Distribution Contracts: Formulating and Terminating The Agreement

Distribution Contracts: Formulating and Terminating The Agreement

By Stephen T. Sigler

Too often the quality of a contract is defined by the problems that later arise as a result of poor drafting. Even the best laid plans, contractually, can devolve into a morass of litigation when unforeseen issues arise or relationships breakdown. The formation of distribution contracts requires not only foresight and experience with possible problems, but needs a healthy relationship between the parent or supplier and distributor. Legal guidance can help the parties avoid these pitfalls. Developing a framework for addressing common contractual issues specific to distribution contracts is both possible and necessary.

The Distribution Contract

A distribution contract is contractual arrangement wherein a manufacturer or supplier permits an outside party to sell/distribute their products to consumers within a specific geographic area. We see the results of distribution contracts on a daily basis with brand-name products being sold in any number of locations despite the manufacturer or supplier maintaining a small centralized operation. The distributed products can range from high-tech electronics to high fashion merchandise to simple home goods. The actual distribution contract serves as the “behind the scenes” agreement between the supplier and the distributor who then contract with retail establishments or organizations who deal with the public at large. The distribution contract is generally defined by the overall supply agreement and timeframes, wherein the actual terms of the distribution arrangement and exclusivity or non-exclusivity are built into the contract.

The foundation for a healthy contractual relationship often mirrors the relationship between the individuals controlling the contracting parties. The nature of relations can become very strained if the distribution contract does not go as planned. Unfortunately, many of the aspects requiring the most scrutiny prior to establishing a distribution agreement are those which can only be properly assessed by the parties as they pertain to industry standards, projected sales and the ability to meet sales goals. An experienced attorney acting as an advisor and counselor can provide some support, but areas of business expertise require direct attention and feedback from the players.

Identifying Basic Concerns For The Supplier And Distributor

When a supplier or distributor seeks legal advice about the formation of a new distribution agreement, initial considerations focus on client specific issues. Will a general boilerplate contract suffice or does the client want/need a specially drafted contract tailor-made to their industry or business relationship? When considering a distribution agreement, the parties need to have done their homework. Is this a situation where the other side has shown an ability to play well with others? Has an attorney asked to step in to draft the contract? Do you know if either side has an established history/reputation with regard to their prior distributors or prior distribution contracts? You may have the best product in the world, but if the supplier’s history is one of scorched earth litigation at the conclusion of each distribution contract you might want to pass on the distribution. Is the supplier willing to share some ‘control’ with the distributor or will this be “their way or the highway”.

Specific issues that must be included in the contract include the term of the agreement, the required performance, exclusivity or non-exclusivity, defining the territorial restrictions, establishing transfer of materials and specific definition of the conditions relating to sales. Additionally, these contracts should contain specific terms for allowable or required marketing and advertising, required reporting of activities and sales, consideration of what is considered competition regardless of the exclusivity decisions, concerns about trade marks and intellectual property concerns and the classic choice of law provisions for both interpretation and application of the contract. Remember these contracts are designed to be mutually beneficial for both parties, so be sure to ensure considerations and obligations are shared between the parties. Avoid situations where one party maintains total control over the other – too much control can color the relationship. Finally, there needs to be specific clauses regarding the grounds for termination, the impact as to existing orders and return of merchandise, customers, contacts as well as numerous catch-all contractual terms for contingencies (integration, force majeure, waivers, surviving obligations, antitrust considerations and others).

For the distributor, does your client want exclusivity and have they considered whether this will impact other potential lines or products they sell? Distributors need to lockdown sales terms and terms regarding the procurement of the product line. Also, distributors need to know the level of support they can expect to receive in areas like advertising and how quantity and pricing match reasonable expectations in the new market. Finally, additional concerns related to the effect of restrictions with the contract and whether they trigger problems with foreign jurisdictional provisions against vertical restraints or passive sales bans.[1]

For the supplier, have your client consider how strict they want the distributor’s reporting requirements to be in order to maintain the pulse of the distribution arrangement without crowding the distributor. Oftentimes the supplier wants to establish a structure that ensures sufficient performance and grants them the right to end the relationship. Additional contractual considerations a supplier or supplier’s counsel should consider include:

  • How will the payment process work?
  • What set of rules will be applied to establish when the legal responsibility for goods shifts from the supplier to the distributor?
  • What happens with regard to the expanded customer base or goods should the contract be terminated?

Specific supplier expectations regarding promotion, advertising or intellectual property should also be defined.

Termination Concerns

In cases of termination or expiration of the distribution contract, the provisions set up at formation become the primary focus. Is the termination process spelled out, does it avoid any legal entanglements regarding anti-trust litigation? These issues can be handled well in advance -provided of course, they are discussed at the outset of the business relationship.

A common area of concern at termination is the status of the expanded customer base or client lists and how such information is handled when no specific clauses govern the issue. Clearly, both sides have vested interests in maintaining control or financial relationships with the end-of-distribution chain entities. The supplier wants to maintain the expanded market obtained through the distribution contract and distributors often want to limit supplier use of customer information. It is important to account for what each party learns by reason of its relationship with the other.

When such issues are left to chance, the question can hinge on the discretionary power attributed to a specific party within the contract. In California controlled contracts, arguments can be made by both sides about such data based upon rights spelled out or conferred under the initial contract or through California’s implied covenant of good faith and fair dealing. Attempting to make these determinations at the conclusion of the contractual relationship is both costly and frustrating.

It is not unusual to want to seek compensation for such information under a termination arrangement. This can be accounted for in a carefully drafted liquidated damages clause, which is allowed under California law - provided the clauses can show a reasonable estimate for the valuation of the information. (Cal. Civ. Code § 1671(b).) Clearly, the need for carefully developed clauses and the foresight to consider how they will play out with such valued information as client lists is imperative to the success of the contract and distribution relationship.

As you can see, there are a lot of factors to consider when crafting a well-tailored distribution contract. You must consider and deal with a multitude of facts, contingencies, regulations, statutes, business practices, and many times the parties’ egos. More times than not, provisions initially considered to be minor or axiomatic become huge problems down the road. This can be avoided with transparency and planning in the initial stage of contract negotiations. As an attorney you must take the time to work closely with your client to ensure their needs are met, but their backs are covered as well. In doing so you will curry favor with your client and allow them to get back to what they do best without worrying if they made a “bad deal”.

___________________________

[1] See the Consolidated Version of the Treaty on the Functioning of the European Union, Mar. 30, 2010, 2010 O.J. (C 83) 47, and Commission Regulation (EU) No. 330/2010 of April 20, 2010 on the application of Article 101(3) of the Treaty on the Functioning of the European Union to categories of vertical agreements and concerted practices, 2010, OJEU L 102/1 or the similar Chinese competition law, Anti-Monopoly Law (promulgated by the Standing Comm. Nat’l People’s Cong., Aug. 30, 2007, effective Aug. 1, 2008), art. 1 (China).


Stephen T. Sigler is a shareholder and trial lawyer at Neil Dymott. He specializes in business transactions and civil litigation with emphasis in general and professional liability. Mr. Sigler may be reached at (619)238-1712 or ssigler@neildymott.com 

Back to Articles