Gray Wail

Executives at GT Bicycles were ecstatic when Moscow businessman James Avchuk offered to help them break into the burgeoning Russian market for upscale Western goods.

A deal was quickly struck, and in mid-1995, Santa Ana-based GT began shipping 2,600 pricey mountain bikes. But somewhere along the line, GT now alleges, the bikes made an unscheduled detour back into the United States, where Price/Costco sold them at prices well below what authorized bike shops were charging.

GT is now suing Price/Costco, alleging that the giant retailer conspired with Avchuk to illegally steer bikes into its stores. The lawsuit highlights the bitter infighting between upscale manufacturers, many of which limit sales to pricier shops, and discount chains, which are scrambling to sate consumer demand for hot name brands at bargain-basement prices.

When upscale goods--ranging from expensive GT bicycles and stylish Oakley sunglasses to distinctive Great Big Bertha golf clubs and fashionable apparel from Mossimo--are siphoned from authorized distribution channels, they fall into a murky world that retailers call the gray market.

As its name suggests, the gray market operates somewhere between the black market, where goods change hands illegally, and the general retail market, where most products are sold. Unlike the costly and growing counterfeit market, which involves imitations, the gray market involves legitimate goods.

Most gray-market transactions are perfectly legal. In fact, some clothing, camera and cosmetic manufacturers regularly dump excess merchandise on the gray market to be sold at discount stores.

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But questions of illegality arise when goods shipped by a manufacturer to, say, Russia unexpectedly pop up in another country at substantially lower prices. Manufacturers complain that this undermines their pricing strategies.

Consumers can get burned when they buy a computer or automobile designed for another market because regulatory requirements vary from country to country. And, the Better Business Bureau cautions, not all gray-market goods carry warranties.

But despite the cautionary notes, the gray market is thriving because consumers want to buy quality products at rock-bottom prices.

“Brands are the sprinkles on top of the ice cream cone,” said New York-based retail industry newsletter publisher Alan Milstein. “They’re the colorful stuff that makes the rest of the cone look good.”

Manufacturers go to great lengths to protect their pricey images. Some use detectives to police distribution channels, while others imprint secret codes on their products to trace leaks. And it’s not uncommon for a manufacturer to pull out its checkbook and buy goods that somehow end up in a discount store.

Companies such as GT maintain that it’s outright fraud when discounters work in concert with middlemen to get their hands on their exclusive goods.

Retailers such as Price/Costco won’t discuss their role in the gray market. But in court documents, they say they’re merely catering to customers by selling goods at the lowest prices possible.

Yet even executives at upscale manufacturing companies acknowledge that the gray market provides an instant barometer of how status-conscious consumers view their goods.

“If nobody wants my product, then I don’t have a gray-market problem,” said Callaway Golf general counsel Steve McCracken, who’s charged with keeping the Carlsbad, Calif.-based company’s Big Bertha drivers from falling out of its authorized distribution channel. “I guess if that time comes around, I’m even more worried.”

Manufacturers and retailers typically enjoy a symbiotic relationship. But the gray market can be a touchy area, and both sides resort to cat-and-mouse games as they scramble to turn a profit.

Executives at No Fear once tracked a truckload of sealed containers from their Carlsbad headquarters to the Port of Long Beach, where a crew scurried to unload the apparel before shipping the empty container off to India.

The apparel, which subsequently was seized by No Fear, had been earmarked for sale through an unauthorized discount chain, said Marty Moates, who directs an eight-person security department at No Fear.

“We fight tooth-and-nail to keep our product out of certain stores,” Moates said. “You really have no other choice. Once your trademark loses its purity, the value goes down.”

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Even as they fight to control where their merchandise is sold, some manufacturers express a grudging admiration for the gray market’s inherent efficiency.

“We’ve had a product introduced in the Chinese market that resurfaced a couple of months later in Sweden,” McCracken said. “Go figure. It’s all operating right below the surface, and if you factor in the supposed tariffs and freight charges, it’s hard to believe that they can make a profit.”

Manufacturers such as GT maintain that the gray market hurts consumers in the long run because unauthorized sales can wreck a company’s business.

“We spend heavily to advertise our goods, as do our dealers,” said GT General Counsel Patrick Carroll. “That creates demand for our product. But [discounters] cherry-pick customers without the added expense of advertising . . . and we think that’s an unfair business practice.”

Manufacturers such as Irvine-based Oakley and Cannondale also argue that discounters open them up to product-liability lawsuits because off-price stores typically don’t handle warranty work.

Oakley regularly voids warranties on sunglasses sold by unauthorized retailers, arguing that discount store clerks lack the training needed to sell its expensive eye wear.

“It’s real simple,” said Greg Weeks, an attorney who represents Oakley. “We don’t want our goods in Price/Costco, Sam’s Club or any other warehouse-style wholesaler. They can’t guarantee a proper level of service for our customers.”

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Callaway’s McCracken said consumers have their pick of cheaper clubs, “which is fine with us. But our pricing strategy is designed to give us the funds to conduct research and development for more breakthrough products. And I think that’s what our customers expect from us.”

Legal scholars describe the gray market as also encompassing a gray area of the law because it sits at the junction of laws that are designed to protect manufacturers and consumers.

It’s outright illegal for manufacturers to dictate retail pricing, said Warren Grimes, a former Federal Trade Commission attorney and a professor at Southwestern School of Law in Los Angeles. “That’s considered an automatic violation of antitrust law.”

But can a manufacturer hold an unauthorized dealer responsible for selling merchandise acquired through a middleman?

Some attorneys argue that it’s the manufacturer’s responsibility to police its own distribution ranks. Others maintain that the courts have a duty to protect manufacturers from unfair trade practices.

“The people who theorize and write about antitrust law have not reached consensus on the gray market,” Grimes said. “My personal belief is that the gray market benefits consumers because it helps to hold down prices.”

GT is challenging that argument in court.

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In its civil lawsuit, GT alleges that Avchuk, the Russian businessman, worked in concert with Price/Costco to break terms of an agreement not to sell the bikes outside of Moscow. The suit, filed in Superior Court in Santa Ana, is seeking unspecified damages.

Avchuk wasn’t available for comment, and Price/Costco executives wouldn’t talk about the suit or how it acquires certain name-brand products.

But court documents filed by GT and interviews with other manufacturers provide a glimpse into the constant warring that goes on between manufacturers and retailers regarding the gray market.

GT executives argue that their company’s livelihood is being threatened by middlemen such as Avchuk and chains such as Price/Costco, which sell goods typically found only at authorized dealers.

“It’s fraud,” said GT Corporate Counsel Patrick Carroll. “It’s a predatory practice, and we think it’s time for the courts to make a determination on this kind of behavior.”

But Price/Costco’s lawyers dismiss the suit as a “business dispute” between a profit-hungry manufacturer and a retail chain in “the legitimate business . . . of providing the consumer with high-quality products at a substantially reduced price.”

One attorney with a manufacturing company complained that some unauthorized retailers systematically try to get their hands on shipments of the most highly desired goods.

“They send out people with lists of the top 20 or 30 products they’d like to sell,” he said. “And they send out ‘feeler letters’ to middlemen, encouraging them to break terms of their contracts by selling to them.”

And, manufacturers contend, some chains don’t expect to make a profit when the goods finally are sold.

“When Price/Costco had our bikes, it was a loss leader,” said Dan Pullman, vice president of Georgetown, Conn.-based Cannondale, an upscale bike manufacturer. “As far as we could tell, they were selling the bikes at the same price we originally sold them [to a wholesaler] for. It was a promotional gimmick.”

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Sometimes, manufacturers say, discounters and middlemen use circuitous routes to cover their tracks.

Weeks said Oakley once tracked a shipment of sunglasses to its intended destination in India--where it reversed course and traveled back to stores in the United States via the United Arab Emirates.

Other times, there’s relatively little attempt at deception.

During the late 1980s, for example, Levi Strauss store managers in the United States were stunned when hordes of young shoppers began clearing out their supplies of 501 jeans--a hot commodity in other countries. Middlemen, who had hired the shoppers, then shipped the popular jeans overseas, where they were sold at whatever the market would bear, a practice that upset the overall market for Levi’s products, company spokeswoman Julie Higgins said.

Levi eventually slapped a limit on how many jeans a customer could buy, which made gray-market purchases less attractive.

“It was much like kids at a liquor store who buy the beer for someone else who’s under age,” Higgins said.

Some manufacturers exacerbate their gray-market problems by dealing with middlemen when merchandise begins to pile up in their warehouses.

Middlemen--known as diverters--somehow sense when companies have excess goods, said Ilse Metchek, executive director of the Los Angeles-based California Fashion Assn.

“Diverters know exactly when to come in with that check,” Metchek said. “It’s a tough decision when you’re facing a large order from someone. You know you should turn your back on it, but if it’s the slow part of the season, it’s hard to say no.”

Once goods have fallen out of the distribution channel, manufacturers use everything from high technology to old-fashioned detective work to find and patch leaks.

Oakley reportedly uses a laser device to burn identification codes into each pair of pricey sunglasses shipped from its Irvine plant.

Several other manufacturers acknowledged that they use everything from invisible ink to more complex methods to mark their goods.

“We have several ways of tracking our clubs,” McCracken said. “But we don’t ever discuss them.”

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When goods do pop up where they’re not supposed to be, some manufacturers pay big sums to buy up the merchandise--and then head into court to file claims against unauthorized retailers.

Three years ago, when No Fear learned that a middleman was about to sell a large shipment of its apparel to an unauthorized retailer, security department director Moates spent $685,000 to buy the clothing back. Oakley, too, has a track record of repurchasing goods that end up on discount store shelves--then going to court to recoup its costs along with damages.

“These people can be very hard to catch because they’re very creative,” Moates said. “Staying up with them is a constant challenge.”

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Buyer Checklist

Some things to consider if you are thinking of making a gray-market purchase:

* Will the lack of a warranty mean it will end up costing me more down the road?

* Does the seller provide a warranty or service contract?

* If so, is there a fee?

* Does the contract cover all or part of the product?

* Where will you be required to take the item for service?

* Will work be performed according to manufacturer specifications?

* Is the product eligible for any rebates offered by the manufacturer?

* Is it compatible with U.S. electrical currents, broadcast frequencies or other standards?