As e-commerce has developed and evolved over the past two decades, consumers have had an increasingly difficult time verifying the authenticity of purchased goods. Brand owners often sell authentic goods on their own websites or through the websites of authorized online retailers, such as Amazon.com, Walmart.com, or Target.com. Suppliers of knock-off goods that are made to look like authentic, branded products, but don’t employ infringing trademarks, are also widely available online, often through the same authorized retailers that are selling authentic, branded products. However, less scrupulous online sellers may be selling counterfeit goods or goods that improperly employ the trademarks or copyrights of branded products.
A third category of goods factoring into consumers’ purchasing decisions reside in a gray area of market legitimacy. In a nutshell, these gray market goods are authentic, branded products that are sold through unauthorized distribution channels. While these gray market products are authentic, there are numerous ways in which the presence of such products in the marketplace may negatively impact brand value and cause harm to brand owners and their constituents. Herein, we discuss the following topics: 1) what gray market goods are; 2) how gray market goods enter U.S. commerce; 3) how gray market goods impact brands; 4) how harm caused by gray market goods can be quantified; and 5) how brand owners can attempt to control the flow of gray market goods.
Simply put, gray market goods are authentic products that have been diverted from authorized distribution channels. For example, a brand owner may sell its authentic products to an authorized distributor outside the United States; if that non-U.S. distributor then resells those products online to U.S. customers – outside the terms of its distribution agreement with the brand owner – those products would be considered gray market goods. Among the problems that gray market goods may cause in the unauthorized market (for the purpose of this example, we assume that the unauthorized market is the U.S.) are: 1) the gray market goods may have been designed or formulated for different geographic markets; 2) the gray market goods may have been tampered with before entering the U.S.; 3) the gray market goods may include expired, damaged, or returned products; and 4) the gray market goods may not be covered by standard manufacturer’s warranties.
As for the problem of design or formulation for different geographic markets, the products may contain different ingredients or components than authentic products designed or formulated for consumption or use in the U.S. The foreign markets for which the products were designed or formulated may have less stringent regulatory requirements than the U.S. Labels or instructions included with those products may be written in foreign languages or may use units of measure not commonly used in the U.S. Furthermore, these authentic goods bound for foreign markets may reflect different consumer preferences (different tastes or default configurations) than those designed or formulated for use in the U.S.
Unsuspecting consumers may have a difficult time determining whether a purchased product is a gray market good. Some clues that can tip off whether a purchase may be a gray market good include: 1) different labeling than the authentic U.S. good; 2) instructions in foreign languages; 3) serial numbers or other product identifiers may be obscured; 4) damaged products; and/or 5) different warranty coverage or rebate offers from what was advertised in the U.S.
Gray market goods can enter U.S. commerce through a variety of methods – often through non-U.S. authorized distributors, or occasionally through the brand owners themselves. As an example, an authorized distributor outside the U.S. may over-order products from the brand owner to take advantage of volume discounts. The excess inventory (above the needs of the authorized territory) could then be resold to brokers, who, in turn, sell those products back to U.S. consumers online or through non-authorized U.S. resellers. As another example, brand owners themselves may provide brokers with access to end-of-life stock and production overruns, which are then sold to U.S. consumers online or through non-authorized U.S. resellers.
Although some of the above-described activity may sound innocuous, it is important to note that the same brokers who are acquiring and reselling these authentic goods may also be acquiring and reselling counterfeit goods. Thus, establishing a path to market for the gray market goods may simultaneously pave a path for counterfeit goods to enter commerce.
In fact, the issue of gray market goods has widely affected numerous companies across many different industries. In 2001, the Alliance for Gray Market and Counterfeit Abatement (“AGMA”) was formed by multiple technology companies to address the global impact of gray marketing and counterfeiting of technology products. Originally, AGMA was formed by 3Com, Cisco Systems, Hewlett-Packard (HP), and Nortel, and has since expanded to include companies such as Microsoft, Texas Instruments, and Fitbit, among others. AGMA’s ultimate goal is to “protect the authorized distribution channels and intellectual property of authorized goods in order to preserve customer satisfaction and preserve brand integrity.” In an effort to promote awareness of the gray market goods problem, AGMA has produced whitepapers outlining ways in which gray market goods affect product markets.
To date, few empirical studies have been performed to measure the scale and impact of the gray market goods problem. Among the few published reports, AGMA, in conjunction with KPMG, published a study in 2008 that surveyed multiple respondents, representing original equipment manufacturers (OEMs), channel partners, and brokers in the technology industry affected by gray market goods. The whitepaper reported that, in 2007, as much as $218 billion in revenue’s worth of gray market product was sold, a significant increase from a 2002 study which estimated that as much as $40 billion in revenue’s worth of gray market product was sold. AGMA subsequently released an update to the aforementioned study in 2016, in which the vast majority of OEMs (roughly 63%) indicated that they had seen an increase in gray market activity since 2008. While it is difficult to measure the exact magnitude of gray market product sales in markets in aggregate, these studies suggest that the sale of gray market goods is significant and has been increasing.
Gray market goods impact brands at every level of the food chain, starting with their impacts upon consumers, moving up through authorized distributors/resellers, governments, and ultimately brand owners. At the consumer level, unsuspecting consumers may purchase gray market goods thinking that the goods are authentic and authorized. However, those consumers may be surprised to find that their purchased products are missing accessories, functionality, or documentation. Those products may also contain cheaper components or may fail to meet U.S. safety/environmental standards. In the case of expired pharmaceuticals, the products may not perform as expected. Finally, consumers may find that those products are not covered under standard product warranties if service or repair is required. Ultimately, any of these issues may result in consumer dissatisfaction, which can be expressed through customer reviews on retailer websites, social media posts, or customer service contacts to the brand owner. It goes without saying that once enough volume of such dissatisfaction is expressed, harm to the brand may be a consequence.
At the authorized distributor/reseller level, those authorized distribution partners in the U.S. may start to feel the pinch of competition with lower-priced sources of the same authentic goods. However, while authorized U.S. distributors and resellers may have invested in marketing and promotion activities to support the brand and may have invested in developing education or service programs around the branded products, the unauthorized gray market sellers may not have. That is, the unauthorized gray market sellers are able to avoid certain overhead costs that authorized U.S. distributors are required to pay, leaving those authorized U.S. distributors at a further competitive disadvantage. Furthermore, to the extent that authorized U.S. distributors expect to bundle sales of services along with sales of the branded products, such convoyed sales opportunities may evaporate without the ability to capture the initial product sale. Finally, the authorized U.S. distributors may receive requests for warranty coverage for unauthorized goods that they did not sell. All of these factors may lead to other forms of harm to the brand: authorized U.S. distributors may have decreased motivation to sell and support the brand owner’s products; authorized U.S. distributors may feel that gray marketeers are benefiting unfairly from their advertising, point-of-sale, and post-sale services, as well as other investments in the brand owner’s products; and authorized U.S. distributors may feel dissatisfaction with the brand owner for not better controlling sources of supply.
At the government level, distribution of unauthorized goods into the U.S. may have consequences with respect to potential lost tax revenues, as well as entry into U.S. commerce of goods that are potentially non-compliant with agencies such as the Food and Drug Administration (FDA) and Environmental Protection Agency (EPA).
Finally, at the brand-owner level, distribution of unauthorized gray market goods may result in pricing harm and channel conflict, in which authorized distributors face unexpected competition and may be forced to reduce prices. Such issues may result in complaints or the expression of other dissatisfaction by authorized resellers, as described above. The brand owner may also receive requests for warranty coverage on unauthorized goods. At this level, the brand owner may need to make a decision to authorize service/repair of the gray market goods, incurring unexpected expense, or risk further dissatisfaction from the consumers who purchased those goods. With repatriation of goods not expected to be sold in the U.S., brand owners may experience geographically unbalanced product revenue streams, requiring additional analysis to better understand their markets. With potential dissatisfaction being expressed at other levels of the food chain, brand owners face issues of reputational harm and dilution of brand value.
As is the case in any situation involving potential consumer dissatisfaction and distribution channel conflict, reduced sales volumes and dilution/loss of brand value can be very real results of a gray market problem. For example, if consumers express dissatisfaction through customer ratings/reviews on retailer websites or social media sites, average product ratings may decline, which could result in reduced sales and associated profits. In fact, at least one study reviewed the effect of electronic word of mouth (e.g., e-commerce platforms such as Amazon and eBay and social media platforms such as Facebook, blogs and discussion forums) on consumers’ purchase decisions and concluded that there is a significant relationship between sales and electronic word-of-mouth platforms. Because certain brand valuation methodologies rely upon expected future sales and profitability of the branded product, royalty rates that a brand may be able to command in the marketplace, and riskiness of achieving expected future cash flows, such dissatisfaction may also flow through to brand value.
To the extent that brand owners choose to provide warranty service/repair on unauthorized gray market goods, those brand owners may incur increased warranty costs over those that would have been anticipated for the U.S. territory.
Finally, if brand owners choose to take legal or other corrective actions, additional costs and management time would be borne by the brand owner in doing so.
In one example, Hyundai Construction Equipment U.S.A., Inc. v. Chris Johnson Equipment, Inc., the defendant purchased 29 Hyundai heavy construction machines in Korea from the plaintiff’s parent company (Hyundai-Korea) at a price well below the price at which Hyundai-U.S.A. was able to sell machines to its domestic retailers. The units purchased by the defendant were intended for sales in Korea and/or China and, as a result, did not include the standard warranty all U.S. machines sold through Hyundai-U.S.A. contained, had non-English language safety, operational, and maintenance labels and manuals, contained non-EPA-compliant engines, and included model numbers not sold within the United States. In fact, the gray market machines’ serial numbers were altered by the defendant. As a result, the court permanently enjoined the defendant from importing or selling any Hyundai heavy construction equipment with less than 100 hours of operational time and awarded Hyundai-U.S.A. almost $1 million in damages (the profits earned by the defendant from selling the 29 gray market goods).
In another example, HP reached a settlement in a gray market case in 2008 against Maxicom PC, a former reseller of HP products that allegedly sold its products in unauthorized channels. In this settlement, HP sought to recover over $4 million in pricing discounts for computer equipment that was sold outside of its contracted sales channels. In its statement regarding the settlement, HP stated that it was “focusing on three key initiatives: education and training; tightening business practices and controls; and taking appropriate action in relation to resellers who violate terms of their authorized reseller agreements.”
In one additional example, Uber was recently involved in dangerous gray market goods activity in Singapore. Due to the high price of car ownership in Singapore, Uber obtained an $800 million bank loan to buy its own cars in that country and lease them to drivers, who otherwise could not afford to buy cars. However, instead of purchasing the cars through authorized dealers, Uber turned to gray market importers who offered cost savings of approximately 12%. Many of the purchased gray market cars had a known defect and were under recall by Honda. In early 2017, one of those cars caught fire with the driver inside. (Fortunately, the driver was not hurt.)
Brand owners do have at their disposal certain legal options to combat the flow of gray market goods. Because gray market traffic may violate the terms of contractual distribution agreements, the first step may be to send cease-and-desist letters to gray market importers.
More powerful enforcement techniques may be available in the U.S. through the Lanham Act, which provides means for obtaining exclusion orders (§ 42) and/or profit disgorgement (§ 32 or § 43). In particular, in order to invoke remedies through the Lanham Act, it is often required for brand owners to satisfy the Material Difference Test, in which the courts seek evidence of one or more material differences between the gray market products and the authorized, authentic products. A single material difference creates presumption of the potential to mislead or confuse consumers about the nature or quality of the product. Proof of actual confusion is not required. Examples of material differences include: altered or obliterated serial numbers; non-English language instructions, manuals, or labels; significantly reduced price from that of exclusive U.S. distributors and/or sold without a standard U.S. warranty; and physical differences, including packaging or product composition. Some material difference proofs that have been offered in prior disputes include:
Outside of legal remedies, there are numerous, practical steps that brand owners can take to control the flow of gray market goods. For instance, due to the potential for gray market goods to originate at contract manufacturers, brand owners should pay close attention to manufacturing and inventory variances at contract manufacturer plants. Brand owners may also wish to implement and monitor product control and tracking procedures for non-U.S. distributors. Destruction of excess inventory is a technique often used in the fashion industry to prevent authentic goods from being sold by unauthorized distributors. And, of course, consumer education efforts can always help: for example, teaching consumers how to tell the differences between gray and authorized domestic goods; providing notice that gray market goods are not covered under manufacturer’s warranties; providing a toll-free number to report incidents of gray market good sales. In order to help combat gray market goods in the pharmaceutical industry, the FDA will require unique device identification (UDI) systems for all Class I-III medical devices and packaging by 2020.
With the reduction of selling barriers resulting from increases in online commerce, it will be imperative for brand owners to better monitor the distribution of their branded goods in the U.S. and other markets. The presence of unauthorized gray market goods in the marketplace can impact the perception and satisfaction level of every stakeholder and constituent group in the distribution chain – from consumers to distributors to government entities and back up to the brand owners. As a brand-protection strategy, we suggest that brand owners take steps to monitor and curtail the flow of unauthorized, but authentic, goods into their markets, just as they already do in their efforts to halt the flow of counterfeit goods.