Unwelcome (Product) Diversions

Product diversion costs manufacturers millions, but often isn't technically illegal. CSOs say combating diversion involves equal parts investigation and corporate politicking.

Product diversion costs companies worldwide billions of dollars a year in lost revenue. It's insidious, widespread and, to the consternation of executives who watch products and profits dribble out of their supply chains like milk from a baby's lips, often legal.

To discover how diversion works and how they deal with it in their respective companies, Senior Editor Todd Datz talked with two experts on the topic, Randy Arnt and Max Brenton. Arnt serves as executive director of global security for retail giant Kimberly-Clark, maker of well-known brands such as Huggies and Kleenex. His responsibilities include supply chain security, brand and asset protection, litigation support and all other security-related activities worldwide. Previous stops include Whirlpool, Greyhound and Standard Oil. Brenton is head of corporate security and a 17-year veteran of medical products maker Roche Diagnostics. Brenton also has 20 years of law enforcement experience on his résumé.

Also see 'How product diversion works' for an illustration of the mechanics of diversion.

CSO: You've both noted that product diversion is a growing problem. Why is that?

Randy Arnt: Partly it's due to globalization. We see a lot of antiquated regulatory enforcement systems in various parts of the world. And certainly the Internet plays a major part. If you go on eBay, for example, or a number of similar sites, you can see a lot that's counterfeit or diverted product.

Max Brenton: It's often a civil contractual problem in the United States, selling outside of the class of trade [for which products are intended]. For instance, if you sell to a certain mail-order distributor, a contractual clause states they can't sell the product over-the-counter. But sometimes that mail-order product will end up online somewhere. Or it will end up being sold on the shelves of local drugstores based on the fact that the chemistry of the product is the same.

CSO: In cases where it's a contractual problem, and not actually illegal, is this something that the board of directors keeps an eye on? The politics of dealing with your big business partners sounds potentially tricky.

Arnt: You have to get management's buy-in for that before you do anything else. Because if you don't, and if they give mixed messages or if sometimes they enforce it and sometimes they don't, it really becomes a mess. So it's been to the top levels of our company. Because if you don't have that, you're wasting your time.

Brenton: I'm fortunate to the extent that I've got the ear of senior management in sales and marketing and the legal division. I report to the legal division and all the way up to our CEO. And we have a partnership, a team created with the sales, marketing and manufacturing groups to look specifically at diversion, theft and counterfeiting.

CSO: Give me typical diversion tactics you face, and the controls you use to combat them.

Arnt: Internationally, what we would normally see would be a distributor buying huge quantities—much bigger than their markets could absorb—and that product is being turned around and sent back here and resold.

Brenton: Diverters create shell corporations [to disguise diversion], which can change in no time flat. What you have to do is pursue the owners and/or the boards of directors to see if the same people are involved in that particular shell corporation.

Arnt: We do a pretty good job of monitoring new distributors closely. We do a due diligence on [new distribution partners] to find out whether there may have been problems in the past with other consumer product companies. Then for a period of a year we look at their sales, and make sure that we're satisfied that the products are being used for the [agreed-upon] market. We have been able to find good service providers for those due diligence checks. If we uncover issues, of course, then we don't do business with those distributors. It seems that globally there are due diligence or investigative service providers out there that have a long reach and do a pretty good job.

CSO: What about a domestic examplea customer that's bought huge quantities and then resells. Is it typically large, well-known chains? Or the small guy?

Arnt: Many of the big chains purchase diverted goods; their basic premise is that they have a responsibility to their stakeholders to get the product at the lowest price possible. In fact, it doesn't happen to be a customer of ours, but there is a very, very large chain that recently filed suit against one of the hair product providers, suing them for restraint of trade. It turns out that this hair-care company was only selling to salons. And their products would wind up in this chain that had been purchased as diverted product.

So the hair-care company threatened to sue this chain. The chain turned around and sued the hair product company, saying that it was a restraint of trade that they were not able to purchase this product from this manufacturer. Kind of an interesting approach, taking the offensive, I guess, on this. But a lot of big chains just feel that that is the way to do business—that they're going to get the best price they can. If we can get it to them, fine; if we can't, they'll look elsewhere.

And when you've got a huge customer like that, you've got to make a value judgment: "OK, maybe there are distribution clauses in there, but given the volume that they're selling, is that something that we're going to enforce, or are we going handle it differently?"

Brenton: One of our major distributors had been purchasing secondary product. And remember, they're a business, and it's a business decision. But what happened was, someone in that tertiary or secondary market had gotten ahold of counterfeit product. The counterfeit product then became mixed in with the diverted product, and they had no way of knowing that. And so we went back to three of our major distributors saying, "We know you're the victim the same as we are. However, let's make our partnership stronger."

We were able to go back and say, "OK, let's look at the choices—buying from us or buying from secondary dealers. It creates a lot of problems." Now, has that stopped all of the secondary dealers? No. But has it solidified our relationship with our major distributors? Yes, it has.

CSO: So you've mentioned due diligence on international distributions partners, and contractual efforts. What other types of antidiversion controls have you put in place?

Brenton: We have an extensive training program where we go out and explain this issue to our sales folks in the field. Also, I have a great liaison with all stages of law enforcement—the FDA, U.S. Customs, Immigration and Customs Enforcement.

We're now finally taking great steps in reducing the numbers of products that go out, and doing it by identification on the boxes and on the vials, and using tracking devices. It's still a business decision, but the traceability of the product is much better now than it was five years ago. We've actually reduced our classes of trade domestically. Your brand identification is very, very important. And what we've done is we've reduced the numbers of products that go out that are, in essence, the same product but for different arenas.

For instance, mail order for hospitals and caregiver facilities—that product should be sold at a reduced cost simply because we're dealing with people who need that product, and sometimes they are, in essence, strapped for money. And we've taken that into consideration. So [the product] is not identified for over-the-counter sale; the product looks the same, but it's in different colored boxes, and it will say "Exclusively for mail order. Not for sale in retail outlet." If somebody gets that across the counter, then there's a direct line that they can call.

We've also created Accu-Chek Customer Care training sessions for our customer representatives. They've done a wonderful job of filtering calls, and then letting us know when there could be a secondary product or a counterfeit issue.

We make sure that foreign product is registered differently with the FDA. We don't want that product back in the United States, so it has a different box and a different look. And it says, "For export only."

We've tried the holograms [on packaging]. We've tried stickers. But those can be duplicated in no time flat, especially in the Far East but also right here in the United States.

We liaison with the Internet based on a criminal case where we lost about $4 million in product. It was a former employee who sold every bit of it across the Internet. What happened was, this person went out and found several others to purchase this product. And so they were ordering the product under false pretense, shipping it across state lines and making a tremendous amount of money off it. Those folks are now under indictment. One has already been convicted.

So we do pursue it from our old vantage point of investigation. But it's critical to interface with the business units and lend your expertise to them. For instance, a simple change in the number of dots on a box, the forensics that can prove that it's not your glue that seals the box, lot number changes that indicate that it can only go to specific places—these things can tell us exactly where diverted product comes from. And that's borne out of our being burned several times.

Arnt: We do everything from bathroom and facial tissue to health-care products. We're now a health and hygiene company as opposed to just strictly a consumer products company. And obviously with the health products, we have put more controls in place there because of the concerns about product safety. A lot of our controls have to do with packaging—institutional packaging versus hospital packaging versus consumer packaging. Also labeling, although labeling is an interesting issue for us. Because in order to reduce costs for your consumer product packaging, your advertising and so forth, you will see more of the same labeling and packaging throughout the world. If it's got French, English and Spanish on it, that doesn't tell you much in terms of where that product came from.

The packaging does mean more. And then tracking of course. A lot of the big customers that we have (and one of our biggest is Wal-Mart) are requiring radio frequency identification tracking as part of the way we sell to them. This will have a lot of side benefits as this technology expands because it's going to be able to tell you a lot of things about where this product was in the supply chain, and where it should be. It just provides a tremendous amount of information that should help us in the long run, especially with diverted product.

Brenton: Right, we have antitheft devices on the inside of our boxes. And the biggest issue is, people don't really notice this. With a counterfeit product or a foreign product that is repackaged in U.S. packaging, they do not [carry the antitheft devices]. So that's one indicator to us that the product was not manufactured in the United States.

CSO: What are the complications in working with law enforcement abroad?

Arnt: China, a few years ago, before they got into the World Trade Organization, was a huge problem for all consumer product companies. We were able to get very little enforcement until a few years ago. The problem now has significantly diminished because the Chinese authorities have taken much more interest in terms of going after this. China has really emerged as both a consumer and a manufacturing dynamo, and a lot of that is because they're taking intellectual property and trademarks, at least from our experience, much more seriously than they did.

We did find some other countries in Southeast Asia where diversion would show up. But Southeast Asia in general had counterfeiting problems—for instance, Vietnam. But you would see these little mom-and-pop shops. Sometimes they would go to your packaging manufacturer and purchase overruns on your packaging, and then put an inferior product in it, go out and sell it on the marketplace.

CSO: Do you use antidiversion software?

Arnt: We use services to help us identify diversion. I'm not sure what software programs they have. A lot of it is database programs where they've had experience with a diverter before. But we use a couple of services that assist us in getting a heads-up: "This particular diverter has this amount of product out there on the diverter's line. If you'd like us to see what we can find out about it, or make a purchase or whatever, we can do that." We do a number of investigative things that way. We have a couple of ex-diverters who provide some assistance to us in terms of actually being able to go out and speak the language, in some cases make a purchase if we need to, and help us identify some of those channels.

CSO: Explain the "diverter line."

Arnt: The diverter line is where they know to go and look for product that is diverted or sometimes stolen. I don't know the address because the diverters, the people that work for us, don't give us that information. But there is such a thing as a diverter's line where they can go and put their requests out there and respond to one another. Some of it's online. Some of it is simply a Rolodex; they can call people and do it that way.

Brenton: I'm aware of a couple of programs that actually will digest and diagnose pop-ups and spam, and then will pursue it by giving you an in-depth report on your product—what's seen, where it is, what it's going for. Then we know the percentage of profit sometimes or the percentage of loss. We do use one, but we really don't want to discuss it too openly. Mostly, it tells us the who, what, where, when, why. Sometimes it doesn't tell the how. If the product is available on the Internet, for instance, the software will tell you an e-mail address where you can purchase this product. Or it will tell you the name or the phone number to call.

Arnt: There are a couple of other services out there. We will do monitoring ourselves, but we also have somebody do that for us. We use an Internet Crimes Group product called iThreat Solutions. In some cases, they're going into the deep Internet chat rooms, and they'll monitor Internet auction and sale sites for you and spit out a list of what's out there. There's another company called GenuOne, which has an Internet service that lets companies punch in a list of their brands or products that they want to monitor.

CSO: Can you enlist customers to help out?

Arnt: Absolutely. We get a fair amount of tips from customers and distributors, like, "Hey, there are things showing up out here that are below our price." So between your salespeople, your customers and your distributors, you've actually got a pretty good intelligence network.

CSO: In spite of that, clearly there's no simple remedy for diversion. You gather intelligence from many sources, you think about tracking and contracts and training....

Brenton: Things that I was never involved in before, I'm totally involved in now. For instance, the package: the look of it, what needs to be on it, identifying marks on or inside the package. Show the value of how security can increase their revenue and give them background investigations.

You're protecting the customer, and you're protecting your investment for your stockholders and for your corporation. But most important, you're protecting the end customer, the patient.

Arnt: I think I was fortunate; the company had a pretty good understanding to begin with. To Max's point, I think that it is something where security can really show some value added. Let's say that you find $10 million worth of diverted product. And believe me, that isn't a huge amount of diverted product sales. If you've got a 15 percent profit lost opportunity, you're looking at a million and a half dollars that you can stick back on the bottom line.

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