs. While these measures certainly won’t stop TPRs from selling leaked products, they may slow sales by creating an informed consumer base.
• Pay Attention to Red Flags
One of the best preventative tools when it comes to distributor leakage is to simply pay attention to sales. For example, if a distributor suddenly starts ordering large quantities of product with increased frequency, it could mean they’re taking pre-paid orders from unauthorized TPRs.
Similarly, some clever product diverters will try to avoid contractual anti-diversion policies by issuing purchase orders that say something along the lines of “We reserve the right to sell your product anywhere” or “No limits on re-distribution.”xxxvi Train personnel responsible for processing purchase orders to regularly look for such language, and to reject offending documents.
E-Enforcement Measures to Stop Distributor Leakage
Of course, all the planning in the world won’t stop unscrupulous distributors and TPRs from ripping off a popular brand. If distributor leakage does hit your company, swift and effective E-Enforcement is the only way regain control.
• Monitoring and Intelligence
E-Enforcement begins with the identification of potential distributor leaks through marketplace intelligence. Investigators will set up automated processes that scour the internet and marketplaces searching for evidence of a problem. To accomplish this, they will deploy proprietary software and pricing algorithms to root out troublesome sales around the globe. Among other things, these specialized programs locate products sold far below MAP, sold outside of the intended sales channels, and other proprietary indicators.
Investigators can pinpoint sales of defined SKUs/ASINs, as well as the identity of online TPRs. This information provides E-Enforcement teams with a real-time snapshot of how each product is being sold online. Unfortunately, initial reports often reveal multiple unauthorized sellers that the underlying brand wasn’t even aware of yet.
Importantly, monitoring is not a static operation. TPRs utilize sophisticated schemes to hide their identities from those looking to stop them. By continually monitoring the internet for indicia of product diversion and otherwise watching for improper sales, investigators are immediately alerted any time one of those red flags are waived.
• Swift Response
Putting a stop to distributor leakage begins with identifying the TPRs who are peddling the leaked products online. Once an unauthorized TPR is identified, the first enforcement measure involves shutting down his sales.
Typically, the first effort comes in the form of an electronic cease and desist notice (“EC&D Notice”) sent directly to the seller via the online communication portal offered by the marketplace. Amazon, for example, offers a communication form designed for consumers to communicate directly with sellers. E-Enforcement professionals initially use that vehicle to send EC&D and other notices.
Whenever distributor leakage is at suspected, the goal of E-Enforcement is two-fold. First, investigators want to stop the offending sales. More importantly, however, E-Enforcers want to pressure the TPR to identify the distributor who is diverting products. Thus, these initial EC&D Notices typically communicate a set of dire consequences that will befall the TPR if he fails to cooperate in the investigation.
• Covert Product Buys from Suspicious Distributors
Many times, a manufacturer will have fact-based suspicions concerning the distributor that is leaking products. Thus, at the same time EC&D efforts are underway, E-Enforcement teams will also start attempting to make tactical purchases from distributors that may be diverting products. It is important that this step be consummated by E-Enforcement investigators for at least two reasons.
First, investigators are well-versed in the modus operandi of individuals and sham entities who seek to corrupt distributors. Distributors know they have contractual obligations to their suppliers and, despite the temptation of making a quick buck, tend to be careful about first-time sales that result in leakage. Investigators are trained to look and sound just like professional product diverters.
Critically, an experienced E-Enforcement team will also execute the product purchase with extreme caution so that the chain of custody is preserved. In other words, they will follow precise steps to ensure that the offending products are admissible as evidence in court should it ever come to that.
Upon receiving the diverted goods, investigators will examine the products for indicia of an experienced diverter. These include things like obscured bar codes, expired “sell by” dates, or damaged packaging. Results of this examination will be documented and preserved for evidentiary purposes.
In the event the purchased products were intended for sale in another market, investigators will submit samples to U.S. Customs agents so they can keep an eye out for additional products entering the country illegally.
Finally, E-Enforcers will use any precise product information obtained through the covert purchase to enhance computer monitoring and intelligence operations. These efforts often alert the team to other unauthorized TPRs who may have obtained product through that same distributor.
• Detailed Investigations
In most cases, TPRs are fully aware of the identify of the distributors who have sourced products for them. They know the value of this information and, not surprisingly, these dodgy sellers will play all sorts of games to avoid enforcement efforts. In fact, even TPRs who halt sales in response to the initial EC&D Notice, often re-emerge within days using a new seller name.
Fortunately, these tactics are highly ineffective. After all, monitoring software doesn’t have an “off” button. Investigators are alerted the moment leaked products are being sold again and take same-day steps to renew cease and desist demands. In some cases, however, sellers still are not intimidated. They grow comfortable behind the anonymity offered by the internet.
Their confidence is misplaced. If initial efforts are ignored, enforcement efforts are elevated. The next step in the process is to use Open Source Intelligence (“OSINT”), combined with proprietary database intelligence to identify the actual people sitting behind the computer. Within a relatively short period of time, E-Enforcers can find a TPR’s name, physical address, telephone number, and relevant background information.
Once this information is in hand, notices are sent directly to the individuals selling the leaked products. Certified cease and desist demands are delivered right to their home and/or business addresses. Within these demands, sellers are notified that they have between five and seven days to cease sales of all diverted products and identify product sources before more extreme measures are taken.
• Escalated Enforcement
The next step in the E-Enforcement process is specifically aimed at forcing the TPR to affirmatively identify the distributor who is leaking products. Working in conjunction with in-house legal teams or outside law firms, enforcement professionals will prepare a draft trademark infringement/intentional interference with contract complaint against the TPRs and any formal entities they operate.
The draft complaint is sent to the TPR’s home address with a final notice and demand for cooperation. That notice requires immediate compliance and alerts the seller that failure to comply will leave no choice but to file suit.
Fortunately, not many TPRs have the resources or fortitude to enter into a lawsuit just to protect a product source. This is typically the point where the TPR becomes very willing to talk.
In cases of fraud, cargo theft, or other suspected crimes, E-Enforcers will also work with appropriate law enforcement agencies. E-Enforcement teams typically have long-standing relationships with these agencies and can “talk the talk” in order to get formal investigations and appropriate arrests underway.
This dualistic civil/criminal course creates the perfect opportunity to leverage a TPR’s fear to obtain further information. Product diverters can be shady characters, often involved with organized crime networks. They don’t surrender easily and take great measures to avoid detection. Fortunately, specialized E-Enforcement professionals know their tricks, know their networks, and have the proprietary tools and expertise to take them down.
E-Enforce is a division of an internationally recognized investigation firm, Cyber Investigation Services. We have been providing litigation support and investigations for high profile cases and top law firms since 2010.
In 2012, we began combatting unauthorized sellers at the request of our client, Zo Skin Health. When we began that process, the company was overwhelmed with unauthorized retailers in online marketplaces. Today, they have virtually zero. They have also enjoyed exponential growth in that time.
In February 2017, we made our proprietary E-Enforcement system available commercially. We currently work with over 50 brands, including global companies, mid-sized operations, and small-but-growing manufacturers. Our clients represent the following industries:
• Direct sales
• Paper products
• Home repair
• Women’s accessories
• Food supplements
• Pet products
• Sunglasses & accessories
• Consumer electronics
• Vacuum cleaners
• Purses and bags
• Radar detectors
• Skin care
• Health products
• Hair products
If you have questions about tackling distributor leakage, or would like additional information, contact the E-Enforce™ team at firstname.lastname@example.org, or call us at (800) 892-0450. You can also follow us at e-enforceCIS@twitter.com, via the ECommerce Enforcement Group on LinkedIn, or visit E-Enforcement.com/services.
[iv] https://digiday.com/marketing/brands-bristle-third-party-sellers-amazon-little-recourse/; see also https://www.authorizedstore.com/blog/index.php/2016/07/25/retailers-jump-on-product-diversion-bandwagon/
[xxxiv] Please note that E-Enforce™ is not a law firm and does not dispense legal advice. For specific information about the applicability of such terms in your jurisdiction, please consult an attorney.