09/16/2010 Meeting - Emerging Sales Channel Investigations Issues

The Corporate Investigation series presents:
Understanding Emerging
The Corporate Investigation series presents:
g g g
Sales Channel Investigation
IssuesIssues
DRAFT

Discussion agenda
1. Environment level set
2. What is the “channel”
3 Ch l i d i k3. Channel issues and risks
4. Frequently seen issues
5. Increasing transparency into the channel – the BPS
6. BIS
Copyright © 2010 Deloitte Development LLC. All rights reserved.

Global compliance related trends – level set
• Corporate environments are changing
- Shift from engineering to sales focus creating a different compliance
awareness culture
- Changing appetite for risk due to cost constraints
• Increased attention by regulators continuing
- Enforcement and regulatory oversight increasing and expected to increase further
- Local country regulatory bodies are becoming more aggressive
- Use of ‘same agent’ investigations by SEC and request letters
- Parallel investigations across countries
P t ti l li bilit f FCPA d l t d i il l t i f ti f h l t- Potential liability for FCPA and related similar regulatory issues for actions of channel may accrue to
manufacturer or transaction initiating entity
• Risk management is both an expected and a bigger priority for Boards of
Directors
- Recognize that emerging country business risks, particularly through the channel, have become
more complex and have a larger impact on companies
- Assessing new or emerging business risk, particularly channel, high on the agenda

Indirect channels are key for technology
companies reach and revenue expansion
SMBs
(2-999 employees)
Enterprises
(1,000 plus employees)
Indirect Channel Direct ChannelBoth Channels
( p y ) ( , p p y )
• Technology companies align channels with targeted customer segments:
Direct sales for large enterprise accounts
Consumers
- Direct sales for large enterprise accounts
- Indirect channels for SMBs, consumers, and emerging markets
• Indirect channels are growing across all technology sub-sectors
• And the indirect channel is key to penetrating high growth• And, the indirect channel is key to penetrating high growth
emerging markets

The indirect channel is growing across all
technology industry sub-sectors
Software Semiconductor Consumer hardware
Enterprise hardware
and network
equipment
technology industry sub sectors
equipment
• Largely direct sales for
enterprise software (e.g.
Oracle and SAP)
– 40% indirect for Oracle
• Semiconductor
companies sell through
partnerships, and
distributors
• Strong growth of laptops
sales are increasingly
shifting toward indirect
sales for consumer and
SMB ( t il d VAR)
• Major vendors target
large enterprises through
direct sales and indirect
channels for SMB and
i k t
• Mostly indirect for
packaged software (e.g.,
Microsoft and Adobe)
95% indirect for
• In 2009, HP and Dell
accounted for 39 % of
Intel’s sales.
SMB (retail and VAR)
• HP is 80+% indirect
• Dell has shifted from less
emerging markets.
• In 2009, 80% of Cisco’s
revenue was through
channel partners
– 95% indirect for
Microsoft
• In FY10, Microsoft is
increasing its investment
in channel programs by
• In 2009, AMD’s top 5
customers accounted for
more than 50 % of its
annual revenue
than 5% indirect to nearly
25% indirect over the last
5 years
• A global leader in
communications is
adopting a channel-
centric go-to-market
strategy targeting 90+%in channel programs by
14 % to $3.3 billion
strategy, targeting 90+%
indirect sales to drive
reach and growth
* March 20010 Forrester survey of 93 North America based global high-tech products manufacturers

Emerging markets create opportunities and
challenges with channel partners
• Channel partners are the most effective way to serve the vast and fragmented
nature of emerging markets
• In most emerging countries direct coverage by vendors is limited to Tier 1 and• In most emerging countries, direct coverage by vendors is limited to Tier 1 and
2 cities
• Vendors leverage channels in the consumer and SMB segments
• SMB represents more than 75% of business in the BRIC countries• SMB represents more than 75% of business in the BRIC countries
• However, emerging market indirect channels pose significant challenges with
counterfeiting, limited sophistication, poor infrastructure, and regulatory matters
• Also emerging market channels typically require OR expect significant “contra”• Also, emerging market channels typically require OR expect significant contra
revenue investments (e.g., discounts, rebates, promotions, allowances)
- Contra revenue can be as high as 50-75% in APJ
- As much as 70-90% of contra revenue programs in emerging markets can be in higher risk “up front”
investments

Managing a price waterfall is key to capturing the
expected profitsp p
Price Setting
Adjustments
(On-Invoice and(
Off-Invoice)
Cost-to-Serve
• Adjustment
COGS
j
off universal
list to get to
Region,
Channel or
Segment
price
• Channel Adjustment
• Geographic Adjustment
• Segment Discount
• Negotiated Discount
• Competitive Adjustment
• Returns
• Special Freight & Handling
rice
eGrossPrice
tPrice
Margin
ce
p j
• Volume Discount
• Promotion Discounts
• Sample Discounts
• Freight & Handling
• Rebates
• Order Quantity/Small Order
Surcharges
• Commodity/Energy Surcharge
• Services (technical, customer,
billing reconciliation)
• Cost of Consignment
• Variable
Production Cost
• Logistics —
Plant to
ListPr
Invoice
Pocket
Pocket
Gross
Amount
Charged
Price “put in
your pocket”
Profit “put in
your pocket”
Value of
Product Sold
NetPric
Net
Amount
Charged
• Cost of Terms
• Cost of Payments
Cost of Consignment
• Co-op Marketing Expense
• Loss/Damage Credit
Inventory Cost
Charged Charged

Business models may increase risk
• Common channel models
- Direct
- Local country wholly owned subsidiary- Local country wholly owned subsidiary
- Indirect
- Joint venture/partnerships
• Once out of direct sales mode, risk increases significantly due to decrease in, g y
transparency
• Emerging area of concern: investments in local companies
- Recent Bourke case and liability for investees - based on “should have known”
• Understand the three legs to FCPA risk
- Nature of the scheme
- Funding the activity
- Cover-up
• Off book compensation structures more commonly used to help move benefit
off-book
E l
- Employee
- Channel

Common risk elements — pricing
• Major uplifts and discounts are typical in the tech industry
- How to monitor and manage the discounts
- “Mega” deals- Mega deals
- High discounts leaves room for potentially unseen or unmonitored activities
• Markup and extreme discounting (see below)
• ‘Mega ‘dealsMega deals
- High discounts leaving room for other activities
• Product bundling
- Removes visibility to margins and flow through discountingRemoves visibility to margins and flow through discounting
• Cross subsidization of products
- Decreases transparency
• Subsidizing efforts of the distribution channel in various ways — see belowSubsidizing efforts of the distribution channel in various ways see below
• Channel using large deal discounts to fund off-the-radar activity in lower margin
countries and deals
• System integrators and risk of end user relationship maintenance
System integrators and risk of end user relationship maintenance
• Complex end user agreements and pricing
- i.e. offshore training built into delivery pricing

Common risk elements — visibility
• Product spectrum and bundling may decease visibility
- Leasing
- Sales- Sales
- Consulting
- Service
- Financing
• Agent compensation issues
- Issue: transparency into use of agent commission and activities
- What is normal — 5%, 10%, more?
- Dealing with visibility and control over use of commission proceeds
• Market development funds and related programs such as rebates etc.
- Funding distributor efforts/thin margins
P li i l d i- Political donations
- Gifts
- Payments

Common risk elements — 3rd parties
• Multiple touch points in the channel prior to end user
- Lose control and visibility
- Gray market
I l i th “ l dd” ti f h d fi d b th t- Involving other “value add” parties, some of whom are defined by the customer
- Lack of visibility into real end customer transactions
• Size of distribution system
Smaller channel partners are prone to bend the rules to get business- Smaller channel partners are prone to bend the rules to get business
- Both large and small could be likely to be dependent on business in differing ways therefore may
make “accommodations”, such as maintaining off-book funds
• Language, culture and local subsidiary issues — does CHO really understand
what is happening locally
- Amount of real influence by CHO over visibility into the local distribution channel?
• Differing appreciation for corporate governance
- Lack of corporate governance understanding in many countries
- Local culture overrides
- Dependency on family members or relationships locally
- Limited transparency — do what CHO wants
- Limited transparency — do what CHO wants
- Distributor or partner ownership — unclear ownership in some countries

Common risk elements — relationships
• Local on-the-ground sales employees are generally aware of what is happening
in the local channel
- Possible inappropriate payments indirectly sponsored by on-the-ground sales employeesPossible inappropriate payments indirectly sponsored by on the ground sales employees
- Collusion by local sales people and channel to meet goals
- Promises to cover losses in one area through unrelated transactions or programs
• Marketingg
- “Soft” rebate, support and promotion programs used to fund inappropriate activity

Other risks
• Tech/knowledge transfer/theft of IP
- Information value is often traded as a benefit
• Advertising/Marketing outsourcing• Advertising/Marketing outsourcing
• Licensing
- Speeding the process
Obtaining exclusivity (temporary or otherwise)- Obtaining exclusivity (temporary or otherwise)
• Product development, patents and registration
- Fast tracking approvals
- Getting local technical experts with relationshipsGetting local technical experts with relationships
- Licensing approvals
• Product imports and exports
- Expediting through customs
- Use of freight forwarders
- Preferential duty assessments
- OFAC/ITAR

Channel reporting — common issues
• Complexity in managing the relationships
- Number of business partners can exceed 100,000
- Volume of transactions- Volume of transactions
- Contractual and cultural differences
• Accuracy, content and form of reporting/information sharing
- Revenue recognitiong
- Forecasting
- Pricing, discounting
- Programs — MDF, co-op and rebates, price protection and stock rotation
- Warranty and service issues
- Product Sourcing
- Product allocation
Synchronization of data transmissions reporting sell through- Synchronization of data transmissions — reporting sell through
• Behavioral adherence to internal and external expectations
- Codes of conduct of your entity
- Gray market
Gray market
• Old habits, new technology

Common causes
• Transparency
- Inconsistent and/or complex contract terms
- Lack of visibility into Channel Partner operations- Lack of visibility into Channel Partner operations
- Inadequate systems — either Company or Business Partner
- Lack of confirmed mutual understanding
• Fraud vs. error
- Fraud
- Side letters
- Limited or inadequate training
• Operating
- Roles and responsibilities not well defined
- Poor internal controls — systemic issues
Cl i l i k- Clerical mistakes
- Intentional actions/misreporting
- Speed to deal (get the deal done)
• Limited or no risk identification or monitoring processes re: Channel Partners
• Limited or no risk identification or monitoring processes re: Channel Partners

Reasons good companies get in trouble
• Violations are difficult to trace/discover due to violators becoming more
sophisticated in hiding their crimes:
- Technology makes it easier to create genuine looking fake documentationTechnology makes it easier to create genuine looking fake documentation
- Slicing-and-dicing transactions to confuse paper trail
- Misclassify transactions or imbed them within apparently legitimate expenditures
- Existing controls will not necessarily catch today’s schemes
- Lack of paper trail due to the use of text messages, communications via phone rather than email,
etc)
- Failure to continually monitor processes and controls
- Failure to understand how issues arise and map them to related processes and controlsFailure to understand how issues arise and map them to related processes and controls
- Large costs – i.e.: FCPA violations do not require bribery— internal controls, bookkeeping or
accounting procedures the SEC decides should have been taken can result in huge penalties,
regardless of intent
- Companies can innocently miss red flags- Companies can innocently miss red flags

Channel schemes — frequent elements
• 3rd parties are normally used; often multiple layers
- Hidden 3rd party ownership
- Silent partner- Silent partner
- Shell companies
- Joint ventures
- Distributors, agents and lobbyists
• Run through 2 countries to reduce governmental investigation risk
• Muddy the financial trail by transaction slice and dice
• Change nature of transaction as it moves through the payment chaing g p y
• Transactions are misclassified or imbedded within apparently legitimate
expenditures
• Keeping poor records in subsidiary/partnerp g p y p
• Lack of documentation around transaction

Common vehicles
• Extra remuneration into the channel
• Credits
• Returns• Returns
• Discount rate
• Replacing current deal with future deal at higher margin
• Referral fees
• Bonus and special commission rates
• MDF related funds
• Add-on services and subcontractors
f• Managing the product flow
• Bundling
• Anti-competitive arrangements
• End user misstatement• End user misstatement
• Logistics agents
• Making the numbers
• Gray market
Gray market
• EOQ sales
• Channel stuffing/buy and hold and shadow inventory

What you will likely encounter
• Access
• No contract provisions for 3rd party access
• They want lots of time to let you in• They want lots of time to let you in
• They refuse to let you in
• Data and information
• They make the books and transactions palatable for reviewy p
• Restrict access to data , people, facilities
• Thin file syndrome
• No background information available
• Conduct
• Space
• Legal supervision on site
B i d d• Being recorded
• We are a victim complex
• Too much business with client to take action – leverage
• Legal
• Legal
• Asking for NDAs re client disclosure

The business partner challenge
• Issues dealing with business partners
- How do I deal with my emerging market partners?
- With whom am I really doing business?- With whom am I really doing business?
- Could they potentially endanger my company brand or operations?
- Can I make the interaction with my partners more effective and transparent?
- How do I measure and focus my individual and regional business partner risk?
• Reliance on a high volume of business partners
• Increasing regulatory attention to business partner activity
• Do I have enough insight into their operations to protect the Company?g g p p p y
• Are traditional methods of entering into and maintaining a relationship effective,
or even adequate in today’s environment?
• Are my information needs and goals of various Company departments beingy g p y p g
met?

Addressing the challenge
• Framework – a customizable cloud-hosted application based on a self
disclosure and representation survey, directed at the Company's entire business
partner communitypartner community
• Gain access to global business partners’ detailed information in critical areas
• Focused on Company’s areas of most significant concern
• Detailed response risk ranking to provide surgical insight into potential high risk• Detailed response risk ranking to provide surgical insight into potential high risk
business partners, as well as areas of operational improvement
• Self representation/certification by partner CXO
• Minimal resource allocation by the Company• Minimal resource allocation by the Company
- Application and risk assessment fully managed by Deloitte
- Free, or cash flow positive for the Company

Benefits to Company
• Enhanced, low effort and cost protection against “second guess” scrutiny
- Enhanced risk assessment and mitigation vehicle
- Addresses growing concern about potential brand and liability impact which may arise from business- Addresses growing concern about potential brand and liability impact which may arise from business
partner activity
- Demonstrates to regulatory bodies and Boards of Directors that an active risk management system
is in place addressing the business partner community
Targeted rationale for audit or oversight attention- Targeted rationale for audit or oversight attention
• Useful outputs
- Database of information available to Company in one place
- Detailed risk assessment of business partnersDetailed risk assessment of business partners
- Positive attestation by partner on information provided and compliance with Company policies
• No interruption in managing the business – we make it easy for you
- Nominal Company personnel and resource allocation requiredp y p q
- Fully managed by Deloitte for the Company
- Recommendations for potential actions or enhancing Company processes, controls or operations
- Minimal or no cost to the Company

Mitigating your partner selection risk
• PEP/other sanction lists • Number of business partners
Data sources Considerations
/o e sa c o s s
• Adverse media
p
• Common patterns between
partners
• Business partner activity
Level 1
• Includes Level 1 research
• Identify website/media profile
• Business partner contact with
government officials
• Known or prior allegations
Level 2
• Identify website/media profile
• D&B or similar profiles
• Corporate registry check
• Identify shareholders and directors
C dit h k
• Jurisdictional risk (CPI score)
• Industry risk
• Country specific common
• Credit check
• Bankruptcy/civil litigation
• Criminal record check (to extent
available)
Country specific common
schemes
• Local experience
Level 3
• Includes Level 1 and 2 research
• Discreet local source inquiries

Questions?

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