Product Diversion / Gray Market

When you hear someone refer to product diversion or gray markets, they are referring to the same thing: the retailing of products outside a company’s authorized distribution channels. To keep things simple, we will only use the term “product diversion” on this page from this point on.

We want to answer four questions:

• How does product diversion happen?
• Why is product diversion dangerous?
• What are practical ways to prevent diversion from happening?
• What legal recourse does a brand owner have to shut diversion down after it starts happening?

How does product diversion happen?

In short, product diversion occurs when an authorized distributor/retailer sells product to another distributor/retailer that is not authorized. It is really as simple as that. Once the product is in the hands of the new, unauthorized retailer and is offered for sale, it is considered diverted and the retailer is considered to be engaged in the gray market or product diversion.

In our experience, product diversion retailers are not always bad people. As we will note below, this kind of activity is not illegal. In the United States, if an entity owns a product that they have acquired legally, they have the legal right to sell it. Even large companies like Target sell products that have been diverted.

In many cases, the brand owner creates a situation that leads to diversion. Here are some typical ways brand owners get into a situation where diversion starts to take place.

• New distributors are not being vetted carefully and are allowed to purchase large amounts of product. In some cases, they plan to divert the product from the start, but in other cases, they legitimately cannot sell it and have to start searching for ways to dump it. Eventually it ends up diverted.
• New distributors are forced to place large opening orders. While this might help cashflow, it is a recipe for disaster.
• There are no legally-enforceable distribution agreements in place to protect brand owners against rogue distributors. While this is changing, until recently, very few distributor agreements specifically addressed product diversion.
• The brand owner does not offer a wholesale return policy. If a brand owner does not offer some kind of buyback protection, they can expect to have problems either with deep discounting or diversion.
• There is a wide variance in wholesale pricing. For example, some US brand owners sell their product much cheaper to international buyers who divert it back to the US. Once back in the US, the diverter can sell it at a discount when compared to US retailers because it was acquired cheaper.
• Some kind of theft is taking place inside the company. Dishonest employees may divert product by either stealing it outright or engaging in schemes with product diversion retailers. Sometimes, these schemes can be tricky. For example, we have seen situations where unopened returns were being diverted rather than destroyed.

Why is product diversion dangerous?

Product diversion can destroy your brand. There is one huge reason why: diversion will always put pressure on your retail price. That will happen 100% of the time. If you are retailing your own brand, that in turn cuts your margins. If you do not retail your own brand but instead distribute to retailers, it undercuts the retailers that are doing the real work for you. You are not going to have a good relationship with your retailers if they are working to sell your brand and then losing the sales to diversion discounters on Amazon.

Discounting is the big thing. There are other possible problems that are listed below. We take some of this with a grain of salt because very often, diverters are selling authentic product in a responsible way. In fact, brand owners often use reasons like these not because they are actually true but rather to set up lawsuits and/or scare customers into paying more and buying from authorized distributors.

• The diverted product is possibly compromised and even dangerous because it has been outside the authorized distribution channel. For example, a diverted hair product might be watered down or expired. Selling compromised diverted product lowers customer satisfaction and harms the brand.
• Because the product is being sold by distributors that the brand owner has no distributor agreement with, holding them to a specific customer service level is impossible. Warranties and return policies might not be available. When these kinds of things are happening, the brand is harmed.

What are practical ways to prevent product diversion from happening?

The best way to prevent diversion is to create an environment that is not diversion-friendly. In other words, brand owners should create an environment that addresses the situations listed above that lead to diversion. However, popular brand owners are probably going to struggle with diversion. Here are some tips to help with this problem.

• Relentlessly focus on the problem. You never win the war for good because as you shut down diverters, more will show up. We operate in a world where even small time players can import product and start selling on Amazon and Ebay, Your strategy has to include a way to monitor the market for new product diverters and then take steps to shut them down.
• Find ways to track your product. If you have lots of product diversion occurring, you almost certainly have dishonesty in the chain. Most of the time, an authorized retailer is either selling product in an unauthorized place like Ebay on the sly or is selling the product to the diverter. If you find that retailer, you can shut them down and choke off the diversion. The best way to do this is to find some way to mark the product you ship out. There are expensive solutions that put unique codes on every product. If you cannot take that step, look for other ways to mark product going to suspected retailers. Then place test orders from the product diverter and see if you can identify the retailer by how the product is marked.
• Make sure that your distribution agreement has a clause that addresses product diversion. Also, make sure your distributors and retailers know that you will hold them legally responsible if they intentionally sell to product diverters.
• Get tough and enforce your policy. Many companies do not follow through with their threats to shut down product diverters and as a result, greatly harm their margins and distributor relationships. Enforcing your product diversion policy may be expensive but is necessary. If you do play hard ball a time or two, you will scare other product diverters to other brands. Product diverters absolutely do the research to see how willing a company is to fight this problem and they tend to gravitate to less risky opportunities.
• Offer all online retail as an exclusive deal to a single distributor you trust. In other words, work with a company like us that will get you online exposure on all selling channels while following and enforcing your product diversion policy. You can learn more about what we offer here.

What legal recourse does a brand owner have to shut diversion down after it starts happening?

As we mentioned earlier, in itself, selling diverted product is legal. However, there are legal strategies to shut down product diverters. We will keep you up to date on relevant court cases but in general, successful legal strategies include the following:

• Send legal warning letters. Sending these letters is inexpensive and will scare a lot of product diverters into moving on. If you do send such letters, make them legally impressive. Demonstrate that your company has researched the product diverter, identified legal weaknesses, and done some legal research on the legal strategy that would be used in a trial. Cite court cases if possible.
• Try to work out deals outside of court. Fighting these kinds of cases is very expensive and recovery is usually doubtful. Sometimes, offering a sell-off period to a product diverter with the promise from them that they will move on is a simple solution. In some cases, you might offer to purchase their product back in exchange for a simple settlement that forbids them from selling your brand in the future.
• When you have to sue, attack with claims that are working in courts already. These claims do not address diversion itself but can still put pressure on a diverter. Here are a few of the main claims being used successfully:
  • Tortuous interference. If you can prove that the product diverter worked with an authorized distributor/retailer that had an agreement with you that forbid diversion, you can claim that the diverter tortuously interfered in your business dealings.
  • Altered product. If the diverter alters the product label in any way, they are on legally shaky ground, especially if they try to sell the product as new.
  • Lack of quality assurance. Diverters almost always represent their product as new and some brand owners attack that representation with the claim that because the product is outside the authorized channel, the quality assurance that comes with all new products does not exist. Therefore, the product is being misrepresented which in turn weakens the brand.
  • No warranty/return policy. Because diverted product does not come with a brand owner warranty and is not eligible for brand owner returns, it is materially inferior to the product sold inside authorized channels. Therefore, the product is being misrepresented when it is claimed to be in new condition, which in turn weakens the brand.
  • Some other deficiency exists in the diverted product. This is essentially the same claim as the last two. Brand owners try to find something that exists in the sales process in authorized channels but not in the diverted channel. For example, a cosmetic company claimed that only authorized retailers had access to certain tools that helped customers pick the right color of lipstick.

If you are having problems with diversion and want to talk further, contact us. We can help you get that problem under control.