5 ways to prevent discount and warranty fraud

These frauds can undermine your business partnerships and lead to significant financial losses

How is your company competing in the global economy? Are you offering special discounts to specific customers to attract new business or deepen existing relationships? Do you support your products with a robust warranty replacement program? You may not realize it, but these common practices of highly successful companies may be the means by which your company is being robbed blind. 

If your company’s products are in high demand, then you are a tempting target for two kinds of sophisticated fraud schemes aimed at finding and exploiting weaknesses in your discount and warranty programs. Both discount fraud and warranty fraud are on the rise—with large dollar amounts in play—and even the most vigilant of companies have become victims.

What is discount fraud and what is at stake?

Discount fraud exploits the special discounts companies sometimes offer when circumstances justify a lower price (or, put another way, a higher discount) to win a new piece of business or expand an existing relationship. In a typical scenario, your company is asked to steeply discount its product for a new sale based upon the customer’s representations of unique circumstances. As a condition of receiving the discount, that customer pledges that it will use the specially discounted products only for a specific purpose. While the vast majority of new sales opportunities are genuine, situations involving misrepresentations to get the extra discounts are becoming increasingly widespread. The result can cause significant harm to your company, including substantial lost revenues. 

The potential harm, however, extends beyond profits. In many cases, the discounted products obtained through discount fraud end up with brokers. The brokers use the heavily discounted products to compete, unfairly, against your honest channel partners. This causes your partners to question how they can compete if they cannot have access to discounts that, apparently, the brokers receive. This will eventually erode the integrity of your entire channel sales operation.

The law considers discount fraud to be theft.

In 2010, in United States v. Ali, the 9th Circuit upheld the fraud conviction of defendants who made false representations to Microsoft.  The defendants claimed to sell to educational users, and thus received Microsoft’s special pricing for academic edition products. Instead, the defendants sold 90 percent of the software to commercial entities. The court recognized this as theft and upheld the defendants’ sentences. The main defendants were sentenced to five years in prison and ordered to pay Microsoft $20 million in restitution (the difference in price if the products had been sold at normal discount instead of the academic discount).

What is warranty fraud and why does it matter?

Warranty fraud (also frequently called warranty or service abuse) takes many forms and is pervasive throughout many different industries and across many types of products. Warranty fraud schemes frequently are perpetrated by sophisticated, complex criminal enterprises aimed at deceiving your company out of genuine product by making false warranty claims. These schemes used to involve primarily the failure to return damaged products or the return of genuine products of lesser value. But these schemes have evolved over time to include the return of altered or counterfeit parts assembled to appear authentic. This is all done with the intention of defrauding your company and stealing genuine or refurbished parts from you. 

Companies offering post-sale support are prime targets for these schemes and cannot overlook this major threat. For example, in 2007, Nortel Networks won a $10 million judgment against two domestic companies it accused of a warranty fraud scheme. Nortel alleged that the companies claimed to be operating a telecommunications network under a Nortel warranty agreement and fraudulently received replacement parts from Nortel at no charge. Defendants falsely told Nortel that hundreds of parts were defective and that they needed replacement parts for their own network systems—only to turn around and resell the parts to third parties.  

Discount and warranty fraud cause lasting damage.

By procuring products at unjustifiably low prices or through deceitful warranty claims, the defrauders steal money from your company and undercut established sales channels by selling the stolen product in competition with honest channel partners. Your company may have already fallen prey to these frauds, or perhaps your company has identified these frauds as potential problems. In either case, your company needs to position itself for the best protection possible. 

Just how can your company best protect itself from these increasingly sophisticated schemes to defraud? This series of articles will discuss the best practices both to protect your company and to respond legally when you uncover these frauds. The five key steps for establishing an effective deterrence program (which will each be the subject of future articles in this series) are:

  1. Develop a program. Proactive companies addressing discount fraud and warrant abuse build programs specifically to detect and prevent those frauds from ever occurring. While no program is entirely impenetrable, designing controls and protocols into your company’s internal system can help mitigate fraud risks.
  2. Engage with your partners. Oftentimes, your key allies in combating discount and warranty fraud are within your own organization or are already well known to you: your channel sales partners and fulfillment centers. Make sure that they are engaged in detecting fraud. They should also know how and when to report suspicious conduct when they uncover it. Do not be afraid to enlist their support in your efforts to root out this fraud; after all, fraud adversely affects them and their business as well.
  3. Measure the metrics. Building the case for establishing a program to combat these frauds means first getting a handle on how your company can measure the extent of the problem. Companies tackling these abuses head-on use a number of established methods to measure the impact of these crimes. 
  4. Know your criminal referral options and be prepared to execute them. When the circumstances are right, referring a case to law enforcement can  send the important message that your company is not an easy target. Some people think civil judgments are “the cost of doing business.” Simply put: Prison sentences get people’s attention. Certain factors argue toward federal or state criminal referrals. While challenges can arise in presenting these cases for prosecution, the rewards of such deterrents are often huge.
  5. Know your civil litigation options and use them to best advantage. Criminal referral produces the biggest deterrent message, but some cases are not significant enough to justify law enforcement involvement. In those cases, your company’s best approach might be strategic litigation. Here, your goal frequently is to quickly stop the fraud, recover damages and deter future damaging and illegal conduct.

The upcoming series of articles will address each of the five elements for an effective anti-fraud program. The series will provide you with a toolbox to understand the issues related to discount and warranty fraud, and show you ways to combat these illegal operations. 

Contributing Author

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Richard Nelson

Richard J. Nelson is a partner at Sideman & Bancroft LLP in San Francisco, where he specializes in litigation and government investigations. Mr. Nelson often...

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Contributing Author

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Erica Brand Portnoy

Erica Brand Portnoy is an associate at Sideman & Bancroft LLP in San Francisco where she focuses on the representation of corporate crime victims and...

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