Protecting your interests

Distribution Agreements

(This is not legal advise nor does it create an attorney-client relationship. This is just a blog post. It cannot address the many different issues for individual cases.)

Introduction:
Good distribution agreements make a world of difference. Distribution agreements are vital agreements for driving sales of a product. Few companies can manufacture and distribute their own products. The creator of a product more likely will need to find a distributor to give the product proper market exposure and drive sales. For the distributor, it may want a larger product line to sell and already have the connections to rapidly grow market share. In some industries the customer are very loyal to distributor and will easily try new products based on their recommendations. The agreement between these two parties is a delicate balance, however, because both sides want to maximize their profits and yet need each other also. There are also other possibilities such as using sales representatives, supply agreements, or selling on consignment which can be more flexible but not create as much dedication to the supplier’s product.

A distributor normally carries an inventory of the product and maintains title (ownership). This is the key difference between consignment where title does not change and a sales representative who has neither title nor possession. However, sometimes the supplier will want to retain title until full payment is made. The distribution agreement needs to cover many items because it not just a sales contract but defines the supplier-distributor relationship and their competing interests. The following are some typical terms included in a distribution agreement.

Products- Obviously, the products in question must be stated. Less obviously is that this must state whether future improvements or new products will be part of the agreement. The distributor may want compensation for product inventory that becomes obsolete because of the introduction of new or improved products by the supplier. Also, depending on the size of the supplier it may need to clearly state which product lines are subject to the agreement.

Coordinating the manufacturing and distribution is vital to manage sales profitably. Procedures need to be set detailing how and when orders are placed. The supplier needs time to manage production and the distributor needs to know when it can get the merchandise. The distributor should provide future sales forecast to help the supplier meet the demand. Minimum order levels should consider seasonal demand where appropriate as well. There is nothing worse than having lots of orders but no product to ship. Often rolling quarterly forecasts are required but more frequent forecast or long-range forecast may be required where a manufacturer’s lead time is very tight. The failure of the distributor to place orders and the failure of the supplier to ship merchandise are frequent conflicts leading to the demise of a distribution agreement.

Practical tip: Patents

Any patented products must be handled carefully, especially for international contracts. A limited patent license may be needed to ensure that all patent right return to the supplier upon termination of the agreement. The agreement should state that the distributor will not try to subvert the patent or other intellectual property. Care must be also be taken when a distribution agreement is made before a patent is filed. A patent may be invalidated if a distribution agreement is started more than one year prior to the patent application. This is because U.S. patent law prohibits patents for products that have been “on sale” for more than one year prior to filing the patent application. (35 USC 102(b)) This prohibition requires the product be ready for patenting and available for a commercial sale. (see post on patents)
Parts: Parts provisions may be simple where the supplier also supplies the parts, but often this involves an outside party. In such as case, the agreement may address what are acceptable levels of parts inventory and incorporate this requirement into the inspection and reporting requirements.

Scope: Another fundamental item is the scope of the distributorship. This includes the geographic area covered, specific market channel limitations (national accounts), use of sub-distributors, exclusivity. Exclusivity and geographic are the most frequent negotiating points. Often this comes down to which party has the most leverage. A distribute doesn’t want to compete with other distributors and wants the largest market area possible. The supplier doesn’t want to depend on one distributor for its total distribution efforts. This comes down to evaluating the strengths of the distributor and setting clear benchmarks for evaluating the distributor. For example, the agreement could give flexibility to add regional distributors if it becomes clear the distributor doesn’t have the resources to service the whole market. This may be done by including minimum order levels, describing required advertising levels and product service programs.

There are also many important sales support issues. The supplier may need to provide training for the distributor. The distributor may be required to have a certain level of salespeople. This may mean more than the number of salespeople but there qualifications in some cases. Not anyone can sell an advanced medical device. The supplier may need to provide sufficient marketing materials and technical support for the distributor as well.

Pricing: Future price adjustments are a standard clause in distribution agreements because they are usually multi-year agreements. The type of pricing clause depends on the relative strength of the parties and the product. The clause may allow the supplier to change the price at will with proper notification, the price could be adjusted to inflation or the price of a key commodity or part used to produce the product. A non-exclusive distributor will also want guarantees that lower prices are not offered to other distributors. Also, some state laws require you to treat all distributors equally. Likewise, the supplier may want an option to sell to other distributors if minimum orders are not met.

Often the distribution agreement extends credit to the distributor and prices are set to ensure the distributor makes a profit. This creates the need for the supplier to retain a security interest in the goods until full payment is made and possibly require a down payment upfront. (Remember the distributor is getting physical possession and title.) For international agreements this usually done by a letter of credit which guarantees full payment.

In one recent New York case a supplier tried to argue that although the distribution agreement set minimum orders for the distributor this did not mean the supplier had to honor the order because there was not explicit requirement for the supplier to fulfill the orders. The court held in was not commercially reasonable under the New York U.C.C. that an agreement can require the buyer to order but not the seller to deliver on such requirements. On the other hand, many agreements make the orders subject to approval by the supplier.

Many times the supplier will also finance purchases by the distributor to help grow the market. However, this often leads to problems if sales do not go as forecasted. It is important to monitor such situations carefully. In one case amounts owned by a distributor could not be challenged in court because they never disputed the monthly statement sent to them by the supplier.

Warranties
In most cases, the distributor will demand various warranties to ensure they get what they intended whereas the supplier will want to limit warranties to guard against future expenses and litigation. Often there is a warranty for fitness of purpose and absence of defects but remedies are limited to repair or replacement products and only if the claim is made within a specified warranty period. There may also be warranties regarding intellectual property rights. These are generally considered express warranties but there are also implied warranties. Implied warranties may cover matters such as the ability to use a product for a specific purpose known and also for the general purpose for which it was made. You might consider these the ‘obvious’ warranties. Suppliers often require want to disclaim all implied warranties and negotiate the terms of the express warranties. In this way they limit their liability to only what is stated in the contract. Such disclaimers are usually required by Uniform Commercial Code (U.C.C.) to be printed in capital letters. The distributor may also be providing warranties to its customer. These multiple warranties to the end-customer need to be coordinated carefully or simple warranty claim could ruin the relationship. This includes detailing who pays for the cost of all warranty repairs.

Intellectual property warranties should always be considered because you do not want find out from Customs or a legal papers, that you purchased products using unauthorized trademarks or unauthorized copyright protected content.The supplier needs to detail how its trademarks and other intellectual property may be used by the distributor. The manner in which the distributor may use the suppliers marks must be clearly detailed to protect the good will of the marks. The distributor will usually want to use your logo other protected items. For this, the supplier will want to require approval. For example, the distributor may want to use the logos along with advertising that is not consistent with the corporate image of the supplier. If the use is permitted is should be reviewed that the logo is corrected reproduced and protected according to local laws. The distributor may also want to modify the product for the local product and this can affect both intellectual property issues and warranties. The distributor may also want to use the brand name for a website. Also termination rights must be carefully crafted because otherwise the distributor could continue to possess intellectual property even though the distribution agreement is terminated. Assignment back to the manufacture should be part of the approval process so the distributor doesn’t retain any intellectual property of other assets such as domain names.

Indemnity: The flip side of a warranty is indemnity. Indemnity is payment for certain expenses, in this context expenses related to warranties. Indemnity may cover expenses caused by a distributor’s changes to product, product liability claims and intellectual property infringement claims. Usually there is extensive negotiation between the parties regarding whether there will be indemnity and if so what are the limits. This also will relate to insurance issues. In the end, an indemnity claim may only be as good as the insurance coverage.

Export Controls
For international contracts life gets more complicated still, because of a myriad of export and international law. The Federal Corrupt Practices Act, anti-boycott compliance, and many other laws exist- especially where technology or defense related products are being exported. A future post will cover FCPA and other laws but here are some issue to consider as a start.

The FCPA prohibits bribing foreign officials to secure business. This includes any agent or person, such as a foreign subsidiary, acting on behalf of a U.S. company. The act does not have to occur in the United States. The only exception is a limited exception for “facilitating payments” for “routine governmental action”. Under the Export Administration Act (‘EAA’), no U.S. ‘person’ (includes companies as legal persons) may act with “intent to comply with, further, or support an unsanctioned foreign boycott”. The law is primarily used to prohibit U.S. companies from cooperating with the Arab boycott against Israel. However, it also prohibits agreements to discriminate based on race, religion, sex, national origin or nationality. Violation of the FCPA or EAA have several monetary and sometimes criminal penalties.

Caution: It is important to remember that you must do extra due diligence on foreign distributors because the EAA may hold you responsible for the acts of your distributor.

Payment: Sometimes making a sale is the easy part but actually getting paid is a different story. Letters of credit good, full payment in advance is even better, but often not possible. What do you do when your distributor doesn’t pay. This is supposed to be a mutually beneficial relationship and now it may be mutual destruction. In the United States, this usually involves filing a U.C.C. claim (Canada has a similar system). In Europe often the seller retains title until paid in full. South America has something called the Prenda, but are expensive are complex. Then getting property out is another hurdle. And then there is currency risk. What happens if the exchange rate changes drastically before full payment is made— who bears the risk? Enforcing a judgement for payment even in the U.S. may be difficult but they are exponentially harder for international contracts. Many countries will not enforce a U.S. judgement and many do not respect a choice of law clause. This will give a supplier no good options once they have shipped the product.

Termination: The parties responsibilities when the agreement terminates is often neglected when negotiating a distribution agreement. If a distribution agreement needs to be terminated the procedures and responsibilities should be clearly stated in the contract to make the termination as painless as possible. This works well when the standards of performance are clearly stated making it clear when a party may terminate the agreement. One failsafe provision is to use fixed time periods with renewal rights rather than an ongoing agreement. This gives a deadline for the agreement should it not be working well but terminating the agreement early may cause difficulties. Termination can also be available without cause given proper notice, although local state law and foreign law should be consulted before doing so. Furthermore, many states and foreign countries have restrictions on terminating a distributor.

The termination of a contract does not remove any pending obligations such as payment or shipments due. Often the terminated party will attempt to sue for restitution, or lost profits, for the termination of the agreement. This is further complicated in international agreement because many other countries protect distributor’s rights. The agreement should provide for an orderly termination process dealing with existing inventory, training materials, exchanges of property, if any, intellectual property, and future customer issues. A personal guaranty may be prudent depending on the financial position of the parties.

Caution: Many states in the United States are moving to broader interpretations of state franchising law and stricter law on when and why a distributorship may be terminated. This trend is increasingly treating more distribution agreements as franchises as well as limiting the reasons for canceling a distributorship despite the wording of the contract. A franchise is much more highly regulated than a distributorship usually to the benefit of the distributor. This may affect events as simple as new product introductions to the right to terminate the contract. International contracts, of course, must consider local laws as well which often strongly protect local distributorships.

Conclusion:
Distribution agreements can be the most important phase of a successful company. As hard as it is to create a strong product it will fail without a strong distribution channel. Likewise a poor distributor can prevent the best products from achieving success.