A distribution agreement is a contract through which one party agrees to resell the products of another company, and sets forth the respective rights and responsibilities of the parties. Often a distributorship agreement will encompass a major portion of the business of the manufacturer, distributor, or both.
As a consequence, it is not uncommon for problems to arise due to the possibility that the termination of a contract, or the failure of a party to perform, will have a significant and negative impact on the other party's business. A poorly drafted distributorship agreement can lock a party into an arrangement that is no longer working to its advantage, or can increase the possibility of litigation in the event of a dispute over the terms of the agreement or allegations of breach.
Principal vs. Agent
One important consideration when entering into a distributorship agreement is whether the distributor will be an agent, whose role is to find buyers for the principal's goods without ever taking ownership of those goods, or if the distributor will be a principal, with the distributor taking ownership of and subsequently reselling the goods. Agency relationships carry special risks for the principal due to the potential for vicarious liability, where a principal is liable for the wrongful acts of its agent. A distributor agreement should not include any language that suggests an agency relationship unless that is what the parties intend.
The person drafting a distributorship agreement should be aware of both federal and state antitrust laws, and how they can affect the negotiation and implementation of a distributor agreement. A distributor agreement will often include areas of exclusivity, whether by assigning distributors different geographic territories, different categories of customer, or both.
While exclusive relationships can work to the advantage of a manufacturer as part of a vertical relationship, the same restrictions can constitute unlawful restraints of trade if negotiated at a horizontal level (the same level of business, such as distributor-to-distributor). A manufacturer needs to be careful not to negotiate with groups of distributors, or even in relationship to how it approaches disputes between distributors, in order to avoid participating in a horizontal restraint of trade in violation of antitrust laws.
Antitrust issues can also be triggered by requirements that a manufacturer imposes on a distributor. For example, a manufacturer that holds significant market share may risk violating antitrust laws if exclusive dealing requirements impair its competitors' ability to find sufficient sources of distribution. Due to the complexity of antitrust laws and the potentially serious consequences of a violation, any time they may be implicated by a distributor agreement or relationship it is important to have the issue reviewed by a qualified attorney.
In addition to the essentials, such as the identity of the parties to the contract and the term of the agreement, a distributor agreement may include the following clauses:
Territory and Customers
A manufacturer will often choose to make a distributorship agreement exclusive for a specified territory, for a particular class of customer, or both. For example, a distributor may be given the exclusive rights to serve customers in the health care industry in California. A manufacturer may also agree not to make direct sales in the geographical area or to classes of customers assigned to a distributor.
As an alternative to exclusivity, a manufacturer may prefer to give distributors overlapping territories or the rights to sell outside of their primary territory. For example, a manufacturer may designate an area of primary responsibility (APR) for each distributor, for which the distributor is to exercise its best efforts to obtain sales, typically with performance goals for the distributor within the APR.
In such an arrangement, the distributor has an incentive to make sales within the APR, but is not prohibited from making sales outside of its defined APR. APRs can be adjusted based upon the parties' needs and capacity, and may overlap. A manufacturer may give distributors incentives to sell within their APR, such as by shipping product only to designated locations within the APR or by only offering drop-shipping to addresses within the APR. The less exclusive a territory, the less appealing a distributorship is likely to be to possible distributors.
Inclusion of performance targets can help the distributor understand the results they are expected to achieve. Any performance targets should be clearly defined, along with the consequences that will follow if a distributor does not meet the defined targets. Targets should be subject to being modified upon a periodic basis and upon renewal of the contract.
As an alternative to termination, a manufacturer may reserve the option to convert an exclusive territory into a non-exclusive territory or, if the manufacturer utilizes areas of primary responsibility, to adjust the APRs of its distributors, giving one or more other distributors an overlapping APR.
Amendments to the Agreement
Although it may seem ideal to negotiate a distributor agreement that has fixed terms for the duration of the contract, changes in circumstances may arise that will cause one or both parties to want to amend their contract before it's expiration. The parties should be cautious about restricting the amendment of the distributor agreement in order to preserve the flexibility that they may need in the event of unforeseen circumstances or business developments.
Restrictions on Price Changes
A distributor may want a contractual limit on how frequently a manufacturer may change its prices. A manufacturer, on the other hand, will normally want some pricing flexibility to allow it to pass along the increased cost of production. A middle ground solution is to allow for price increases consistent with the manufacturer's needs, but with their coming into effect only after an agreed period of notice (e.g., thirty days) to the distributor.
Marketing and Sales
A distributor agreement will often incorporate sales and marketing plans that the distributor is obligated to follow. As the distributor will normally be allowed to use the manufacturer's name, brands and logo in its marketing of the manufacturer's products, the plan should include provisions governing the use of the manufacturer's intellectual property and trademarks. The agreement will often include provisions for collaboration on marketing, and the potential for amendment of the marketing plan based upon the parties' needs and goals.
The distributor agreement should describe the parties' respective duties in the event of a warranty claim or product recall.
A distributor agreement will normally be for a specified term (e.g., one year), subject to renewal. For example, the parties could agree that an initial one-year term will automatically renew on its anniversary for additional one-year terms, unless one of the parties gives notice to cancel the contract not less than thirty days before its expiration. The notice period should be sufficient to allow the parties to prepare for the end of their relationship, but no longer than is reasonably necessary.
A good distributor agreement will allow for the termination of the agreement for cause, with either no notice or very short notice to the other party, and some of the causes for termination may be defined within the agreement. For example, the contract may automatically terminate if one of the parties to the agreement becomes insolvent or files for bankruptcy protection.
A distributor agreement will often provide for termination for cause if the distributor sells counterfeit goods under the brand of the manufacturer, is found to have switched a customer's order from the manufacturer's product to a competitor's, or if the distributor becomes a direct competitor to the manufacturer.
When a distributor contract restricts the right of one party to terminate an agreement, it is more likely to result in litigation and to be regarded by a court as coercive. Many distributor agreements will also provide for termination without cause upon a specified period of notice too the other party.
A clause permitting termination without cause may help the parties avoid being bound to a contract that no longer returns the benefits that they anticipated when entering into the contract, and can also allow them to avoid argument or litigation over whether a cause cited as a basis for termination is sufficient to warrant a "for cause" termination of the contract. Also, a broad right of termination can help prevent a later accusation by a distributor that the manufacturer coerced the distributor to take a particular action.
When defining a notice period for termination without cause, the manufacturer should consider the nature of its relationship with the distributor, and the application of federal and state business and franchise laws. Although in some cases it may be possible to allow for termination without notice or on very short notice, in others the termination of the agreement may be governed by state business opportunity and franchise laws that require a longer notice period, typically ninety days.
A distributor agreement should describe the rights and responsibilities of the parties following the giving of notice of termination, and also subsequent to termination of the agreement.
- The agreement should also describe whether a distributor will be allowed to sell product that remains in inventory, or if it must immediately stop selling the manufacturer's products.
- The agreement should also describe how any pending sales commitments will be handled, including which party will be responsible for those commitments.
A manufacturer may reserve the right to buy back any unsold inventory that remains in the distributor's possession following the termination of the distributor agreement. Repurchase agreements can facilitate the transition to a new distributor, and can also help ensure that end customers receive proper service and support following the termination of the agreement. However, the manufacturer should be careful not to obligate itself to buy back inventory, as such a requirement may trigger the application of state business opportunity laws.
The parties to a distributor agreement may choose to designate a dispute resolution mechanism as an alternative to litigation.