Aqua Systems is caught in a noose. Whether employees with the Roslyn, N.Y.-based VAR tied the rope themselves by knowingly selling counterfeit goods is up to a New York circuit court to decide. QLogic says yes, and hopes to prove that the sale of fake host bus adapters by Aqua Systems was both intentional and damaging to the manufacturer's reputation, channel sales and bottom line. Aqua Systems claims it was duped right along with its customers, and accuses its own suppliers of being the real guilty parties.
Aqua's tale is not unusual. Counterfeit goods, both hardware and software, have infiltrated the channel, and solution providers that aren't careful could—knowingly or not—get burned.
Peddling goods on the black market is big business. According to a report published by KPMG and the Alliance for Gray Market and Counterfeit Abatement (AGMA), the IT industry loses an estimated $100 billion annually to counterfeit products.
Also, according to the Department of Homeland Security (DHS), computer hardware accounted for 9 percent of all types of counterfeit goods seized by U.S. Customs and Border Protection in fiscal year 2006. The total amount was worth approximately $14.3 million—an increase of 198 percent compared with the year prior. On the software side, the fourth annual Software Piracy Study conducted by the Business Software Alliance and IDC found that 22 percent of total software installations in North America last year were pirated, a loss of more than $8.1 billion for the region.
"We have seen counterfeit product from day one and we continue to see it on a daily basis," said Josh McCarter, president and COO of independent distributor Arbitech. "In certain product lines, there's so much counterfeit and, in some instances, so little information available to distinguish real from fake product, that companies will unknowingly buy or sell the fake product."
Typically, the most counterfeited goods are those that are made in large quantity, such as Gigabit interface converters, WAN interface cards, memory, printer cartridges, network modules, or standard desktop applications from mainstream, marketable vendors, such as Cisco Systems and Microsoft.
China remains the hotbed of counterfeit goods. Coding of software programs is cracked and copied, and hardware products are reverse-engineered and re-created. In the case of the latter, many point to vendors' use of original design manufacturers, or ODMs, that can make their products for much less overseas. With fewer controls in these locations, exposure of processes inevitably occurs. Identical products without the brand name are created and sold for discounts of up to 90 percent, often bought by unscrupulous players that add a fake label and packaging and sell them as genuine products, McCarter said. Because these are often (but not always) commodity-type products, they're easily counterfeited.
"Manufacturers don't make their products—they rely on others for that," said Frank Kobuszewski, vice president of the Technology Solutions Group at CXtec. The Syracuse, N.Y.-based VAR offers both new and refurbished technology equipment. "And with the increasing emphasis on offshoring, people don't know what's happening at the facility. This is a very fragmented market because of people that want to make a buck, and mom-and-pop shops looking for discounts."
Next: Tracing the Source
Tracing the Source
Products typically go from counterfeiter to what Kobuszewski and others in the industry call "tweeners." These companies know where to find cheap goods—sometimes fake, sometimes stolen—and market themselves as legitimate suppliers to customers shopping around for the lowest price. When a potential buyer inquires about certain products, the tweener digs into the black market to find the goods, then passes them off as genuine, from the manufacturer.
And that's where VARs often get entangled in the black market.
Take American Data and Computer Products. In September 2006, CRN sister publication GovernmentVAR reported on incidents involving allegedly counterfeit goods that resulted in lawsuits between the Tampa, Fla., solution provider and Largo, Fla.-based Gulfcoast Workstation, a division of Relational Technology Solutions. According to court documents, American Data went to Gulfcoast to source Cisco switches for a contract with Lockheed Martin, having been told the supplier could leverage Relational's position as a Cisco Gold partner. When the switches were delivered, Lockheed discovered duplicate serial numbers.
Upon investigation, court documents from Cisco revealed the serial numbers listed on the Gulfcoast invoices were attached to products produced as early as 2003 and shipped to locations all over the U.S. and Europe. Many of those serial numbers have since been traced to units still being used by other customers.
"If these companies still have physical possession of the switch, then how is it that another like piece of equipment was delivered to Lockheed's receiving dock with the same serial number?" asked Robert Castro, president of American Data. "No other conclusion can be arrived at, except that black market or counterfeit equipment is involved here."
Indeed, evidence shows that the collection of switches was a mix of gray- and black-market equipment. Documents filed with the court showed that Relational and Gulfcoast bought the switches from VOIP Inc., Murrieta, Calif., and Epoch Sales, Santa Ana, Calif. Neither is a certified Cisco partner, and both specialize in liquidation and "alternative" sources. In recent developments, subpoenaed invoices prove that VOIP got at least some of the equipment from Chicago-based Equivoice, which sourced the products from distributor Comstor, a division of Westcon. Epoch, however, acquired the goods from two companies in Hong Kong, which named both China and Taiwan as countries of origin.
While relatively common, vendors argue that VARs play with fire when they go outside authorized channels.
"There's a phenomenon of gray going black," said Phil Wright, director of worldwide brand protection at Cisco. "After the dot-com bubble burst, there was an ongoing demand for products and a secondary market. This market grew up, and became a source for people who needed product sooner than what was possible through normal channels. There was a good chance a few years ago it was genuine product, but with the rise of the counterfeit base, the gray market has been an attractive conduit for counterfeits. That channel is potentially contaminated with fakes. There's no guarantee at all—there never was, but the chance of getting a mixture of used, fake, not updated and so on are better than ever."
The situation between Aqua Systems and QLogic stands as another example. According to the legal complaint filed by QLogic, Aqua Systems sells host bus adapters with the QLogic name that the vendor claims are not genuine or authorized, charging prices significantly below those charged by the vendor or authorized distributors. In response, Aqua Systems filed a third-party complaint against Microsource, a company based in Singapore. If the goods are indeed counterfeit, the complaint states, Microsource is responsible as Aqua Systems' supplier.
Regardless of whether Aqua Systems was indeed duped along with the end customers, some might argue that sourcing product from an unauthorized supplier in China was asking for trouble. An Internet search for Microsource brings up a static Web site described as "under construction," with contact information included. Microsource could not be reached for comment. Neither QLogic nor Aqua Systems would speak about the suit.
"Buy through authorized channels, and don't worry about anything," Wright said. "It's when [VARs] stray that they have to watch. Just don't do it and you won't have a problem."
Next: Harm Done
The fallout for companies like American Data and Aqua Systems that, knowingly or not, get tangled up in the black market can be significant. Vendor relationships can be damaged or lost, customer trust jeopardized, and huge revenues sacrificed, especially when lawsuits are involved. American Data expects to shell out at least $800,000 in legal fees. And that doesn't factor in the loss of future revenue resulting from severed ties with Cisco. The vendor cut off American Data's partner agreement because the solution provider purchased goods from outside authorized channels.
But playing by all of the rules doesn't necessarily protect VARs from the dangers of the black market. Counterfeit goods in the channel have an indirect impact by draining margin, snagging business opportunities and confusing the market.
"If you're quoting an installation for a small organization, and someone undercuts your price with something unrealistic, it becomes unfeasible to have a legitimate channel," said Michael Beare, channel director of Microsoft's Genuine Software Initiative. "You can literally put a lawful channel out of business."
Shawn Larsen, president of Morris, Minn.-based Morris Electronics, lost a large order for software on price. "When I said there was no way anyone could sell Microsoft Office for $50, this particular entity said, 'It's about price, and if someone gets in trouble, it will be the one who sold it to us,'" he said. "I told him that's assuming [the supplier] is still in business." The customer in question was a government entity, no less. Another of Larsen's customers bought a large number of Adobe licenses off eBay, becoming suspicious only when the owner's manual arrived as a photocopy. In that case, the customer turned the supplier in to authorities, and the Web site got shut down and pulled from eBay.
James Yearnd doesn't resell hardware or software as part of his IT consultancy firm, but he comes across counterfeits in customer IT environments regularly. "I have had equipment returned to Cisco for trades and for repair on SMARTnet contracts turn out to be counterfeits," he said. "I have also purchased used Cisco equipment and had to return it for the same reason, [and] received bad Compaq memory with stickers that look exactly correct. Some look and work so much like the real thing that we cannot determine if it is legit or not. We need some fail-safe method to protect ourselves."
Next: Fighting Back
Demand from the channel, combined with the potential of damage to brand reputation and the bottom line, drive many vendors to take action. Organizations like AGMA, the Business Action to Stop Counterfeiting and Piracy (BASCP) initiative, and the Business Software Alliance unite companies from a range of markets to address intellectual property rights issues. Vendors are also communicating with the channel on the risks of the gray and black markets more than ever before. This month, 3Com's vice president of worldwide channel sales, Nick Tidd, sent an e-mail warning to partners:
"Activity in gray market and counterfeit may appear to be equitable in the short term, but it only hurts both you and your customers in the long term," wrote Tidd, who is also the president and chairman of AGMA. "This activity disrupts forecasting, pricing, quality, service and it may affect the validity of 3Com's warranty [and] also makes everyone vulnerable to the unknown participation in counterfeit distribution. 3Com is very concerned with this behavior and will not hesitate to terminate the partner benefits and/or the focus level status for those identified to be participating in either gray market or distribution of counterfeit 3Com products."
NEC also released a statement following a high-profile counterfeit ring that struck in 2006 by selling keyboards, writeable CDs and DVDs, and MP3 players bearing the NEC logo. The company doesn't even make MP3 players. NEC says it is cooperating with administrative and law enforcement authorities, customs and other organizations.
Among the most proactive vendors in the fight against counterfeiting are Cisco and Microsoft. The former launched the Cisco Brand Protection team, which seeks to ensure authenticity of products, as well as the Cisco Certified Refurbished Equipment Program, which provides partners and customers a less expensive alternative to sourcing new product.
Similarly, Microsoft developed the Windows Genuine Advantage (WGA) program, which notifies consumers using non-genuine Microsoft Windows operating systems. The vendor's How to Tell Web site, www.howtotell.com, also offers a wealth of information for consumers and partners, including a gallery of images showing real software packages next to fakes. The company saw a significant victory last month, when the Chinese Public Security Bureau and the FBI announced the largest bust of counterfeit software manufacturing or distribution ever, valued at $500 million. According to Microsoft, more than 1,000 customers in 12 different countries used WGA to learn their software was counterfeit and submitted the fakes to Microsoft. They then were traced back to the criminal syndicate in China.
That software counterfeit bust highlights a key difference in how vendors track black market software vs. hardware. Pirated or counterfeit software is often discovered when the program is first fired up or linked to the developer for an update, and validated remotely. Microsoft incorporated a Software Protection Platform into Windows to ensure authenticity, and notifications in the latest versions of the operating system and Office make customers aware if their software copy was not licensed correctly. "Software has the intelligence to check itself or check in with us," Microsoft's Beare said. "Hardware manufacturers face bigger problems because counterfeits are more difficult to differentiate."
Vendors are trying. All original 3Com switch products now have a holographic label on the bottom center that combines authentication features, tamper-evident construction and a tightly controlled secure supply chain. And Samsung said last month that it's redoubling efforts to enforce intellectual property rights, investigating any manufacturers and traders who counterfeit Samsung printing supplies. The vendor promises to take punitive action against counterfeit suppliers.
Solution providers stand on the front line for vendors—one of few to see the products before they ship to the customer, and often the first contacted when the customer encounters a problem. Vendors can benefit from that knowledge. In one example from Paul Busch, director of distributor Ingram Micro's Ingram Micro Outlet for distribution of refurbished goods, a reseller returned products that it thought were defective, but turned out to be counterfeit. The reseller had supplemented digital cards ordered through distribution with others it acquired from the gray market. The vendor, which Busch would not name, provided full credit only after the reseller provided all information on where it got the goods.
But that scenario may be the exception. Some VARs argue that vendors fail to adequately work with the most obvious community in efforts to combat counterfeiting: the channel.
"Cisco won't help," said Mike Sheldon, president and CEO of Network Hardware Resale, which provides preowned, used and refurbished Cisco, Juniper, Extreme and Redback products. "They won't engage, and they won't help identify the product. We've offered to share the knowledge we have with them about what we see, and also who we see offering counterfeit products. All we ask is that they help us identify the most common products. And they refuse. We're essentially on our own."
Part of the reason for that lack of cooperation is that vendors typically have policies against working with gray marketers. Network Hardware, for example, defines itself as a secondary reseller; others in the market would call it a "rogue vendor" that sells products without official approval from vendors. Regardless, Sheldon said that the lack of a vendor relationship requires the company to maintain very high standards of quality control. The vendors would benefit from taking advantage of that, he said.
To ensure the authenticity of products, Network Hardware tests output with a light meter, which measures strength and wavelength, and checks the Common Language Equipment Identification (CLEI) code. A counterfeiter will buy the cheaper model, Sheldon said, then relabel it as higher. Beyond that, the company checks the serial number to make sure the format matches the standard used by the manufacturer, and the internal and external numbers are the same.
Avoiding The Black Market Morass
Solution providers that peddle new products often don't have the opportunity to dissect hardware or software. So how do they protect themselves? First, lessons learned by companies like American Data should resonate. While the competitive nature of the channel drives many companies to look for deeper discounts from alternative sources, the ultimate price could prove very damaging.
Second, VARs can unite with vendors in their efforts to combat counterfeit goods by joining any one of the organizations actively working with law enforcement and policy makers to tighten laws protecting intellectual property rights.
And the best advice might be the most obvious: If something appears to be too good to be true, it probably is. These products are considered commodities because the market generally keeps the price at a given standard. One distributor may be a bit better than another in pricing for a particular vendor, but rarely beyond a couple points. When someone comes in 10, 20 or 30 points below the industry standard, Network Hardware's Sheldon says, channel beware.
"If you're offered large quantities of new equipment at really good prices, you ought to cock your eyebrow."