Ten things to consider for your company distribution project

Distribution Deals
The "Dirty Dozen" of Distribution Contract Terms©

By Donald W. Hudspeth

Distributorship Agreements, especially International Distribution Agreements, can be the magnum opus of the contract world. In our firm, we have a Checklist with 118 points to consider, about 30 of them specific to International contracts. Here are some quick pointers:

1. Agent Duties.
A distributorship agreement, like any representative's agreement, should delineate the rights and authority of the selling agent.¹ The agreement should specify whether it is the principal (e.g. manufacturer or license-holder) or the agent (here, the distributor) who is to handle customer inquiries, provide price quotes, authorize credit, finalize the sale, collect payment and handle returns.

2. Agent Authority.
Distributors want to make the sale, and buyers sometimes hear what they want to hear; thus, where the authority of the selling agent is not clearly defined and appropriately limited, the principal can face customer claims for special pricing, non-standard payment terms, unapproved warranties, or liberal and excessive returns. To mitigate this kind of problem the distributorship agreement should preclude the distributor or other selling agent from making such offers. The agreement should also require the use of only approved sales forms which clearly delineate and limit the agent's authority. The agreement might also include an indemnification clause (roughly, a promise to repay) under which the agent becomes liable for the cost of such transgressions. Finally, the agreement may require dual signatures, the first being the signature of the agent; the second being the signature of the principal. This way, the order is not accepted until the principal accepts it. This may seem cumbersome, but arguably it is no more cumbersome than the standard purchasing procedure in which an order is not considered made until the buyer issues the purchase order for same.²

3. Accounts.
A distributor is granted the right to sell the product or service in the defined territory. But, sometimes purchase orders come from outside the territory where a sale to that customer would infringe on the territory of another distributor. Typically, the situation is handled by referral of the inquiry or purchase to the appropriate distributor with "penalties"³ for non-compliance, perhaps, some liquidated sum or reduction of the distributor's discount (i.e. "mark up") on an equivalent order.

Some of the principal's customers, e.g. those with their own sub-distributors, authorized dealers or representatives, may have sales outlets in more than one territory. Often, these so-called "Regional" or "National" accounts become the "property" of the principal. The distributor may object to principal's claim to or retention of these regional or national accounts because it loses what could have been its biggest customers. And, the distributor may argue the system is unfair because the distributor is investing considerable time, resources and money to sell the product or service in that territory.

These are arguments have merit, but there is some justification for this practice. The orders may come from a "centralized" regional or national office, the person with authority to place the order may be an executive of the regional office or parent company of the local outlet, the order may cover multiple territories, and volume sales and discounts may be achieved. In such cases it may make sense for the principal to retain control over the sales and servicing of regional or national accounts. And, in some cases the principal manufacturer or license-holder can grant the local agent (distributor, dealer or representative) the right to service the customer under a different commission or payment schedule.

4. Pricing.
Antitrust laws do not apply just to big companies with humongous market share, but also to the way a principal does business with its distributors and dealers. Antitrust and restraint of trade case decisions have been "all over the lot," but generally, for now anyway, a manufacturer or license-holder cannot dictate prices, but may establish minimum suggested retail prices ("MSRP") and refuse to sell to dealers who do not comply with the MSRP without raising restraint of trade issues. A manufacturer or other seller may lawfully retain complete control of, i.e. "dictate," pricing by retaining title – in effect making the sale a consignment sale. But, consignment sales have the disadvantages of delayed payment, risk of loss during shipping and while in inventory, and record keeping.

5. Standards of Performance.
The distribution agreement, like any sales representative agreement, should explain what the distributor is expected and agrees to do under the contract. For example, it should specify if the Distributor is responsible for one or more of the following:

a. Product or service training,
b. Best efforts⁴ in sales,
c. Sales quotas,
d. A minimum number of sub-distributors, dealer or sales representatives in place within a specified period of time,
e. Sales or performance reports, how often and in what detail.

The agreement should also state (i) whether the distributor or its representatives will receive an incentive bonus for increased sales and (ii) the requirements for the distributor to have and maintain exclusive rights in the defined territory and time period.

6. Exclusivity.
Distributors, sub-distributors, dealer or "manufacturer's rep's" nearly always want an exclusive right to sell the product or service in the territory. They justify this request by pointing to (a) the required investment of time, money and resources to represent and sell the product and (b) the inescapable fact that without the distributor and other sales agents, sale of the product or service cannot happen.⁵ This is less true, of course, in the Internet world, but many products or services require educating the client about their use and benefits, e.g. medical devices. And, the agents in the distribution chain are often the most effective means of providing this education.

But, granting exclusive rights, particularly to a new, untested party can place the seller at great risk for actions it cannot directly control, i.e. the everyday sales efforts, talents and self-interest of the distributor or sales agent. The distributor may simply stop selling because it believes the product is not saleable or competitive or because it acquires the rights to sell a better product.⁶ For this reason, the contract term (i.e. length) and termination provisions should be carefully considered. Often, to reduce risk to the manufacturer or license-holder, it is also a good idea to include in the agreement terms such as quotas, milestones, the right to reduce territory, or to send in company representatives.

7. Trademarks.
It has become more important than ever to control one's brand because much or most of the value of a company is now in its intellectual property, not its hard assets. For this reason the distribution agreement should strictly limit use of company trademarks. Use of the manufacturer or license-holder's name and trademarks by distributors and dealers should be defined as to market and type, e.g. luxury and mass-market sales channels, and granted to implement and achieve the purpose of the distribution agreement, i.e. the sale of the product, and for no other purpose. These restrictions may be stated in (i) the body of the main agreement, (ii) a separate "trademark agreement," or (iii) an attachment; often a combination of (i) plus (ii) or (iii) is used.

8. Confidentiality, Non-Competition, Non-Solicitation, Non Circumvention and Other Restrictive Covenants.
Distributors, dealers and representatives knowledgeable in the industry and the product can be invaluable. For example, an experienced and accepted medical device representative may be in the operating room to aid in the surgeons' use of the product, say, a defibrillator. It can take years to establish this level of rapport with, and acceptance by, the doctors and hospital. The manufacturer naturally will want to protect itself against distributors, dealers and representatives who leave the distribution network. The best way to do this can be to have provisions in the distribution (or dealer or representative agreement) which establish the confidential nature of proprietary product and company information, and which restrict the departing agent's rights to sell competitive products in the territory for some period of time, to call on the principal's customers or to solicit its employees. These "Restrictive Covenants" are common and if tailored and perhaps narrowed, in their scope to the laws of the State, and the type of selling entity, e.g. independent contractor, enforceable should be enforceable in many states.

Some states, like California, are more restrictive in their acceptance of Restrictive Covenants. Other states, like Arizona, accept them. In fact, in Arizona, one can even name the competitors that the representative (and perhaps distributor or dealer) may not work for, for a certain "restrictive period" of time following termination of the agreement. Our firm recently represented a client who left his employer to start his own company. Because he was the general manager and "face" of the company and its products, when he left much of the customer base followed him. As a result his startup company enjoyed immediate sales of about $100,000 a month, while his former employer lost many customers and sales. The principal could have avoided or at least substantially mitigated this disastrous result with the right terms and conditions in the employment agreement; that is, by having the "right agreement."⁷

9. Marketing.
The distributor may want to have its own website, and perhaps even its own white label mini-brand. This is usually not a good idea and in any case, should be tightly controlled. Independent marketing can cause confusion in the marketplace about the product and brand. Often the principal will not allow the distributor (or other sales agent) to advertise the company's product or service, or to use the company trademark, on the distributor's own website, but limit the distributor's website marketing to inclusion of the distributor's name, territory and contact information on the principal's central Website. The principal may require the distributor or agent to use only sales and marketing materials produced or approved in advance by the company. Bottom line, the contract terms regarding "who can do what" marketing and where in the distribution chain are essential.

10. Warranty Disclaimers and Limitation of Remedies.
Any good sales contract includes disclaimers of warranties and limitations of remedies. A distributor may disclaim warranties by expressly stating in the distributorship agreement that the sub-distributor, dealer or sales representative does not have the authority to make promises, including warranties, on behalf of the principal without the principal's prior approval, and that the agent shall indemnify (payback) the principal for the cost incurred by the agent's violation of this promise.

A "limitation of liability" or "limitation of remedies" provision allows the distributor to avoid or limit consequences for which it otherwise might be fully liable. An example would be drafting to preclude extended liability for malfunctioning software that causes a contractor to underbid a construction job and lose money or which delays or interrupts the flow of work. Typically, the limitation of remedies clause seeks to limit claims to damages directly caused by the breach, e.g. cost to fix, and to eliminate claims for consequential damages such as lost profits or damages caused to a third party, e.g. where a part breaks, causing an accident, sending someone to the hospital, etc. Although contract law has special rules to govern claims arising farther down the chain of causation, the first and best line of defense against such claims is to expressly eliminate or limit such claims by including a provision in the distribution agreement stating the principal is not liable for the lost profits or other consequential damages of the distributor, or of its dealers or other third parties who may make claims against the distributor. The agreement should also state that the distributor shall indemnify principal for claims arising out the actions of the distributor, sub-distributor or agent.

Most such "limitation of remedies" provisions have a fallback position stating that in any case (i.e. if the principal is or could be found liable) the principal would not be liable for any sum greater than amounts it received under the contract. For example, if the principal sold $10,000 of defective products or services to the distributor, the distributor's claim for damages would be limited by prior agreement to that maximum amount.

11. Indemnification.
As with some other topics covered by this brief article, a treatise could be written about indemnification clauses. In general, an indemnification clause states where and how one contract party will pay another if something goes wrong. The best use of such a clause is to deal with third party or consequential damages claims, such as the profits lost due to malfunctioning software, or damage claims by a trademark holder against a party who has ostensibly licensed or purchased rights to the trademark from another party. Sometimes such provisions allow the indemnifying party to take over defense of the claim, e.g. where a trademark licensor assumes defense of claims brought against its licensee by a person claiming to have rights to the mark superior to the licensor. In a distributorship agreement an indemnification clause may be used by the principal to limit its risk of loss against claims caused by the distributor or others in the chain of distribution.

12. Governing Law and Forum.
Arguments over venue and jurisdiction (i.e. where the case is decided) can seem like they cost as much the suit itself. Thus, any good agreement should specify the State law governing the dispute and the venue and jurisdiction of the action. For example, the agreement (oversimplified) might say something to the effect: Disputes arising out of this agreement shall be governed by the law of the State of Arizona with venue and jurisdiction in Maricopa County Arizona.

Arbitration is frequently used as a dispute resolution procedure and companies like the American Arbitration Association are a common place for such proceedings. In arbitration the parties choose the person who will decide the issue(s). The arbitrator does not need to be an attorney; sometimes it works better to have a person more familiar with the subject matter of the case, e.g. an engineer, adjudicate the case.⁸ An arbitration award has the force of judgment and may be recorded as same. Although it tends to be considerably more expensive "upfront," arbitration generally, but not always, costs less money overall due to its typically shorter dispute resolution period, more limited proceedings, and informality. It also has the advantage of being private; neither the pleadings nor the suit itself are of public record as court pleadings would be. This avoids the "Google Effect' where the court filing, especially in federal court, may become the top search result for any and all of the parties.

13. A Final Word. (OK, this is number 13. Consider it part of a "baker's dozen.")
A distributorship agreement, as with other contracts, may be viewed from the perspective of risk allocation, i.e. (a.) what is to be done or provided and (b). who pays if it isn't.⁹ A well written contract carefully and precisely defines the objective and "scope of work," i.e. what is supposed to happen under the agreement and what will be done to accomplish that objective, e.g. the software specifications for well functioning construction bidding software. Then, through warranty disclaimers, limitation of remedies, default, indemnification, attorneys' fees, and other terms and conditions, the final agreement allocates the risk of negative events and outcome among the parties.

Defining the deal in the Scope of Work and allocating the risk in the other terms and conditions are two essential functions of a well drafted agreement. A well drafted agreement serves not only the parties, but also everyone in the economic system by improving efficiency and reducing time wasted in the distribution of goods and services.

¹ For purposes of this Agreement the source of the product or service is the manufacturer or trademark license-holder, herein called the "principal." The distribution chain or channel is assumed to be from principal to distributor (perhaps to sub-distributor) to dealer. But, the same considerations apply to a manufacturer's representative agreement.
² More than one of my clients has made this mistake, including the one who had roughly a million dollars worth of Star Trek figurines made in China, imported to the U.S. and trucked to the distributor who refused to accept the goods sitting in the trucks at its receiving dock because no Purchase Order had been issued.
³ Strictly speaking "penalties" are not allowed in contract law. Oversimplified, "freedom of contract" includes the freedom to breach the contract if one is willing to pay for the damage caused by the breach. But, a principal must have some mechanism to enforce its agreements, so, unless egregious, imposing reasonable consequences for breach, particularly in a business to business contract, should not render the remedy unenforceable.
⁴ "Best efforts" in legal contracts generally means that the promisor is required to do everything in its power to accomplish the goal. This may be in contrast to "reasonable efforts" which would be determined by an objective party according to the industry standard. For example, under the commercial reasonableness standard it might be sufficient to approach three or four banks in the effort to obtain project financing, but under a best efforts standard exceptional efforts would be required, perhaps beyond the point of reasonableness, any likelihood of success and at great cost to the promising party.
⁵ This, of course, begs the questions whether sales have to be done through this distributor or by using the distributorship model at all.
⁶ This happened to a client who granted exclusive rights to its newly patented product to a distributor without receiving corresponding assurances of best efforts, sales quotas and loyalty. As for loyalty, it seems only fair that if the principal grants to the distributor exclusive rights to the sell the product, the distributor in turn should grant the principal an "exclusive" by agreeing to sell no competing product. Otherwise, there could be a conflict of interest.
⁷ The possibilities and legal outcomes do not translate equally and completely between employees and contractors states or exactly from state to state, but generally some Restrictive Covenants are lawful, and those that are tend to be extremely valuable.
⁸ This can be another reason why arbitration might be preferred over a civil action in a court of law. Some commentators believe the jury system does not work well in cases involving current science or technology because the subject matter is beyond the common experience, if not comprehension, of most people.
⁹ It may also state where and what will happen in venue, jurisdiction, arbitration and other contract provisions, commonly referred to as "boilerplate." Incidentally, FYI, another name for "boilerplate" is "collective wisdom;" someone had to learn the importance of these terms the hard way.

Categorised in: Contracts & Transactions

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