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Chargebacks Reform: Vendors Hope Probes Level the Playing Field

With chargebacks on center stage in the Saks Fifth Avenue investigation, the question on people's minds is: Can the industry be rehabilitated?

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NEW YORK — With chargebacks taking center stage in the Saks Fifth Avenue investigation, the question on people's minds is: Can the industry be rehabilitated?

Stories of outrageous chargebacks and markdown contribution demands from all the major department store groups have long been rampant on Seventh Avenue. It continues to be a sensitive subject, and very few vendors agreed to speak for attribution, fearing department stores could terminate relations with them.

But the tide appears to be turning in the chargeback battle. A number of vendors have formed a formal group to address the issue even as speculation increases that the U.S. Attorney's office in Manhattan might broaden its probe of Saks Fifth Avenue into an industry-wide investigation covering all department stores.

As reported, Saks Inc. is widening the internal investigation over chargebacks and related accounting issues at its Saks Fifth Avenue unit to cover categories beyond the bridge area. Saks Fifth Avenue's chairman and chief executive, Fred Wilson, also is vowing to fully repay 12 bridge vendors in an attempt to put the issue behind the retailer. Meanwhile, Nordstrom last month revealed for the first time the scale of its vendor allowances, reporting that they amounted to $206.4 million in 2004. The largest single amount came in "cosmetic selling expenses," which totaled $96.9 million.

Yet, despite the Saks investigation, industry insiders don't believe chargebacks or markdown contributions will disappear.

"It's like a morphine drip," said one industry source. "In the short term, you want relief so you can rehabilitate, but in the long term, it's an addiction, and you are addicted to carry forward with these guarantees."

"You can't keep draining the manufacturers because they are the ones who give you the juice," said an executive at a Seventh Avenue apparel firm.

That said, many are hopeful the latest controversy over chargebacks will result in a clearer relationship between vendor and retailer.

"I think that there's a new feeling among vendors that, for the first time, there is a window open to the possibility that the playing field can be made more level," said Donald Kreindler, partner at law firm Phillips Nizer, which is helping to form the vendor group to discuss the issue. "Vendors have reacted very enthusiastically to the concept of a council being set up to develop fair and equitable standards for the relationship between retailers and vendors."
Kreindler also was quick to point out that "nobody is suggesting that valid and proper chargebacks should be eliminated. It is a question of what chargebacks are valid and appropriate. If a vendor fails to meet reasonable requirements that have been set forth by the retailer, then the retailer would have every right to issue a chargeback to reflect [that] nonconformity….Proper chargebacks for nonconformity with reasonable requirements is all that any vendor could ask for."

While there is skepticism that the result of all these probes will be the disappearance of chargebacks, observers expect some good to come out of the investigations, for retailers and vendors alike.

"I think that what [the Saks problem] will do as far as retailers are concerned is to provide an impetus for the others to take a hard look at their internal processes, looking at whether the procedures will stand up to this new scrutiny that may come from Sarbanes-Oxley [a federal law passed in 2002 that mandates certain financial and accounting disclosures] and whether they have the requisite documentation to back up the charges sought. You may see some retailers revise their processes, which would provide an opportunity for collaboration between them and vendors. I think vendors will have a bigger say than before," observed Jessica Butler, principal of Attain Consulting Group, a deduction and chargeback management advisory firm.

"I think it's going to make retailers more sensitive as to how they deal with vendors, and hopefully it will enable vendors to require clarity as to what the charges are and aren't, so there is a mathematically transparent way to reconcile whether money is owed," said one industry insider. "Taking a look at models around the world, what could happen is that more and more concession [leased department] models emerge, and then you really are on your own."

Many hope the result will be agreements that are fairly monitored throughout the season.

Richard Rosenthal, president of Alvin Valley, said, "As a general principle, chargebacks relieve purchasers from responsibility for their orders by requiring vendors to indemnify sell-throughs. Retailers overbuy and undermerchandise with impunity based on arbitrary markdowns all over."

Ideally, retailers would negotiate discounts with vendors in advance, he said. "This way, retailers have some vested economic interest in the success of the product selling," said Rosenthal.
"What could become different is that the retailers are feeling they have to be more careful and validate what they come up with," one industry executive said. "With markdowns, vendors are really questioning whether the numbers they are given by stores are legitimate. Since that data is given to you by the retailer, the legitimacy of that information has to be verifiable."

A U.S. executive of a high-end European label said, "It would be good to have a form of certification, an independent review of the chargebacks ... so there is a way for vendors to know that charges are 100 percent true and accurate."

Bud Konheim, ceo of Nicole Miller, pointed to retail overexpansion, especially in large shopping malls; a stagnant population, and just too much merchandise out there as factors fueling markdowns and chargebacks. "We're all part of the problem if we are looking to sell into those oversized spaces. People are not out there to buy it."

Konheim said the only way stores can distinguish themselves from their competitors is through product, something Neiman Marcus and Lord & Taylor have been doing. "Neiman Marcus is a perfect example. They have merchandise selectors and other stores have deal-makers. Look at Neiman's numbers. They are phenomenal."

Konheim said May Department Stores Co.'s increased buying power has hindered the retailer to some degree. "It's actually getting to be a really tight world in retail. Frankly, I think the May Co. was losing buying power because no one wanted to do business with them. They were the leader of chargebacks and markdown money, and they were pounding manufacturers to the ground. I didn't do business with them."

But even vendors admit there are limits to how sweeping the changes might be. Many agreed that, in such a contract between the vendor and retailer, guidelines have to be strictly set from the very beginning.

"There's always give and take," said an apparel resource. "If my goods are on the floor and they are not selling well, I understand that we are partners with the retailers, but it's gotten to the point of never being able to be good. I don't think it will change much, because they have to start being better buyers. They have to change their philosophy on how to be profitable, and I don't know if the stores are willing to do that."
For Liz Claiborne Inc. chargebacks have clearly become part of doing business.

In its 2004 annual report, the firm stipulated: "Costs associated with potential returns of products as well as allowable customer markdowns and chargebacks, net of expected recoveries, are included as a reduction to net sales and are part of the provision for allowances included in 'accounts receivable-trade, net'" in its consolidated balance sheet, which for the year ended Jan. 1, was $432.1 million.

The report added: "These provisions result from seasonal negotiations with our customers as well as historic reduction trends net of expected recoveries and the evaluation of current market conditions. Should circumstances change or economic or distribution channel conditions deteriorate significantly, we may need to increase our provisions. Our historical estimates of these costs have not differed materially from actual results."

One outerwear executive who asked not to be named said it all comes down to product: "If you have a product stores want, they are going to trade with you. If you have a product that is marginal, they're not. To me, it's all about business."

If a company is charged for something that was not agreed upon beforehand, it has a legitimate complaint, he said, adding that, for the most part, "I think it is a lot of sour grapes on the part of the manufacturers."

"Seventy-five percent of the time, there is a discrepancy in terms of what we think is fair and what they ask for. The accountability has gotten a little out of control in the past 10 to 15 years. Chargebacks are a bit of a built-in profit center for stores."

On the flip side, he thinks manufacturers should be accountable if they don't follow through on the terms that were agreed upon. "But once the retailers get comfortable or the vendors get accustomed, retailers get more unfair or lopsided."

Many believe that the controversy over chargebacks will fade in time even without government intervention. Retail consolidation, coupled with increasing competition from mass merchants and specialty stores, will make it more important for department stores to compete on product and service, rather than on financial engineering.
Chargebacks, like bankruptcy, used to serve a positive purpose, said Robin Lewis, ceo of Robin Lewis Inc., a consulting firm here. "Bankruptcy provided some reasonable protection from creditors, allowing failing businesses time to reorganize, shed their debt and right themselves for another chance. Now, in many cases, it's being abused as a proactive strategic weapon to gain competitive advantage, and often not once, but several times.

"Likewise, chargebacks were intended to provide a positive mechanism through which retailers and vendors could share in their mistakes," Lewis added. " In my opinion, even though the issue is now just coming out of the closet, this positive sharing ended about 30 years ago and has just gotten worse, particularly among those retailers that don't know how to compete by providing value that the consumer wants, so they compete by the 'numbers.' Therefore, the chargeback has become an abusive weapon, for many retailers, to hide the reality of their vendors' subsidizing their bottom lines.

"Chargebacks will disappear along with the very retailers that are now abusing them to 'make their numbers,'" observed Lewis.

One sportswear vendor, who requested anonymity, said, "It's really not as bad as it used to be a year ago. We deal with two types of chargebacks: authorized, which we agree on before we do business, and unauthorized, which are not agreed on beforehand. When I look back at the past year, those unauthorized chargebacks have drastically decreased for us. Chargebacks are part of the game, and if I'm not going to make money dealing with a particular retailer, then I will not do business with them. What's the point of doing business with them if you don't make any money? Right now, I'm working with about two or three retailers to correct the chargeback situation. If it becomes abusive, I won't do business with them."

According to Craig Johnson, president of consulting firm Customer Growth Partners, "Chargebacks have been a long and pervasive tradition in the industry, so you're not going to get rid of them overnight. The fact that this is coming to light with the Saks situation has to be healthy. Getting it out in the open is the best way to deal with it."
Richard Hastings, senior retail analyst at Bernard Sands, noted that recent software innovation, combined with accounting and regulatory reforms, helps increase the rate of discovery of improper procedures and improve the handling of shipping and other compliance errors.

"Some of what we are hearing today, especially in the case of Saks, is a result of the greatly improved corporate governance systems and internal controls as a result of Sarbanes-Oxley. We are not looking at a worsening of the situation, but a situation that is getting better overall."