Exposed: Dangers of the Gray Market

Robert Castro, president of American Data and Computer Products, shares his office with two pallets of Cisco Catalyst 3750 switches. He has 53 switches in all, at least three of which are suspected of being counterfeit. His company is out roughly $500,000, and much of his days are spent dealing with legal proceedings that he hopes will end with a court verdict that helps him recoup some of his losses.

The future of American Data, in fact, may ride on whether Castro's lawyer can convince the court that Largo, Fla.-based Gulfcoast Workstation, a division of Relational Technology Services of Rolling Meadows, Ill., sold him gray-market merchandise as new.

As if that weren't tough enough for a small disabled veteran-owned business, American Data must also figure out how it can compete in the federal market without authorization to sell one of the most sought-after brand names out there--Cisco Systems. The vendor terminated American Data's indirect partner agreement because it went outside normal product-sourcing channels to find a lower-cost supply of switches.

American Data's tale unveils the challenges faced by many small government solution providers that must deliver the lowest-price products, which aren't always available through authorized channels. While they can win solid contracts with government agencies and prime contractors by going through alternative sourcing, solution providers run the risk of getting caught up in the gray-market morass, just as American Data did.

NEXT: Here's the story.

American Data was presented an opportunity two years ago when Lockheed offered it the chance to participate in a U.S. Navy deal that required a small business to take on a portion of the contract. All American Data had to do was deliver 30 network switches, 38 Gigabit switches, 536 network adapters and 68 connector cables.

"There was nothing unique about the switches that would require any sort of value-add," Castro says. "It was simply a piece of off-the-shelf, standard hardware that Lockheed required. Sure, it was an expensive piece of equipment, but no special type of configuration [was required]. The lowest bid price was going to win."

While an authorized Cisco partner at the time, American Data was not large enough to buy direct from Cisco, which requires its smaller, low-volume partners to source through distribution. But the price quoted by Tech Data was too high and would've been similar to what all other small businesses would bid on the contract, undercutting American Data's competitive position. American Data solicited quotes from a variety of alternative sources, which is frowned upon by Cisco but is still a fairly common practice. In fact, Castro claims he was unaware of Cisco's policy against partner sourcing. (See "Rules Meant To Be Broken?")

"Some suppliers are hungrier than others and will sacrifice [some] margin to win business," Castro says. In this case, American Data's marching order from Lockheed's Southeast Material Acquisition Center was to source product from any of its established suppliers that could fulfill the requirement at the lowest price.

Enter Gulfcoast. The reseller is a subsidiary of Relational, which is a Cisco Premier Certified Partner and No. 105 on the VARBusiness 500. Just months before the American Data deal, Gulfcoast began marketing to other solution providers its ability to deliver lower-priced Cisco products through its parent company.

"We knew virtually nothing about Relational, except that they were the parent company of [Gulfcoast] and that they were an authorized--and large--Cisco partner," Castro says. "It actually seemed like a good move on their part to take advantage of their respective strengths. So we did what we always do, [bidding] it out to several suppliers, including Gulfcoast/Relational to give them a shot. This was a longtime supplier of ours; we had about a 10-year relationship with nary a problem."

Gulfcoast did not win the American Data contract, initially. The winning bid first went to Rice Integration of Anaheim, Calif. American Data backed out of that deal after Rice required a 50 percent prepayment of $250,000--more than American Data could afford. Gulfcoast then matched the price, guaranteed terms of Net 30 Days and won the deal.

Gulfcoast, Relational and Lockheed declined to comment, but Castro maintains that he always believed Gulfcoast would deliver genuine Cisco products. He provided GovernmentVAR with copies of a November 2004 e-mail from Gulfcoast's account manager, Drew Warner, stating that Gulfcoast placed the American Data order directly with Cisco because distribution did not have the products in stock.

"Procuring direct was the only way to get the order moving," Warner wrote to Jamie Starnes, account manager at American Data. "According to Cisco, it will take a minimum of three weeks to fulfill the order, with an average ETA of four weeks. This was recently explained to us over the past few days from Cisco, and we confirmed this through Tech Data and Ingram."

Despite such statements, Gulfcoast's court filings against American Data tell a different story. "At all times, American Data was adamant with Gulfcoast that the Cisco equipment had to be procured from outside of Cisco's authorized distribution channels," the Gulfcoast complaint states. "American Data never disclosed its customer's equipment requirements to Gulfcoast. Had Gulfcoast known that the end user required authorized Cisco equipment, it would never have entered into the transaction with American Data."

NEXT: Everything seemed normal.

Lockheed received the first part of the American Data-supplied switches in January 2005. Everything seemed normal as the Cisco switches passed their initial inspections without incident and were delivered to the Navy for installation.

The second shipment arrived in March 2005, but the review process didn't go as smoothly this time. According to Castro, Lockheed discovered that at least three of the switches had duplicate serial numbers and that the manufacture dates on the boxes didn't match the equipment labels.

Lockheed immediately notified Cisco and American Data, which notified Gulfcoast. Initially, Gulfcoast requested the suspect switches be returned, but Lockheed retained the switches until it could notify the Cisco Brand Protection Team, which maintains policies against counterfeit and gray-market sales. Gulfcoast reportedly declined the return of the equipment after Cisco got involved.

"We were given duplicate serial numbers from our vendor," Gulfcoast's Warner wrote in an April 2005 e-mail to American Data. "The vendor is now going through all of their invoicing and serial numbers. I am hoping that they get something to us quickly."

Cisco discovered that the serial numbers listed on the Gulfcoast invoices were attached to products produced as early as 2003 and shipped to locations all over the United States and Europe. At least three of those serial numbers were traced to units that are still being used by other customers.

"I believe that no other conclusion can be arrived at except that black-market or counterfeit equipment is involved here," Castro says. "This can only be said for the units that we are finding to still be in the physical possession of the original owners. The others would just be speculation on our part. We may find that some of the equipment is Cisco-manufactured but 'used.' We just don't know for sure."

In court filings, Gulfcoast claimed the equipment was new but agreed that it was disqualified for the standard manufacturer warranties because it was sourced through unauthorized channels.

Regardless, American Data couldn't sell the questionable Cisco switches to the Navy, so it had to seek a one-time 42 percent discount from Cisco and permission to buy through Tech Data. Since the Navy had already installed 15 of the switches at a secure facility--including at least one with a disputed serial number--American Data had to replace only 53 switches. Those cost the solution provider $4,000 a piece, and American Data had to pay $40,000 in inspection fees to boot.

"At the time the replacement order was placed, we were all under the presumption that we were probably dealing with used equipment from [Gulfcoast/]Relational," Castro says. "This was bad enough, but I think everyone at least had the idea that the switches the Navy kept were genuine, Cisco-manufactured product. And, as far as we knew, Cisco looked them over and was willing to recertify them. We left it at that."

American Data gave Gulfcoast a deposit of more than $250,000, with a remaining balance of a quarter-million dollars. Gulfcoast filed suit against American Data in the Florida circuit court for the outstanding balance on the account, and American Data filed a countersuit to recoup its losses.

NEXT: Tracing back to the source.

The lawsuit filed by American Data revealed an immense amount of information about where the switches came from and helped define a murky gray-market channel.

Documents filed with the court showed that Relational and Gulfcoast bought the Cisco switches from VOIP Inc. of Murrieta, Calif., and Epoch Sales of Santa Ana, Calif. Neither company is a certified Cisco partner, and both specialize in liquidation and "alternative" sources. Epoch claims to have been a Cisco partner at the time of the transaction but could not produce supporting documentation.

"Everyone looks at money," says Epoch president Dana Skaggs. "We get our products from several sources all over. With every order we ask, 'If we find cheaper refurbished equipment, will you take it?'" For this particular order, Skaggs says Relational "just asked that it be clean and new." Skaggs says this was essentially determined by packaging. The switches, for example, came in a Cisco box, with the standard shipping tape carrying the brand name.

While Skaggs didn't give specifics about where the company acquired the merchandise, a subpoenaed invoice shows the merchandise coming from two companies in Hong Kong, and naming both China and Taiwan as countries of origin. GovernmentVAR couldn't track down or reach the source companies through the contact information listed on the documents. The government prohibits the sale of products sourced or manufactured in China.

"Even though Gulfcoast/Relational may have been unwitting dupes to anything sinister regarding possible black-market product from China, they are still culpable for the scam they perpetrated with the equipment," Castro wrote in an e-mail to GovernmentVAR.

VOIP president Ricardo Delgado contends that Cisco is responsible. He says such incidents result from the growing trend by vendors to outsource manufacturing to China. The manufacturing plants inevitably create extra units for the gray and black markets.

"We get our products on liquidation, when available, and try to get discounts from the Internet and other places," Delgado says. "I check out [the products], because I know how [to spot faulty or counterfeit goods]."

Delgado says Relational placed no requirement on VOIP for the equipment to be certified as new by Cisco. He won't divulge where VOIP sourced products, saying only that he encourages all customers to examine the products upon receipt. Relational, which Delgado describes as a very good customer, would have returned any merchandise that did not meet its requirements, he says.

"Our position is clear in the legal filing," says Allan Umans, corporate attorney for Relational. "We have no comment on any other [issues regarding the court proceedings]."

NEXT: Unfinished business.

So here's a military facility running equipment of questionable origin, and that's not all. Even Cisco, which wouldn't comment because of its role in the litigation, may need to defend its brand from being tarnished by its association with black-market or counterfeit goods. At the same time, government solution providers will likely wait to see how Cisco handles the situation.

"If Gulfcoast had actually sourced the equipment through authorized channels or from Cisco directly, what harm would have befallen Lockheed or the Navy? None," Castro says. "Sure, Cisco may well have issued a stern reprimand to us, but I'm not so sure they would have terminated our agreement for doing something we didn't even know was improper."

Cisco has yet to take any action against Relational, despite the fact that documents and court proceedings show the company went outside normal distribution channels and sourced product from two unauthorized companies. Cisco won't comment on what action, if any, it will take against Relational, which is among Cisco's top revenue partners.

Castro says that American Data's relationship with Lockheed has been affected as well. "Our relationship with Lockheed dates back eight to 10 years," Castro says. "Does Cisco or anyone else seriously think we would jeopardize this unique relationship for one order? Not in a hundred years."

In addition, the financial strain has led Castro to question whether his company will survive. Already, the situation has cost American Data about $450,000, with $100,000 to $150,000 in additional legal fees expected. And that doesn't factor in the loss of future revenue resulting from severed ties with Cisco. Nor does it reflect layoffs at American Data, the company's trailing cash flow, late payments to suppliers or lost productivity. "We have no other choice," Castro says. "I know what we're doing is the right thing. I've just about exhausted all our financial options, but we'll have to find a way."

The civil action may not be the only court proceeding in this case. The Navy Criminal Investigative Service is looking into a possible breach of national security and violation of the Trade Agreements Act. It's unclear which company is the target of the Navy's investigation. NCIS declined to comment for this article.

NEXT: Rules meant to be broken?

Rules Meant To Be Broken?

Distribution--particularly in the public sector--is necessary for vendors to accommodate solution-provider demand for products and services. But in a market that so often rides on price, rules that keep partners shackled to a single channel may be driving some toward unauthorized product sources.

Many vendors, including Cisco Systems, sell direct only to their largest partners--typically known as direct value-added resellers, or DVARs--and send the rest through distribution. Vendors will often add a clause to indirect-partner agreements that prohibits sales of product between solution providers.

"For smaller resellers, the 'norm' is to drive them through distribution so the vendor doesn't have to be directly involved with small order sizes and less-than-stellar creditworthiness," says Rick Marcotte, president and CEO of DLT Solutions, Herndon, Va., and a member of the GovernmentVAR advisory board. "Many large resellers push the vendor to buy direct, and, depending on the reseller's clout and the vendor's channel policy, that's sometimes allowed. However, most vendors do not allow 'distributor shopping' and force a somewhat permanent relationship between distribution partners and major resellers."

There are always exceptions. As the reseller grows and sells significant volume, vendors will start working direct with them and provide them with better pricing. Or if a larger systems integrator is having trouble meeting sales goals or needs to do more work with small business, a vendor may direct certain solution providers to purchase through that larger partner. Such changes in policy can be frustrating for the distributor and confusing to solution providers, causing some to seek out other options.

"Changing policy causes disturbing behavior, and then what happens? The vendor has to go to the end customer, a federal agency, and say, 'you may have some counterfeit products.' How does that make them look?" asks Bob Laclede, vice president and general manager of Ingram Micro's government and education business. "This is the ugly part of the business."

That disturbing behavior is even more pronounced in government, where small businesses have a hard time winning bids on commodity products that are entirely determined by price.

"It's a pricing game; if vendors would pass discounts through distribution only and let the channel do its job, this wouldn't happen," Laclede says. "Instead, everyone bids the same switch and resellers shop around for the cheapest price; distribution is roughly the same, so they say 'where else?'"

The answer, often, is larger partners that are willing to sacrifice a part of their margin to win the business. At the same time, solution providers may be directed by their prime contractors to contact particular businesses for product fulfillment.

Robert Castro, president of American Data and Computer Products, says that he is often asked by systems integrators to purchase products on their behalf from small companies. Often, it's a one-time deal, "but we do it because our customers ask us to," he says.

However, to other solution providers, stepping outside the bounds of authorized channels--whether knowingly or not--does nothing but negatively impact the process.

"This 'throw it into the channel and let them fight it out' mentality doesn't serve anyone's interest--vendor, distributor or reseller," Marcotte says, even if it does result in a lower price for the customer. "[It leads to a] classic case of playing with fire and getting burned. These resellers who go around the system in an attempt to save a few bucks have no perspective of a long-term business strategy."

NEXT: Suit/countersuit

NEXT: Suit/Countersuit

The ugliness between Gulfcoast Workstation and American Data and Computer Products has escalated from a typical deal between two longtime partners to allegations of breach of contract and fraud.

Currently, the two companies are preparing to battle in court to determine who's accountable for the sale of Cisco switches with duplicate serial numbers. American Data is being sued for not paying the balance of its contract with Gulfcoast. In turn, Gulfcoast is being sued for not reimbursing American Data for payment made for merchandise that didn't meet contractual requirements.

Prior to any court filings, both companies attempted to settle the disagreement. The first attempt was made by John Bobcock, general manager of Relational Technology Services. He sent a settlement agreement to American Data president Robert Castro that required payment for the remaining balance of the order--$523,520--as well as additional purchase orders totaling at least $500,000. American Data refused the terms and responded with a settlement agreement of its own that called for Gulfcoast to reimburse American Data $216,634 for the return of the disputed switches and incurred legal costs.

When settlement talks failed in September 2005, Gulfcoast filed a lawsuit against American Data in the Florida circuit court for breach of contract, demanding the balance of payment owed.

In response, American Data filed a counterclaim the next month, stating that Gulfcoast delivered nonconforming goods, and that the expectation for Cisco-authorized goods was indeed communicated and confirmed by Gulfcoast. That counterclaim was amended soon after, incorporating a third-party complaint against Relational, the parent company of Gulfcoast, as well as two Gulfcoast employees that played key roles in the situation, Drew Warner and William Allison. Relational and Gulfcoast unsuccessfully tried to have the counterclaim dismissed.

The cases are slowly winding their way through the court system, and many of the major players have been deposed, including representatives from Relational, Gulfcoast, American Data, Lockheed Martin, Cisco and the two California equipment suppliers, Epoch Sales and VOIP.

Assuming no settlement is reached, the cases will go to trial; dates have not yet been determined.