The shadowy business of diversion

(Fortune Magazine) -- You might not have heard of product diversion before, but odds are you've bought diverted goods. Visit the nearest big supermarket, drug, or electronics chain and you may find diverted merchandise. Just about every product sold, from cars to crackers, can be diverted.

Diversion is a big business, with annual sales in the U.S. in the tens of billions of dollars. The industry has its own lawyers, lobbyists, and friends on Capitol Hill.

There is not necessarily anything illegal about diversion. The term simply refers to merchandise that has somehow shifted from the intended distribution channel. The practice, which advocates describe as a form of arbitrage, takes advantage of price differences -- either by geographic region or between customers who are sold differently priced products at different times.

One of the most benign forms of diversion works like this: A retailer orders steeply discounted promotional products, fails to sell them all, and then sells off the surplus to a third party without the manufacturer's consent.

The largest diverter, Quality King Distribution of Long Island, does more than $2 billion a year in business. It made news in 1998 when it appealed to the Supreme Court and won a copyright case involving diverted hair products. The unanimous court ruled the copyright holder or manufacturer could not prohibit the reimportation of its own authorized goods.

But diversion is illegal when it involves fraud, as was the case, the government charges, in the Dina Wein Reis business. Her alleged sampling ruse is just one of many forms such deception can take. Another common one, called "the U-boat," works like this: A diverter orders merchandise ostensibly for sale in a foreign country and loads it onto a cargo ship. The ship sets sail, then turns around and docks in the U.S., where the goods are resold.

Manufacturers periodically have tried to stamp out diversion with civil lawsuits, but there have been few big criminal cases -- until now, with the Wein Reis matter. That's mainly because manufacturers generally prefer to settle the civil cases quickly and quietly. One reason: The manufacturers themselves are sometimes complicit, having willfully sold goods to diverters in order to hit sales targets or dump out-of-date products.

Quality King and another big diversion firm, Victory Wholesale Grocers, were, at different times, Wein Reis customers, according to court records. Milt Cantor, founder of Victory, says he stopped doing business with Wein Reis soon after Unilever (UL) filed suit. "I never dreamt she was doing anything dishonest," he said. "I never knew how she got her product." A lawyer for Quality King said that that firm, too, didn't know where or how Wein Reis obtained merchandise.