Drafting and Negotiating Distribution Agreements: Common Mistakes that Lead to Litigation

Distribution partnerships, like marriages, are entered into during a period of optimism and excitement. You have a great product and you found the right partner who will help you take it to the masses. It’s a relationship that will last a lifetime, right? Maybe. As with any relationship, failure to communicate expectations or poorly communicating expectations can lead to conflict and, in some circumstances, it leads to business divorce litigation.

The following are five areas that are often overlooked when drafting and negotiating distribution agreements. The failure to address these areas can result in costly and protracted litigation.

The Scope of the Relationship

Determine and expressly address whether the distributor can assign or delegate its rights and obligations under the distribution agreement, for example, by appointing a subdistributor. Subdistributors can have a detrimental effect on a manufacturer by reducing the manufacturer’s control over distribution channels, increasing the risk of liability because actions of subdistributors may be attributed to the manufacturer, and diluting the marketing message and value proposition of the product as a result of subdistributors that don’t really know the product well. If the manufacturer is willing to permit the appointment of subdistributors (in writing and with express consent only), the manufacturer should insist on certain protections, including specifying the terms that must be included in a subdistribution agreement, and specifying the person or category of persons who may be appointed as subdistributors.

Sales Restrictions

Determine and address whether the distributor can freely set its own prices for the goods and consider the implications if the resale price is determined by the manufacturer. For example, if the distributor agrees to maintain certain prices or it is found to have been coerced to maintain certain prices, there could be a price-fixing violation under US antitrust law. Also, if the manufacturer sets the pricing for the distributor’s sales, a court could find that a franchise relationship exists on the grounds the distributor’s business is subject to the manufacturer’s control.

Termination

Consider whether either or both parties will have the right to terminate the agreement for convenience or no cause at all. Agreements that allow for termination under limited circumstances beg for controversy. Disagreements over the presence of cause for termination lead to litigation. A distribution agreement that allows for termination for convenience avoids this. When one party wishes to terminate the agreement, the party provides the required notice, and the relationship concludes at the end of the notice period. Without the distraction of a legal fight, the manufacturer can focus on its customers and new distribution relationships.

Amendments

Like any relationship, a distribution partnership will change over time. External factors, like market forces, will apply pressure and will test the relationship. Changes to the relationship will sometimes be required in order to deal with those outside factors and preserve the relationship. If the distribution agreement does not allow for amendments, or allows for amendments once a year, the relationship would have to survive undue pressure to accommodate the rigidity of the distribution agreement. On the other hand, a distribution agreement that allows for changes as necessary by agreement of the parties will ensure that the relationship develops and grows.

Post-Termination Obligations

The rights and responsibilities of the parties during the termination notice period and post termination need to be carefully defined. This includes the treatment of pending orders or goods in transit; outstanding payments (and whether they are accelerated); demonstration units; marketing materials; confidential information and intellectual property. The distribution agreement should specify whether the distributor’s rights to purchase products is limited during the last few months of the term and, if so, by how much and for how long? The distribution agreement should address whether the manufacturer has the right or obligation to buy back the products in the distributor’s inventory after termination. Some products, like powersports vehicles, have statutes that already set forth a manufacturer’s post-termination obligation to purchase inventory. If there is no statute regulating your product, your distribution agreement should describe the terms and conditions for buying back the inventory, such as model year, price and condition. Finally, the distribution agreement should also spell out the distributor’s right, if any, to sell the unsold products after the relationship ended, for how long and whether that right is limited by the manufacturer’s rights, if any, to buy-back the products.

In sum, distribution agreements are a key part of a distribution partnership. The failure to be comprehensive when negotiating and drafting a distribution agreement can frustrate the expectations of the parties and result in litigation. On the other hand, a well-written agreement helps avoid legal quarrels that consume time and resources and, instead, allows the parties to focus on their business and customers.