Discount fraud

Sales of “gray market” products generally are viewed as legal, but diversion of deeply discounted products from authorized distribution networks is often based upon fraud. Here we examine schemes to illicitly obtain millions of dollars of discounts through this pervasive but relatively unknown type of fraud. And we offer ways to ward off fraudsters’ efforts.

For years, Florida-based Tropical Investments obtained from U.S. manufacturers at deeply discounted prices large quantities of baby formula and other products regulated by the U.S. Food and Drug Administration. The company’s principals told the items’ manufacturers they needed the discounts to support their humanitarian efforts to sell the products to disadvantaged customers in Suriname via government procurement contracts.

Tropical Investments touted to the products’ manufacturers that it had contracts with the Suriname government to supply the goods, and that one of the company’s principals was originally from Suriname.

The company also provided export documents that showed shipments of these products into Suriname. Despite the company’s assertions, the entire operation was a fraud. Tropical Investments never exported the products but sold them in the U.S. at prevailing prices, which netted the fraudsters over $200 million in illicit profits.

The company generated export documents by shipping to Suriname empty crates and crates filled with products that were later returned to the U.S. Sometimes the company simply fabricated export documents.

In May 2022, three defendants were convicted in U.S. federal court of wire fraud, money laundering, smuggling and other charges, and received 18-year prison sentences. The court also entered forfeiture judgments totaling over $202 million. [See “Fraud Scheme Involving Baby Formula Leads to 18-Year Federal Prison Sentences for Swindlers,” U.S. Department of Justice (DOJ), May 20, 2022.]

Discount fraud and the ‘gray market’

Many large manufacturers control sales and distribution through partner relationships with authorized distributors and resellers. These networks are known as “authorized distribution” or “authorized channels.” Manufacturers offer discounts to distribution partners to stay competitive, increase market share or develop new markets. Goods that are sold with discounts by unauthorized, unintended or unofficial resellers — diverted from authorized channels — are “gray market” (but still genuine) products. Gray markets are generally legal as compared to black markets, such as those dealing in counterfeit and stolen products. Companies may also provide discounts to support disaster recovery efforts and can require specific conditions of eligibility, such as restricting the sales to pre-identified end customers or selling within a given country or region. Critically, they provide these discounts to companies to meet specific business needs but not for products manufacturers intend to resell in the open market.

However, there’s also a dark side to the gray market as these deals can be worth millions of dollars and unsurprisingly attract fraudsters who scheme to extract the products from authorized distribution networks and exploit promotional pricing in their favor. A company successfully commits discount fraud when it not only diverts products from authorized distribution but obtains the products at the lowest possible prices to maximize resale profit. Often, the lowest prices may be available in developing markets that don’t have stringent internal controls — perfect conditions, of course, for fraudsters. Therefore, many diverted products flow across international borders. In what’s essentially a form of global arbitrage, the diverted products often move from geographic areas where the lowest prices are available to developed markets anywhere in the world where companies can obtain the best prices.

Manufacturers can lose a great deal of money to the gray market. Therefore, many have implemented enhanced controls on their discounting practices. These practices, which are a form of “know your customer,” generally involve verification of the business case and the end customer to try to ensure that the discounts are appropriate to the circumstances and based upon a legitimate business rationale. However, sometimes when manufacturers don’t have any controls or poorly execute controls they do have, opportunists may not even need to make fraudulent misrepresentations to obtain discounts.

The types and levels of discounts are attractive targets for fraudsters, so the gray market in many diverse products is flourishing. Buying gray market products can have the unintended consequence of supporting criminal enterprises. (See “The Top Five Unintended Consequences Of The Gray Market,” by Shelley Raina, Forbes, Aug. 25, 2022.)

Scope of discount fraud

It’s difficult to accurately determine the percentage of product diversion attributable to fraud, but it’s probably significant. The gray market permeates all types of businesses and products, including consumer goods, medical products, automobiles, cigarettes, and fashion and beauty products. Billions of dollars in gray products are sold each year. KPMG has estimated that $58 billion of information technology products alone flow through the gray market globally each year, costing manufacturers $8 billion to $10 billion annually. (See “Effective Channel Management Is Critical in Combatting the Gray Market and Increasing Technology Companies’ Bottom Line,” KPMG Gray Market Study Update, 2008.)

Consumers may be attracted to the low prices of gray market products, but they take a risk that the products aren’t eligible for warranty repair, contain software that’s invalid or can’t be updated, or contain components that are used or not genuine. However, gray market discount fraud saddles manufacturers with decreased profit margins, price erosion, brand and reputation damage, and even potential exposure to trade violations if prohibited products are imported into embargoed or sanctioned countries. Perhaps the most significant impact is on legitimate authorized resellers that are forced to compete with illicit low-priced products diverted through fraud.

Discount fraud and the Fraud Triangle

As fraud examiners, we’re intimately familiar with Cressey’s Fraud Triangle, which postulates that perceived non-shareable financial need, perceived opportunity and rationalization are the necessary precursors to fraud. And in practice, we’ve witnessed the psychological gymnastics of fraudsters attempting to rationalize their misdeeds.

Discount fraud offers a particularly enticing scenario to rationalize the theft of discounts, rather than the entire value of a product. A potential fraudster might find it easy to blame a greedy manufacturer for perceived inflated prices for an agreed selling price, albeit based upon fraudulent misrepresentations to justify the discounts.

The rationalization of discount fraud most likely is the result of the major technique of what some researchers call “denial of consequences” (negating or trivializing offending impacts) and, more specifically, denial of injury (“The business can afford it”) and denial of a corporate victim (“They had it coming”). (See “How Fraud Offenders Rationalize Financial Crime,” by Iva Charlopova, Paul Andon and Clinton Free, from “Corporate Fraud Exposed,” ResearchGate, October 2020.)

A fraudster can slide down the slippery slope of easily projecting their greed onto a corporate victim because of a misguided belief that the victim won’t be harmed. This aspect sets discount fraud apart from more traditional forms of fraud and provides a fertile ground for rationalization of these acts.

Is fraudulently obtaining discounts a crime?

This question was clearly answered in a Microsoft discount fraud case prosecuted in California in 2009. (See “Four Defendants Sentenced in Scheme to Defraud Microsoft Corporation,” U.S. Department of Justice, Oct. 25, 2007.) Microsoft sold at significant discount to “authorized education resellers” (AERs) a special “academic edition” of its software that was identical to the regular retail edition. Microsoft required the AERs to sell the discounted products to “educational users.”

The defendants in this case, who falsely represented themselves to Microsoft to obtain AER status, sold 90% of the discounted products to end customers who didn’t qualify to receive the educational discount. The defendants were convicted of mail and wire fraud and money laundering, ordered to pay $20 million in restitution and given prison sentences ranging from 33 to 60 months.

During the defendants’ unsuccessful appeal, they claimed their actions weren’t criminal because discounts are only a “potential profit” and don’t actually result in losses to victims. The United States Court of Appeals for the Ninth Circuit held that the right to full payment for its products was “money or property” for the purpose of U.S. mail and wire fraud statutes. (See “Louis Feuchtbaum writes ‘Defenses to Discount Fraud Stripped’ for The Recorder,” Sideman Bancroft LLP, Nov. 4, 2011.)

The court concluded that “Microsoft only sold the software to those distributors with the agreement that it would only be resold to other AERs or to AE users. The mere fact that the software traveled through other hands on its way from Microsoft to Defendants is immaterial: Microsoft sold the software only for limited distribution and Defendants fraudulently obtained it for indiscriminate distribution.” (See “United States v. Ali,” United States Court of Appeals, Ninth Circuit, argued and submitted Nov. 2, 2009.)

Multiple cases in U.S. federal courts have supported the loss calculation in discount frauds to be the amount of additional discount provided — that is the additional discounts granted based upon the misrepresentations in the case. For instance, the court reached a similar conclusion in a case involving unauthorized purchases made through Hewlett Packard’s “Big Deal” program, which offered discounts to approved resellers. (See “United States v. Ashraf,” United States District Court Central District of California Southern Division, Sept. 21, 2017.)

Many cases of discount fraud may be resolved through civil processes, but criminal prosecution is an option for egregious cases where prosecutors can prove elements of crimes. Criminal cases of discount fraud typically involve charges of mail and wire fraud and may also include money laundering and other charges. The distinction in discount fraud is the exploitation of discounting programs and the unjust profit acquired through the diversion of the product for resale.

Avoiding detection

As manufacturers implement enhanced business controls, these schemes have become more sophisticated to evade detection. Such was the case for a British national, who was convicted of wire fraud and money laundering in U.S. federal court in 2014 for a discount fraud perpetrated against the same Hewlett Packard Big Deal program cited above.

HP’s discounting program required verification of end users and business cases to support providing discounts. The defendant circumvented these controls by recruiting business owners from across the globe as straw buyers who could appear to have legitimate needs for the hardware. An unauthorized reseller provided the cash up front to make the purchases. The defendant then funneled the cash to the straw buyers. HP lost over $14 million on these deals. He also disguised the final destination of the products by routing them to an intermediary location or through what is called blind shipping, a technique that hides the identity of the supplier from the customer and is often used by third-party sellers wishing to hide the source of the product. (See “Blind Shipping: What Is It & Should You Use It?” Extensiv.) In the end, the defendant was convicted and sentenced to five years and ordered to repay the $14 million in restitution. (See “Jury Convicts British National In $14 Million Computer Equipment Scheme,” DOJ, May 15, 2014.)

In addition to recruiting straw buyers or falsifying export documents, fraudsters bribe or plant employees in companies to access company emails that they use to validate nonexistent projects. Others purchase web domains that appear to be linked to major corporations or they use false identities. Perpetrators sometimes disguise sources of money through cash payments, payments through fronts, claims of confidentiality or “secret” government projects. Sometimes they employ elaborate but fictitious project plans or company websites in their deceptions.

If fraud occurs in developing countries, it can be challenging for manufacturers to validate the legitimacy of the businesses or IDs. However, with the advent of websites that collect government tenders and more pervasive information on the internet, investigators can often assess the risk of fraud associated with business deals that purportedly require significant discounts. Governments and some commercial enterprises in both developed and emerging markets have set up such websites. For example, in India, there’s etenders.gov.in, jetro.go.jp in Japan and tenders.nsw.au in Australia. Meanwhile, tendersontime.com is a commercial site that incorporates tenders across the globe. Organizations must be aware of possible discount fraud so that they can identify suspect deals early and escalate them for greater scrutiny.

Discount fraud prevention

Online monitoring will help identify unauthorized resellers who are most involved in gray market trafficking of products.

Gray market controls begin with fundamentals, such as strong channel partner contracts that prohibit sourcing from, or selling to, the gray market. Partner contracts should include strong audit clauses that require partners to cooperate with investigations and provide supporting documentation to validate sales to end users named in the requests for discounts. Manufacturers should also routinely exercise these audit rights to enhance compliance.

Prior to shipment, manufacturers’ brand protection specialists or others skilled in fraud detection should investigate suspect deals. If these investigations don’t resolve all questions, obtaining declarations from resellers and end customers that they won’t resell products can be a deterrent. Or manufacturers can use the declarations in enforcement actions if the products are later diverted.

Online monitoring will help identify unauthorized resellers who are most involved in gray market trafficking of products. Tracking and tracing of test purchases will identify diversion from specific deals and can ID counterfeits in the marketplace.

Proactively use existing supply-chain data, such as warranty events, service contracts and product registrations to determine possible diversion. Products of all kinds are also now connected to the internet in what is commonly called the Internet of Things (IoT), and as a result manufacturers can also geolocate IP addresses and possibly determine diversion of products. (See “What is IoT?” Oracle.) The analysis of these types of data may yield critical trend and pattern information to determine suspect deals, partners and customers; products most diverted; geographic areas from which the products are diverted; and geographic areas to which products are diverted.

Discount fraud enforcement

Potential enforcement opportunities range from breach-of-partner contracts and other civil actions, including fraud, to criminal referrals. Pragmatically consider that discount fraud cases are typically complex financial crimes and are difficult to explain to juries. Only the most egregious, repetitive cases are likely to be prosecuted when losses are high, evidence is clear and victims are many. Fraud cases pursued through civil courts may provide certain advantages to the manufacturer, such as having more control over the case.

Effective internal controls, like documented end-user verifications, facilitate enforcement actions as manufacturers collect and preserve misrepresentations and related false documents regarding requests for discounts. They can be used as evidence if products are diverted.

Also, consider jurisdictions of crimes. Given the global nature of discount fraud, criminal prosecutions are subject to the justice system in those regions or countries. So, it’s worth pondering how prosecutors and jurors might perceive this type of fraud in those jurisdictions. One potentially effective approach is to focus on whether a victim would’ve willingly provided huge discounts but for the misrepresentations of the fraudster. Another compelling consideration is the impact on third parties, such as the direct loss of business experienced by legitimate authorized partners who are forced to unfairly compete against low-priced products obtained through fraud.

Prevent coffer fleecing

If you work for a manufacturer, your company may not recognize the risks inherent in failing to control the gray market. Be aware that if you offer deep discounts, customers might be taking advantage of your marketing plans. You must have rigid controls to ward off opportunistic players who want to fleece your coffers.

Daniel Mascaro, CFE, is global investigations manager at law firm Sideman & Bancroft and director of investigations and audits at technology company True Pedigree. Contact him at dmascaro@sideman.com or dmascaro@truepedigree.com.