Inside Experts: Right product, wrong place

Why product diversion has a significant effect on brands—and how to mitigate it.

Many brand owners face a difficult problem when their products are sold through unauthorized channels. Unfortunately, this is a familiar problem for many brands worldwide. Sometimes dubbed “diversion” or the “gray market,” this issue differs from the sale of traditional “gray market goods” or “parallel imports,” which refers to the unauthorized importation or sale in the U.S. of products originally intended for and used in foreign markets that are materially different from the products intended for the domestic market. Of course, this problem also differs from “black markets” in which contraband products—counterfeit or genuine—are sold illegally. The concern over product diversion, however, is well-founded.

The sale of legitimate products in the wrong place or channel has become so ubiquitous that most consumers have unknowingly witnessed or been subject to the problem. This type of unauthorized market exists for seemingly every product imaginable, from health and beauty aids, food, electronics and apparel to prescription drugs and even broadcast signals. Indeed, product diversion, or leaks in the authorized supply chain that allow products to appear in unapproved retail locations, poses a unique problem for manufacturers and brand owners.

Diversion can happen for multiple reasons: A reseller may represent to a manufacturer that it is exporting the goods overseas, but divert them to someone else in the domestic marketplace; products may be inappropriately disposed of at the end of life; when an authorized retailer can’t sell all its inventory to consumers, it may move the leftover items to an unauthorized dealer; rogue authorized dealers may profit by selling to unauthorized dealers; companies can buy in bulk and resell to unauthorized distributors; and sometimes a manufacturer itself may even sell to unauthorized distributors if its salespeople are struggling to meet certain goals or in an attempt to cover costs. Of course, the breadth of the Internet makes it even easier for companies, resellers or distributors operating in the “gray market” to reach a wide range of consumers. 

Diversion can have serious consequences for companies and brand owners, which is why many are paying increasing attention to the issue and even devoting money and manpower to deal with it. An immediate consequence of product diversion is the “watering down” of exclusive rights to distribute a product. For instance, an authorized distributor could become merely one of many sources of distribution for a product, instead of being the sole distributor or one of a select few establishments that carries the product. This can result in fallout or complaints from not only the authorized distributor, but also consumers who may be paying a premium for what they believed to be an “exclusive” product.  Even worse, authorized distributors, in a backlash against the brand owner for what they perceive to be a lack of control over the supply chain, could start skimping on the services they normally provide, which can affect a company’s brand image or competitive strategy in the marketplace. 

Diversion can also damage relationships within a company’s authorized distribution network, especially if an authorized distributor has invested significant sums of money on branding, public relations or other associated costs with selling a company’s products. Finally, perhaps the most serious consequence of product diversion is a company’s inability to control what consumers are buying. Products sold in unauthorized stores can be outdated or expired, tampered with or diluted, or contaminated and can be very dangerous to consumers. At worst, an unknowing brand owner can be subjected to product liability lawsuits and suffer from significant damage to its brand and reputation. 

Fortunately, there are some ways to try to successfully manage (or at least attempt to manage) the issue of product diversion. First, companies should have mechanisms or programs in place so that they can continuously monitor the marketplace within their existing internal and external distribution channels in an effort to detect product diversion. Companies are increasingly using a wide range of techniques to detect product diversion, which include placing unique bar codes on their labels in order to track the source of unauthorized distribution, conducting unannounced audits of their distributor’s sales records, contracting with market research firms to track the market and even setting up toll-free numbers that authorized distributors can use to report on unauthorized distribution in their territory. Just as important, companies should work closely with the marketing team to establish brand protection guidelines for authorized retailers. By engaging in this exercise, not only is brand equity maintained, but standards are set which can serve to facilitate easier identification of an unauthorized retailer or distributor.  Companies should also work closely and carefully with their marketing teams when determining who is, in fact, an unauthorized retailer or distributor so as to avoid false accusations against authorized retailers and potential backlash or bad publicity. It’s a good idea to develop internal processes and assign responsibility to a specific manager to monitor the activity and manage the information received.

Finally, it is extremely important for companies to work closely with their authorized distributors and retailers to adequately control the supply chain. This can include careful screening of distributors and the use of incentives to prevent diversion of products. In addition, agreements with distributors and retailers should include a contractual provision prohibiting the sale to those outside of the intended chain of distribution. The contractual provision will at least provide a brand owner with a breach of contract claim against any authorized distributor who sells to unauthorized third-parties. Companies should keep in mind, however, that if they wish to control the downstream distribution of their products, they will have limited success with contractual limitations on their distributors because those provisions place no restrictions on unauthorized third parties. An alternative approach has been to use claims under the Lanham Act or Copyright Act against unauthorized resellers because such resellers often infringe upon the company’s trademarks. There are, however, significant legal and budgetary hurdles to successfully prosecuting such claims. Therefore, while they remain important weapons in a company’s arsenal against unauthorized resellers, it is critical for a company to develop proactive strategies to try to prevent diversion of its products.

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Adrienne Logan

Adrienne Logan is associate general counsel of Godiva Chocolatier, Inc.

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