Shedding light on a black market

This past November Lebanese authorities disrupted a smuggling operation that had evaded detection for over a decade. The items trafficked were mobile phones to the tune of 2.5 million devices valued at some $45 million during the network’s lifespan, local media reported. The trafficking network’s alleged mastermind? Kamel Amhaz.

The name might sound familiar. Just a few years back, in July 2014, the United States placed financial sanctions on Amhaz, his businesses and several associates. The US accused Amhaz of using Stars Group Holding (whose subsidiaries together form one of the larger distributors of mobile phones in Lebanon, with retail branches throughout the country) to buy sophisticated electronics for Hezbollah. “Items obtained by Hizballah using the Stars Group Holding network have directly supported the group’s military capabilities,” a statement announcing the sanctions read.

The sanctions came just months after Lebanon lifted a regulation meant to curb mobile smuggling. Last November, Ahmaz was arrested on smuggling charges. His release on $10,000 bail in December indicates the government does not really care about an underground market that costs the treasury tens of millions of dollars in lost tax and tariff revenues every year, distorts the competitive landscape and negatively impacts consumer welfare.

Whitelisting

In 2013 the Ministry of Telecommunications attempted to control the mobile phone market, implementing a software system intended to curb smuggling by verifying a device’s International Mobile Equipment Identity (IMEI), a 15-digit serial number unique to the phone. The IMEI number was used by the government to verify the phone, a process known in industry terms as whitelisting. IMEIs that were not imported through proper channels were blacklisted and blocked from connecting to the cellular networks of Lebanon’s two publicly-owned but privately managed operators, Alfa and touch.

The new regulation added an extra layer of bureaucracy, but whitelisting was, in theory, a relatively simple process. All importers had to do was register their shipment’s IMEIs with customs; upon import, traders were to clear their shipment with the customs Directorate of the Ministry of Finance, paying a 10 percent value added tax (VAT) for each device imported and a 5 percent customs duty on the total value of the shipment. After receiving payment, customs forwarded the IMEIs to the Ministry of Telecommunications for whitelisting. Travelers from abroad had to register their device’s IMEI upon arrival at the airport. Local subscribers were grandfathered in and users looking to trade in their mobiles, or switch their SIM card between phones, first had to send one text message to release the number from the initial phone’s IMEI.

The IMEI block had two intentions: to prevent mobiles that were not whitelisted from connecting to the country’s cellular networks, and requiring importers to trade above the table. It’s not clear how effective the system was because figures are not public and government officials would not discuss the matter with Executive. But the IMEI block did have an impact, Lebanese customs data shows. For less than a year it turned a mostly black and gray market into one that was nearly as clean as the sullied snow along the road to Faraya.

In 2014, with Boutros Harb at the helm, the Ministry of Telecommunications did an about-face, cancelling the IMEI block. Harb agreed to an interview with Executive for this article, but did not commit to its scheduling. In a statement from 2014, Harb cited a number of reasons for cancelling the system but offered little evidence to support his claims. According to Harb, the IMEI block forced mom-and-pop shops out of business, eliminated jobs, delayed imported mobiles from reaching the market to the benefit of other traders and had no effect on revenue collection or in curbing smuggling. At the ripe age of ten months the IMEI block was no more.

Regardless of the motive, Harb’s arguments do not appear to have actually been measured; there are no figures published online and the Ministry of Telecommunications, now led by Jamal Jarrah, did not grant an interview.

Lack of data

Nicolas Sehnaoui, the minister of telecommunications who implemented the IMEI block, who also was not available to comment for this story, said back in 2013 that it was meant to curb mobile phone smuggling, as his administration estimated the market to be 70 percent black.

Implementation of the IMEI block uncovered not only the black market, but also dimensions of the market that industry players estimate to be at least 20 to 25 percent gray (see explainer below on black versus gray markets), leaving legitimately imported phones to account for as little as 5 percent by quantity, if both estimates are correct. 

Lebanese customs data does show that the IMEI block made the market more transparent. In 2012, before the IMEI block was put in place, customs recorded imports of almost 150,000 mobiles with a declared value of nearly $31 million. Implementation of the IMEI block got underway in the middle of 2013 and end-of-year records show nearly 1.4 million phones were imported with a declared value of $193 million. In 2015, the first full year of data after the IMEI block ended, the figures dropped off a cliff: 263,000 devices at a declared value of $21 million.

A comparison of UN Comtrade Database, a depository of international trade data reported by countries, with Lebanese customs data suggests a much larger black market than the government thought and shows a total market size by quantity larger than industry insiders project. The IMEI block was not in place for a full calendar year, only the second half of 2013 and the first quarter of 2014. The 2.3 million devices officially imported over 2013 and 2014 is only 30 percent of the 7.6 million that trade partners reported leaving their countries with destination Lebanon. The database is not specific enough to make any conclusions for intra-year changes and neither global market fluctuations nor reported Lebanese exports explain the discrepancy between imports from one period to another. What the UN’s data does suggest is that smuggling is much more rampant than the government thought and shows a market size 2 times larger than industry projections.

In terms of revenues, it is not clear how much in VAT and tariffs the IMEI block helped catch because the financial data is not public, and government officials would not discuss the matter with Executive. What is available are overall figures on VAT and customs revenue that flow to the government’s coffer. But those figures do not give an indication of what is collected from mobile phone imports because there are too many variables to isolate – the data combines all duties assessed on the total value of imported shipments where the flow of trade can fluctuate from month to month, and it lumps together VAT collections on goods and services at points of sale, which might fluctuate due to consumer behavior, with VAT collected on each product imported.

For the treasury, the removal of the registration system meant lost revenues that the Ministry of Telecommunications estimated in its 2013 annual report to be upwards of $40 million annually, though Sehnaoui placed the loss at no less than $60 million per year when he announced the IMEI block that year. But if the UN data were the measure, treasury losses might be above $100 million every year.

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New regulation added an extra layer of bureaucracy, but whitelisting was a relatively simple process

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The Ministry of Finance declined to comment on the impact on VAT collection and the amounts that were received before, during or after the IMEI block was in place. Customs, which falls under the purview of the Ministry of Finance, was also not available for comment on the flow of revenue to the treasury from the collection of duties on mobile imports.

Rita Khairallah, then a project manager at the telecoms ministry, told The Daily Star in 2013 that the IMEI block was an impressive success. An assessment conducted by the ministry after the first three months of implementation claimed that customs and VAT revenues on mobile phone imports multiplied by more than ten times, she said. Khairallah, now a customer experience manager with network operator touch according to her LinkedIn profile, did not respond to Executive’s requests for comment.

The lack of data and the unwillingness of government officials to discuss the issue might suggest an undercurrent to this story that publicly available sources alone cannot tell.

The losses for industry

Industry players had long wanted the government to crackdown on smuggling and parallel imports. Eddy Cherfan, CEO of Cherfan, Tawil & Co. (CTC) – the one market player that agreed to speak on the record with Executive – argues at least 90 to 95 percent of phones on the market before the IMEI block were, and are now again, black or gray devices.

The IMEI block provided what Cherfan thought was a golden opportunity. With it in place, he moved to aggressively expand CTC, updating stores and adding new ones, increasing the payroll and growing the distribution line, where the company does the bulk of its business, with a new warehouse.

Cherfan was thinking strategically. He saw opportunity in a retail market he viewed as unorganized, offering little to customers in terms of service and guaranteed quality, and in return, he believed the IMEI block would level prices. Before and after the IMEI block, Cherfan cited smuggling, parallel imports and the misinvoicing (see explainer below on misinvoicing) of imported shipments as reasons why CTC could not compete on price. He guessed that with more importers paying taxes and tariffs, the number of cheaper black and gray phones in the market would shrink. “We thought we had a fair chance competing in mobile phone sales. Consumers would come to our shop and find well-trained salespeople offering a full-fledged service, with original accessories and warranty at a fair price,” he tells Executive.

It’s not clear how much market share CTC grabbed while the IMEI block was in effect, and Cherfan wouldn’t say. CTC doesn’t have exclusivity on Samsung mobile phones (it does for other Samsung consumer electronics), but the company is the only authorized distributor in Lebanon. He calculates the country’s mobile phone market size to be above 1.5 million devices annually, a much smaller estimate than UN data shows. But given the aggressive expansion plan, it’s a fair guess that CTC projected an increase of market share by healthy margins.

The move to discontinue the IMEI block halted any ambitions Cherfan had planned. The company immediately lost $1.2 million, he says. Retailers stopped buying, content to wait for cheaper mobiles to flood the market. “As soon as minister [Harb] went on TV to announce the cancellation of the IMEI block, the market stopped buying, and we had a large stock [left] in our warehouse – thousands of phones,” Cherfan says.

In the months that followed the IMEI block’s removal, CTC losses added up to millions of dollars. Stores were closed and 80 employees were let go. Cherfan was forced to change tack, shifting much of the company’s mobile trading business, due to regulatory uncertainty and lower investor confidence, outside of the country.

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In the months that followed the IMEI block’s removal, CTC losses added millions of dollars. Stores were closed and 80 employees were let go

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“The cancellation of the registration system cost our company dearly,” he tells Executive. Tallying stock losses, compensation to employees that were laid off, the closure of five shops that had been renovated, rental fees that were paid upfront, IT infrastructure and a new warehouse built for mobile phone distribution, Cherfan says the total losses approached $4 million.

Adding insult to injury was the speedy shut down of the IMEI block. Before its implementation, the government allowed a grace period of several months for traders to clear their stock. Importers that had smuggled phones into the country by not paying VAT or duties were forgiven, able to avoid financial losses and join the market above the table. But when the government decided to cancel the IMEI block, “They gave us only three days. They gave six months to the smugglers and gave us three days,” Cherfan recounts.

State of affairs

That the mobile phone market is openly recognized as a mostly black and gray market raises concerns. The governing element of the story is that the state is giving up revenue due to the treasury, potentially in the hundreds of millions of dollars annually, and acting to its detriment for unknown reasons. The removal of the IMEI block allows some competitors to have a better cost position, because the data shows some importers continue to evade taxes and duties, resulting in a distortion of the competitive landscape. Because of the opacity of decision making, one is left with the conclusion that the government condones smuggling.

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The removal of the IMEI block allows some competitors to have a better cost position

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Explainer: Black versus gray

A black market is one that functions below the radar of the state. Smuggling is an underground activity where the demand or profit margin for controlled products like weapons, or illegal ones like narcotics, or counterfeit goods create a supply incentive too juicy to pass up despite risks. Tax evasion is another form of smuggling, even when the product imported is a legitimate one. Smugglers might also, knowingly or not, import stolen devices whose data has been wiped, updated with a new operating system and reboxed with new accessories and portrayed as a new or used phone.

A gray market, sometimes called parallel imports, differs in that the product is not illegal but is brought into a country through distribution channels that may be unintended by the manufacturer. The driving force behind parallel imports can be due to price variation between versions of the phone meant for different markets, currency fluctuations where the device may be cheaper when traded in a currency that is stronger than that of the country of origination or of destination, or simply due to consumer demand for a mobile in a market that has not yet officially launched. While consumers may gain by paying lower prices, their experience with a parallel import product can be compromised. The mobile they purchase may be a version of the device localized for another market, so the consumer might not receive the appropriate accessories, or might not qualify for the manufacturer warranty, or it may even be a refurbished phone described as new.

Gray markets often come about because of certain rules in a given market. The gray market definition requires two conditions: “(1) The existence of the agreement of exclusive rights to sell a certain product in the territory, (2) The existence of a strong registered trademark, which is recognized in a territory where a potential grey marketing activity may occur,” reads a 2011 research paper on gray markets.

Lebanese law allows for exclusivity rights for companies, and the economy is often described as laissez-faire. But, the “Lebanese economy is largely oligopolistic”, a slideshow presentation hosted on the Ministry of Economy website (it’s not clear when the presentation was prepared or published) points out, adding that a new competition law is necessary to level the economic playing field. The “ultimate objective of competition policy in general, and competition laws in particular, is consumer welfare that is served by lower prices, better quality products and, eventually, by a more efficient and dynamic economy”, reads a 2002 report prepared by a local consultancy for the Ministry of Economy.

Explainer: Misinvoicing 

Importers can skirt customs duties and VAT taxes by mislabeling, intentionally or not, the shipment’s Bill of Lading (BoL) – what is written on the label may not be exactly what is in the box. At its simplest, mislabeling affects the shipment by misstating its content, downgrading its number of units or their total value.

According to Global Financial Integrity (GFI), a Washington D.C.-based nonprofit researching illicit financial flows, misinvoicing could result in the direct evasion of taxes and customs duties by under-reporting the value of goods, an outcome that would easily be measurable if Lebanese customs data on mobile phone imports, the UN’s data on mobile phone exports to Lebanon and the Ministry of Finance’s figures on VAT and customs revenues for those imports could all be cross-checked. However, the latter is not available and officials with knowledge of government finances were not cleared to discuss the matter with Executive.

Mislabeling the invoice is as simple as it is sophisticated, with the shipment passing through potentially one or more intermediaries between the exporter in Country A and the importer in Country B. The shipment could pass through one of four major distribution points for mobile phones – Hong Kong, Dubai, Amsterdam or Miami – before reaching the country where the units will ultimately be sold. So while the exporter in Country A may declare the actual value of the shipment, intermediaries may alter the BoL at points along the distribution path before forwarding the shipment to Lebanon where the importer might again obscure the true value of the shipment.

Sometimes the opposite might occur and the value of the shipment might be inflated. Intermediaries that are subsidiaries owned by the importing company, or companies working with the importer, might raise the value of the shipment to skim cash off the top, sending the proceeds to offshore bank accounts, where taxes can be dodged and the cash laundered. Because of the volume of trade and the sheer number of and speed at which containers move between ports “trade misinvoicing has become a fairly low-risk endeavor for criminals – especially those who only moderately misinvoice their transactions by, say, 5 to 10 percent”, GFI says.