MILAN, Italy — Midway through March, Italian police raided a factory complex on a quiet street in a leafy suburb of Milan, 11 kilometres from the city’s via Montenapoleone luxury shopping district.

Inside the factory, they found nearly two dozen workers — several employed under the table — making leather bags and accessories for luxury giant Dior. Safety mechanisms had been removed from machinery to enable faster production, with work beginning early in the morning and continuing late into the night, according to court documents. In one instance, Dior paid the supplier €53 ($58) a piece to assemble a handbag it sold for €2,600, the documents said.

LVMH-owned Dior is just one of more than a dozen fashion companies swept up in the Italian investigation linking luxury brands to sweatshop labour. In April, an Armani Group subsidiary was sanctioned by the Court of Milan for failing to ensure its suppliers met Italian labour standards. Alviero Martini, a smaller brand known for its map-print bags, received similar treatment in January. (The company said its suppliers had illegally hired subcontractors). More actions against fashion companies manufacturing in Italy are expected to follow in the coming months.

The investigation threatens the luxury sector’s most precious asset — brand image — calling into question the veracity of the craftsmanship-soaked marketing narrative luxury players routinely use to bolster the perceived quality of their products, while painting labour exploitation as a mass market problem.

The threat comes at a precarious time for the luxury sector. Not only has the market cooled significantly since the heady days of the post-Covid luxury boom. But punchy price hikes amid reports of declining quality have put pressure on the perceived value of luxury products.

On Wednesday, Italy’s Competition Authority announced it had launched its own probe into whether Armani and Dior had misled consumers about their commitments to ethics, craftsmanship and quality in light of the police investigation.

Armani said it has always had measures in place to minimise the risk of supply chain abuses and that it believes the Competition Authority’s allegations “have no merit.” Dior said the initial investigation’s findings don’t reflect the way it operates and that it has stopped working with the suppliers identified by Italian authorities. “The house of Dior firmly condemns these unworthy acts which contradict its values and the code of conduct signed by these suppliers,” the company said in a statement published this week, adding that it is working to improve its supply chain oversight.

It also contested some of the findings in the case. The manufacturers in question weren’t producing women’s handbags, but partially assembling men’s leather goods, Dior said, describing characterisations of its production costs as “ridiculously low” as “erroneous.” “It should be noted that the profit margin of the house of Dior is entirely in line with that of the luxury industry,” the company said.

A Slow-Brewing Backlash

The sweatshop scandal has sparked a slow-brewing online backlash, fuelled in recent weeks by high-profile coverage in publications like The Financial Times and The Wall Street Journal. But it remains to be seen whether social media outrage will impact sales.

The coming week brings the sector’s first public accounting since the Dior news broke in early June — too late in the quarter for much to show up in the numbers when LVMH reports on Tuesday. Luxury investors are anyway currently far more concerned about the fact that Chinese consumers — long the sector’s biggest growth engine — are not shopping like they used to.

“The bigger picture is one of global demand. Right now that is the big topic,” said Adam Cochrane, an analyst at Deutsche Bank Research. “Given everything that’s going on in China, nobody is focused on this in the investment community.”

Judging by history, that’s a reasonable position to take. Luxury brands have largely managed to sidestep associations with poor labour practices that have dogged fast fashion, painting their high price points as both a function and a guarantee of their commitment to artisanal and ethical manufacturing.

Past scandals in Italy and elsewhere have done little to dent this image, quickly fading from collective consciousness, helped along by public commitments to ethical operations and selective investments upstream.

Bernstein analyst Luca Solca first wrote about the risks in Italy’s supply chains 15 years ago. Back then, luxury was in a similarly precarious position, buffeted by the fallout from the 2008 financial crisis. The sector “cannot afford a faux pas in ethical standards,” Solca wrote at the time, warning such missteps could engulf the sector in “a renewed ‘bonfire of the vanities.’”

Instead, Chinese demand stepped in and luxury entered a growth supercycle. If anything, many of the industry’s biggest players have shifted more towards high-margin mass production, while continuing to market their products as exclusive and artisanally crafted. Manufacturing in Italy burnishes this image, but large volumes of production are outsourced across thousands of small producers that make supply chains difficult to control.

“This practice of contractors and subcontractors is in place for a reason. It’s not by accident, it’s in order to reduce costs,” said Solca.

But could things play out differently this time?

‘Disillusioned with Luxury’

As in 2008, the scrutiny on luxury’s supply chain is not a standalone issue, but one of several pressure points putting cracks in luxury’s marketing facade. Soaring prices for high-end handbags already have critics grumbling vocally on social media about sticker shock amid reports of declining quality. Layer on allegations of labour exploitation and the reputational risks are mounting.

“Are people getting temporarily disillusioned with luxury, or is the illusion getting broken for good?” cult fashion Instagram account Diet Prada asked in a recent post referencing conversations around Dior’s alleged €53 handbag.

If luxury’s marketing mythology is indeed “broken,” the implications for the sector are serious.

“I don’t think there is any customer who buys luxury products who would consider it remotely acceptable that, at the price they’re paying for the products, there’s any chance of labour practices being wrong in the supply chain,” said Deutsche Bank’s Cochrane. “It would be a real fundamental risk… the sort of thing that can really change the direction of a brand unless it’s handled the right way.”

Regulators are also playing a bigger role than they have in the past. The investigation by Italy’s Competition Authority is a rare instance of luxury brands getting drawn into a wide-ranging greenwashing crackdown that has already snared numerous mass market players, including H&M Group, Boohoo and Asos. Though potential penalties ranging from €5,000 to €10 million are relatively small, incoming due diligence regulations could bring much more severe fines in the future.

Fixing the issues would require big investments to consolidate supply chains and bring more manufacturing in house. Alternatively, companies could pay suppliers more and step up monitoring and controls. Both have costs, but luxury brands enjoy sizable margins and could make cuts elsewhere to smooth out the impact of any increases.

Still, a real reckoning may only come if fallout from the scandal starts to show up in the bottom line.

Disclosure: LVMH is part of a group of investors who, together, hold a minority interest in The Business of Fashion. All investors have signed shareholders’ documentation guaranteeing BoF’s complete editorial independence.