In this episode…

As we steer through the daily changes inherent in navigating the pandemic, we are also looking to the future. As attorneys, we need to advise our clients on risk as they role out new policies swiftly and help them prepare for the inevitable wave of litigation as unexpected ramifications or events overtake them. The areas we are focusing on today are the supply chain and logistics. We held a discussion with two of our experts, Dr. Zal Phiroz and Mr. Jerry Davis, and asked them their opinions on some of the issues likely to arise due to such disruptive times.

Episode Transcript:

Note: Transcript has been lightly edited for clarity.

Dan Rubin: During a disruptive event like COVID-19, how can smaller retailers ensure that manufacturers are not showing favoritism to certain chains? For instance, would a company like Walmart, that serves many more customers than smaller retailers, be given preference for particular goods? And what steps can small retailers take to avoid this disparity?

Jerry Davis: Well, I’ve had a number of years’ experience in dealing with Walmart and Target and Amazon, the big players, and I can tell you one thing: they are trying to get special treatment. They don’t want holes in their shelves; they want their competitors to have holes in theirs. If I were a 5, 10, 15, 20-store supermarket operator, I would be very concerned that the buyers at Walmart aren’t strong-arming the manufacturers to get them the lion’s share of the product. During the beginning of the pandemic, when you couldn’t get toilet paper, hand-sanitizer, or anything that included bleach…you couldn’t buy it anywhere…that was one of my thoughts: you know that the big retailers are pounding on the manufacturers to get as much of this stuff as they can. And the smaller guys are really at a loss for that. All of the big manufacturers…the Procter & Gambles of the world, the Scott Papers of the world…those folks are going to try and be equitable. But once you get a little father down the food chain in terms of manufacturers, they are really susceptible to pressure from the big guys. So if I were a smaller retailer, I would be asking questions now: Did you provide me? Was I getting fair treatment? If I represent 3% of your business, was I getting 3% of your product? And I would be looking at my purchase orders and my buying contracts with manufacturers, to make sure that they are pledged to give us equitable treatment. There are Robinson-Patman considerations that manufacturers have to take into account in terms of restraint of trade, and if I were a smaller retailer, I would be making sure the manufacturers knew that I was paying attention. I don’t want to overuse the term “existential threat,” but it certainly is for a small retailer relative to Walmart and Amazon and Target and everybody else: if they can’t get product, they won’t survive, so they have to fight for their rights.

Dan Rubin: When there are delays in the distribution of goods, the prolonged storage of these goods may result in product damage, spoilage, or other issues. How can these damages be avoided, and/or whose responsibility should it be to ensure proper storage of goods while awaiting transit and delivery?

Zal Phiroz: A supply chain disaster like we’ve seen here…this is fairly unique. There have been a number of times in which we have had these “supply chain disasters,” whether there’s a hurricane or a typhoon or an earthquake or whatnot, and a section of the supply chain has actually been impacted to the point where everything needs to be transitioned to a new method, a new methodology, a new structure altogether. With what we’re seeing in a situation like this, if there is a delay in the distribution of goods, and the need to prolong storage for certain items, there could be potential for spoilage, product damage, and other issues. For example, if there is a scenario in which a product needs to be distributed by the way of refrigerated trailers, or if the product needs to be kept in some sort of cold storage, or if the product needs some sort of maintenance or regular care throughout a duration in which employees are no longer employed or are not present on the scene, there could be vulnerabilities in the actual product integrity. This reminds me of another case, a case with Mattel. Mattel came into a problem with quality assurance for a little bit of a different reason. Some years ago, they were forced to execute on a rather large recall. They were basically offshoring their production to production facilities in China, and because of the pricing pressure they faced domestically, with Walmart continually pushing and pushing and pushing their pricing down, they essentially had to offset that pressure to their manufacturers in China, who were also trying to lower their costs as much as possible. As a result, what happened was the manufacturers needed to resolve to use cheaper materials, and needed to avoid certain areas of quality control, and ultimately it was discovered that some of these dolls came up with lead-based paint, which resulted in a massive recall. There have been a number of different cases in which I have been an expert that have focused specifically on these areas, where there’s been pressure from all kinds of angles that have resulted in kind of a downward pressure in terms of price. And, as a result, the likelihood of overlooking certain quality control issues and quality control measures, with a situation like we have now with COVID-19, everything having to slow down and stop, and everything resuming now, but at a 50% capacity, with all sorts of different safety measures implemented, with perhaps a skeleton workforce, we are almost more than likely inclined to see situations in which there has to be a focus on getting things up and running at the cost of perhaps maintaining the same integrity of quality from a supply chain perspective, specifically distribution, manufacturing, and storage, as opposed to, perhaps, before.

Dan Rubin: In that same vein, in your expert opinion, do distributors have the duty to examine these products to ensure that they are free from defects?

Zal Phiroz: In terms of quality assurance, typically distributors are responsible for certain nodes of the supply chain. So the notion of distribution is not necessarily just one arm; there’s distribution from supplier to manufacturer, manufacturer to the warehouse, warehouse to the distribution center, distribution center to the retailer, etc. etc. And if we look at online selling, we see that distribution actually doesn’t necessarily revolve in house anymore. It’s more so a third-party logistics arm that might be used, or FedEx or UPS, or any of these entities that are basically managing the distribution of actual property to the door of a consumer, if we’re looking at a consumer product. What this means is that we are seeing a kind of shift in terms of demand, which means that there might not necessarily be that level of quality assurance that we were expecting to receive or had expected pre-COVID. From a quality assurance perspective, distribution basically needs to ensure certain things: it needs to ensure the product is stacked in a certain way, stored in a certain way, distributed in a certain way, even when it’s being distributed in a truck. Usually these trucks are going to be at capacity because of the amount of weight they can hold on their trailer, or the amount of size they can actually squeeze into their trailer. So there are a number of different guidelines and regulations that need to be observed. From a safety perspective, we kind of open up an entirely new can of worms, because there might be new conditions and new guidelines in which protective equipment is needed when unloading, loading, and moving a product. And if this is the case, this could potentially require more time. As we go to a post-COVID kind of world, we’re seeing a lot of changes in the way businesses are actually using employees’ time. There are actually fewer employees because of the need to downsize. Now, what this may mean is that as these measures become more and more conventional, and more and more expected, there might be vulnerabilities in actual quality issues, stacking issues, storage issues, because now, all of a sudden, we’re seeing retail outlets, warehouses, distribution centers, manufacturing centers, even distribution arms that are operating with a 75% employee base and requiring 125% amount of time because they need to basically be on top of certain areas…of disinfecting, and these types of things. So we’re seeing a push and a squeeze in two different ways that begs the question, “where is the shortfall?” Inevitably that shortfall has to come from somewhere, and you would almost assume that that’s going to be possibly at the cost of quality control and quality assurance.
Dan Rubin: As consumer behavior continues to shift as a result of COVID-19, how may retailers utilize online purchasing and distribution, and what issues could arise from removing the brick and mortar stores for home delivery or curbside pickup?

Jerry Davis: I think this is really the crux of the whole COVID/supply chain question. Prior to the pandemic, online retailing was garnering an ever-increasing part of the retail landscape. And as such, bigger companies (certainly the Walmarts and Targets of the world) were increasing their online presence and backing that up with the fulfillment capability. In a traditional brick and mortar retail store, you have manufacturers shipping products to distribution centers that are generally owned by the retailer, and then those distribution centers distributing those products to their individual stores. And sometimes, after they made a delivery, they would stop by a manufacturer’s plant, backhaul the next load of products into the distribution center, and it was just a big circle happening. And that’s the way it was for years. With the advent of online retail, the development of the fulfillment center really became important. And the thing that’s really important to note is that, if you look at JC Penney, and the offerings they have in their store, they might have 75,000 SKUs (stock-keeping units) available for purchase in one of their brick and mortar stores, but if you go to their online location, they may have 250,000 stock-keeping units available. And that is a whole different animal: when you don’t have to have a brick and mortar store with a facing that you have to replenish every day or every other day, then you can have a whole lot more offerings for your customers. Because, in a fulfillment center, the fast moving items will have a one-pallet, two-pallet, or three-pallet facing that order pickers pick individual units from, into a carton, the carton gets full, seal it up, ship it to the consumer. Because they can do that in bulk, they need many fewer fulfillment centers, they’re bigger, and they can handle hundreds and hundreds of thousands of different items and manufacturers, unlike brick and mortar. I think, and I think the data will show very soon, that the pandemic is going to accelerate that shift from brick and mortar purchasing consumers to online. And that’s going to cause these brick and mortar retailers the need to accelerate their fulfillment capabilities.

Fortunately for the big retailers, the Walmarts of the world, they have fulfillment capabilities. Walmart.com is a fully functioning business. Amazon certainly is getting a greater and greater share of all purchases, but the medium-size retailers, if they are going to survive, are going to have to be able to gin up this fulfillment capability very quickly. It is a whole different set of skills than operating a pallet in, case out distribution center. It is “pallet in, individual unit” out.” You have to be able to bill, you have to be able to credit, all from the fulfillment center. It is a much tougher software question, much more difficult handling issues, the size issues of the facilities are way different than the distribution centers, and converting some of the distribution and fulfillment capability will be the challenge for some of these mid-size retailers; but, if they don’t do it, I don’t think they are going to survive. So I think the lasting legacy of this pandemic from the supply chain point of view is going to be the accelerated shift from brick and mortar to online sales, and I think it is going to be a big deal in supply chain.

Dan Rubin: Related to that, with the huge increase in online purchasing, have you seen historical refund/return policies of these businesses remain in effect, or are they going to change as a result of the pandemic?

Jerry Davis: Historically, online retailers (and, to a certain extent brick and mortar retailers as well), have used their return policies as a merchandizing point, as a way to differentiate themselves from their competitors. UPS did a study about three years ago where they surveyed consumers across the country, and one of the big takeaways was that consumers said that whether or not the online retailer had a 100% return guarantee with the online retailer paying the shipping was a determinative factor of whether or not they would shop with that retailer. I think that the retailers really have taken that to heart, so you see most online retailers have very liberal return policies that include paying for shipping. Now they also will have algorithms in their return software that look out for people who might abuse that, and you see instances where Amazon will reach out to a customer and say, “You’re returning 60% of everything we ship you, so either you will need to stop doing that, or we will have to stop selling to you.” So I think that what you are going to see is that these return policies are going to uniformly be liberal. And they are all going to have to do it just to be able to survive, because consumers demand these return privileges from their retailers.

Zal Phiroz: What we are seeing, and I’ve spoken at a number of conferences on this, is that there has been a kind of shift over the last 15/20 years in terms of paradigm, of people who were specifically against online purchasing (they would only buy in store) and who are now moving towards online purchasing. With COVID-19, that trend has accelerated in that there have been certain categories of people in certain segments who have been almost forced to kind of take on online purchasing as their natural way of buying products and using various things: people who would have never gone online who are now buying online. What this might be doing, if we look at it from a little bit of a higher perspective, is it might be changing demand patters, and projecting where those demand patterns are moving towards is going to be a little bit chaotic when it comes to businesses who are actually figuring out what to do. In other words, a traditional supply chain works by way of projecting demand and figuring out exactly where demand is going to be on each node of the supply chain, but when we have different types of buying patterns, we might see a shift of that demand, and we might see situations in which manufacturers are over-shipping or over-producing, so product is expiring because there is not enough buying that takes place. Or there might be reductions in cost to get that product out. Overall, this is not necessarily cultivating an atmosphere of a nice, easy progression that can be forecast or projected. All of a sudden, we have gone from various segments of the buying population that were nowhere near the realm of online shopping to companies having the need to basically attend to these groups altogether.

Dan Rubin: Who is responsible if there are faulty products as a result of supply chain disruptions due to COVID-19? And what happens when things pick back up and workers are forced to work faster, which could cause issues with product quality and liability?

Zal Phiroz: There are a number of vulnerabilities across the chain, and I’ll use a very simple example: If someone goes into a retailer, be it a Walmart, and buys something, whatever it is, and they get home and the product is defective or it’s dangerous or it causes some sort of injury, that consumer rarely thinks to go to the supplier, or the outsourced manufacturer that is offshore. They will go to one of two sources: one will be the retailer, so Walmart will be held accountable and their reputation will suffer; or they’ll go to the manufacturer, or both. As a result, the integrity of the supply chain isn’t called into question, but the integrity of the supply chain is basically where the root of the problem is. The manufacturer who chose to use that supplier, who is cutting costs because of lack of manpower, etc. etc., is responsible in large part for a situation like this, but not necessarily accountable. As things are picking up, moving faster, there might be fewer workers, there is almost likely going to be a little bit of a push to kind of resume the economy. There are a lot of businesses that have kind of been stopped, and a lot of manufacturing that has been restricted because of lack of ability to send product in from offshore (China, etc.) because of the regulations. What this is going to lead to, inevitably, is a slowdown in production that may have created vulnerabilities in the chain, and now almost a push to resume production as quickly as possible. The problem is that in many cases we may have a lack of personnel, a lowered level of manpower, and we may have COVID-related quality assurance standards that might result in the need to speed up production because of these standards and guidelines taking up even that much more time. If we look at what I was just mentioning in terms of the switching in demand to reply on online purchasing, what we may also see is that, all of a sudden, those retail outlets that were in charge of stacking product and storing product and knew exactly what the standards were to make sure that the integrity of the product was in place, that responsibility might be taken away and might now be on the side of the distributor. Looking at a completely arbitrary example: think about a FedEx delivery person who is delivering a TV, not necessarily knowing that they are only supposed to stack it three high or five high because it’s in the back of a delivery truck, or not necessarily knowing that when they put it on a porch, it is supposed to be upright instead of flat. There are countless examples that we can touch on, and in various cases that I’ve worked on, even pre-COVID, these have been examples that have come up. If we look at other areas, we can actually see that these could be precursors for larger situations that may take place, for instance from an insurance standpoint, or vulnerabilities that might take place in terms of insurance for manufacturing defects as a result of poor quality control. And we can also see that, in general, we are actually shifting where the responsibility is for these products. In the past, it was the retailer who was responsible for holding these products. Now, it’s a third-party distributor that’s responsible for the last mile, someone who’s driving a delivery truck who’s been contracted to deliver these products. If the damage takes place during that last mile, who’s responsible: is it the manufacturer, is it the outsourced distributor? All of these questions come up. In general, the likelihood is that it is going to be caused by a lack of manpower, a push to resume economic activity and remain competitive amongst other companies that are also trying to do the same thing, and a complete shift in demand cycles in terms of how people are actually buying: the fact that things are changing in terms of where products have been sourced, how products have been manufactured, what quality assurance standards there are; that’s delaying the entire chain even more.

Jerry Davis: One of the things that retailers and manufacturers have done pre-COVID, and Walmart really led the way on this, is they have negotiated buying arrangements where the retailer would take an off-invoice allowance from everything that they bought from a manufacturer in lieu of having returns. So, for instance, Walmart negotiates with Sony and says, “We’ve done all this research and analysis. We know what our returns are at the store.” (The average brick and mortar retailer has between a 9 and 10% return rate, and they know that. Anecdotally: the online retailers have almost twice the return rate as the brick and mortar retailers do, since you don’t have the in-store sight/feel component. ) So Walmart negotiates with Sony and says we will take a percentage off of every invoice, but I will never send you a return. And I will take that product when it comes back and sell it on the secondary market. (The secondary market for consumer goods in North America now makes up almost 3% of GDP. It is a huge business.) So Walmart has an operation in their return centers (and Amazon even more because of their double return rate) where they are selling truckloads and truckloads of store returns to different liquidators who are then selling it off to B retail stores or flea market operators, or exporting it to South America, Europe, the Middle East, etc. So there’s a whole thing that is happening out there relative to returns and damage…the problems that Zal was talking about…and, post-COVID, that’s going to go up. That double return rate of 20% for online retailers, coupled with what Zal is talking about, is going to make a lot of liquidation product available in the marketplace. And something’s going to have to change there…I don’t think there is an infinite appetite for it…and it will be interesting to see what that is.

Dan Rubin: Most existing supply chain contracts do not account for global pandemics. How can parties to these agreements renegotiate contract terms and/or revisit force majeure clauses following COVID-19?

Jerry Davis: In my past, I was the president of a big wholesale grocery company, and I can promise you that if I had that job again, my purchase orders would now say something different than they did pre-COVID. They would be looking for guarantees that my purchase orders are going to be fulfilled to the best of the ability of the manufacturer. My buying contracts would be talking about what percentage am I of your business, and making sure that I get that percentage, at the minimum, of your output. And have some follow-up mechanisms in it to be able to audit the fact that if you had 100,000 cases to sell, and I’m 10% of your business, I better have gotten 10,000 of them. I do not believe that any of that exists today, but it certainly will post-COVID.

Dan Rubin: The sharp increase in online purchasing as a result of COVID-19 caused delays in the delivery of goods. What vulnerabilities in the supply chain may have led to these delays, and how might these delays be avoided moving forward?

Zal Phiroz: To mitigate these delays, we might be seeing almost a movement away from globalization. The term globalization has become relatively popular. However, now, with the potential for a virus like this, we might see future supply chains become almost more localized, in which there might be a shift away to smaller supply chains. We might see the need to have more of a control. Perhaps that would result in higher cost as well, but localized storage, for example, to reduce lead times, and more dependence on local distribution, be it last mile delivery or third party distribution, just to remove the focus point on low labor costs and paying a tariff, but getting the product made elsewhere. These might be the results, simply because higher product price reduces the risk of an actual shutdown or slowdown. These are the patterns that, from a supply chain analytics standpoint, just by looking at data and at some of the resulting moves that various companies have made as well as some of the other cases I have worked on as an expert, that are becoming a bit more prevalent post-COVID as opposed to pre-COVID.

Jerry Davis: Another aspect of this would be on the brick and mortar fulfillment/distribution center side. There is going to have to be some significant fulfillment capability added, even for the Walmarts of the world that have significant fulfillment capability, to deal with the switch to online sales. Now that may create opportunities in the third-party logistics world, for the bigger 3PLs to get into the fulfillment business in a major way, which most of them aren’t to this point. I think you will see the XPOs of the world starting to really have some fulfillment capability. That is going to take some time and, I think, could cause disruption and delay. The other thing that is going to be interesting to see how it fleshes out is the shortage of truck drivers. As it is now, you can hardly go into a neighborhood any time of the day or evening without seeing an Amazon Prime truck driving around. Those drivers are replacing, to a certain extent, although not completely, commercial truck drivers. I think you may see fewer products in CDL-driven trucks, which is good because there is a significant shortage of commercial truck drivers these days, and I don’t see that getting any better, because it’s just a lifestyle that most people don’t want anything to do with. I actually honestly think we may see, as hard as it is to believe, a reversion back to some railroad shipments from manufacturers into distribution centers as opposed to 100% trucks right now. Most retailers have long ago filled in their inside railroad railroading unloading capabilities, filling them in with concrete to make more floor space. You may see some of that concrete getting shipped out to make room for some of the railcars again.

Dan Rubin: Do you think there will be a permanent consumer behavior shift created by COVID-19? And how will this affect contractual obligations/business interests?

Jerry Davis: I think COVID is going to be the biggest nail in the coffin of the shopping mall. They were dying before COVID, and it’s hard to believe that many, if any, of these enclosed shopping malls are going to survive this. That is going to create a lot of real estate and other issues that will have to be dealt with. There is just no question in my mind that this is just accelerating the switch from brick and mortar to online sales. Retailers that are going to survive are going to have to make that switch too. If you’re not able to do fulfillment direct to consumer, I think you will have a problem within the next ten years.

Zal Phiroz: As of the last four months, you can almost see the differences in terms of how patterns of behavior are actually shaping: everything from how many people are allowed into a store to how many people are allowed into a shopping mall…anything that’s brick and mortar…there are so many restrictions and guidelines on it, which is further killing the notion of an in-person kind of shopping experience. Before COVID, the notion of buying online was relatively easy and quick, but the ability to go into the store and touch and feel the products—the in-store experience—wasn’t there. Now, people have become accustomed to buying in that fashion and, even more so, the people who want to go back to the store are almost inconvenienced in certain ways because there are all sorts of restrictions and guidelines; which means, inevitably, from a supply chain standpoint, that demand has become 10 times harder to project and forecast, and the amount of sell-through and turnover that those brick and mortar stores are going to face is going to be lessened to an extensive degree. In the past, what you would see is that retailers, including Walmart, would have all key items that were not sold too often be online, so someone would walk into the store and, if they wanted one of those items, they wouldn’t be able to get it in the store; they would have to go online to buy it. Now it will be interesting to see if we actually see a switch over altogether, where we actually see the in-person stores holding product that nobody really wants, and you have to go pick it up, whereas the online side is for more frequent deliveries. If that transformation happens, the entire supply chain overall has basically reversed in terms of the advantages and disadvantages for certain types of product.

Jerry Davis: All of the brick and mortar retailers’ automated buying systems have smoke coming out of their ears trying to figure out what’s going on. The whole concept of safety stock in the distribution center: a regular distribution center wants to have a 97–98% order fill rate so they’re not out of stock 97-98% of the time. In order to do that, you have to have safety stock built into a bunch of those items so that you can deal with the fluctuations. What’s going on now is blowing the roof off of all of that. They’re going to be finding inventory in some of those warehouses wondering why they still have it. It’s a crazy time out there.

It’s a crazy time for us all.

Finding certainty now may be impossible, but speaking to experts helps craft good strategies and tactics. If you are an attorney and are interested in discussing your own client’s specific situation with either Dr. Phiroz or Mr. Davis, please contact Round Table Group: www.roundtablegroup.com

Jerry Davis, Reverse Logistics and Sustainability Council and Dr. Zal Phiroz, University of California, San Diego

Mr. Jerry Davis is a recognized thought leader in the supply chain, 3PL, and reverse logistics industries, with decades of experience starting with the supermarket industry in the 1970s.

Dr. Zal Phiroz is an expert on global supply chain management, and a professor at the University of California, San Diego, specializing in supply chain analytics, operations management, and data analytics.