10 Golden Rules for Engaging With a Distributor
By Adv. Liat Vigdor, Partner, Commercial and M&A Practice.
The question of the best way for a manufacturer or supplier to make overseas sales involves numerous considerations, challenges and risks, commercial and legal alike. Traditionally, goods can be internationally merchandised in one of three classic ways: marketing through an agent, direct sales or sales through a distributor.
This article enumerates and discusses the rules of thumb and the many aspects that must be considered when seeking to define and anchor the terms and conditions of engagement with the chosen party, following a decision to merchandise the products by appointing a distributor.
To set the boundaries of the discussion, a distributor is a party that buys the products from the manufacturer/supplier and often keeps stocks of the products, and in its turn sells them to its customers in the territory. The distributor’s profit center in the deal is the difference between the price paid for the goods by the distributor to the manufacturer/supplier, and the price at which the distributor then sells them to its customers in the territory.
Proper consideration, including careful and creative thought, of the following rules in good time (i.e. before the contractual engagement is made between the parties) can help to prevent challenging occurrences during the engagement between the manufacturer/supplier and the distributor, including all aspects of the relationship, and when dealing with everyday situations which can be expected to arise between the parties.
Rule #1: Exclusivity. Will the distributor be granted an exclusive right, or will others be granted the same right at the same time?
Granting exclusivity is not mandatory. The same right to merchandise the products in the foreign territory can be granted to more than a single party simultaneously. However, if the distribution rights are exclusive, there are several elements that must be settled, as follows:
- The territory. Whether the distribution rights apply to a particular country, to a broad, or less broad, geographical region (for example, a district within a country), to a particular market segment (such as the agricultural market in country X), or to specific customers in a specific area. Here, the question of the ability to “protect” the boundaries of that territory occasionally arises, and consequently, it is necessary to provide for the legal means to deal with spillovers of the products into parallel/other markets.
- The product list. Do the rights apply to all of the manufacturer’s/supplier’s products? To only part of them? And if so – what part? Do the rights apply only to existing products, or do they automatically also include future products and those in development? Naturally, thought must be given to products that are defined “private label” products, and it must be determined whether they are covered by the distributor’s distribution right, or if the manufacturer/supplier may sell them independently or otherwise (i.e. other than through the distributor).
- Duration of the exclusive right. Granting exclusivity for a particular market entails a critical commercial-economic risk: the manufacturer/supplier must define and anchor, in advance and with proper care, accepted and applicable legal mechanisms that have a single goal – to prevent a situation in which the scale of purchases of the products by the distributor is unsatisfactory and does not match the potential of the specific market, while the territory/market is “closed” to activity by other parties, which have greater merchandising potential, as a result of exclusivity having been granted to the existing distributor.
- Mutual exclusivity. Whether the right granted to the distributor is symmetrical, i.e., if, while the distributor benefits from the manufacturer’s/supplier’s inability to appoint another distributor in the territory, the distributor is symmetrically obligated not to sell products that are identical/similar to the products under the distribution right, in addition to the manufacturer’s/supplier’s products. This issue has complex implications in terms of the limitation of competition, and consequently care must be taken to provide for applicable solutions that are consistent with the restraint of trade laws.
Rule #2: Minimum purchases as a condition for retaining the distribution right
Whether or not the distribution rights are exclusive, it seems that the accomplishment of performance targets, i.e. actual sales across the time axis during the period of the engagement between the parties, is crucial to reviewing the distributor’s performance. Thus, providing for accepted (but creative) legal mechanisms that will allow, on the one hand, the distributor to properly build the relevant market and operate in it (e.g. a grace period during which exclusivity will not be conditional on any minimum), and on the other, will optimally protect the manufacturer/supplier in terms of partial or complete loss of market due to the distributor’s failure to operate in that market (e.g. definition of a rigid minimum in a certain period, presentation of an activity report and a binding sales forecast, the obligation to appoint a product manager, advertise, etc., with non-accomplishment of all of the foregoing permitting the manufacturer/supplier to terminate exclusivity (or the entire agreement), even before the date prescribed in the agreement).
Rule #3: Identity of the distributor, definition of obligations
Prior analysis and a comprehensive understanding (both legal and commercial) of the identity of the party that the manufacturer/supplier wishes to appoint as the distributor of its products are of great importance. Firstly, the distributor might be a link in a larger distribution chain; the distributor’s owners might operate directly or through related corporations in other territories and additional markets. Thought must be given to the distributor’s financial robustness and its technical capabilities in the relevant field and relevant territory. The number of years that the distributor has been in business in the territory and its past performance must be examined, generally in its business with the manufacturer’s/supplier’s direct competitors. In this way, after a complete picture of the prospective distributor’s dynamic has been received, legal mechanisms that will provide a response to the way in which it is likely that the distributor will act in the relationship with the present manufacturer/supplier can be anchored in the agreement. In this manner, a picture of the distributor’s operating methods and those of its owners can also be formed, and these aspects provided for contractually in good time.
There are many diverse commercial requirements that a manufacturer/supplier may demand of a distributor it plans to appoint, which will remain in place throughout the term of the agreement. For example – and the list is not exhaustive – arranging for regulatory permits to merchandise the products in the relevant market; building a marketing system for the products; advertising; participating in conferences; employing a professional staff; technical/ professional customer support; a warranty and repair system, etc. Often, establishing terms and conditions such as these from the start is very indicative of the distributor’s character and nature, and mainly of its intention and willingness to establish a long term supplier-distributor relationship.
Rule #4: Price of the products; payment terms; shipping
- Naturally, the price of the products is derived from the established catalog price of each individual product. However, the price may be subject to adjustments, changes, discounts, etc., according to various parameters such as the scale of purchases (a quantity discount for bigger purchases), low prices granted in order to penetrate the market or in the context of campaigns among selected customers/groups, X products free of charge in lieu of a warranty for replacement or repair, etc. Thought should be given to the price updating mechanism – whether the price is derived from a change in cost of raw materials indices or foreign exchange differentials, or whether it is derived from the end of a calendar period, after which the price of the products will be raised or lowered – and the mechanism must be properly provided for in the agreement.
- Payment terms can also change. Here, the distributor’s financial strength is, of course, important, as is whether this is a first purchase or a significant purchase (in which case collateral must be provided), or regular purchases by a longstanding distributor with no late payment history. Certain transactions require that adequate sureties are provided (from an open credit account through to customary bank guarantees/letters of credit), and these, of course, necessitate special legal skills and expertise to secure the rights of the manufacturer/supplier. Consignment deals are the most complex and involve many risks that are even more complex.
- Transportation and delivery – the Incoterms rules apply to all transactions in which goods are exchanged. They need to be thoroughly understood in order to establish which party to the transaction bears the legal risk, and consequently – the economic risk.
Rule #5: Protecting the intellectual property rights relating to the products
In many cases and categorically, the manufacturer/supplier invests considerable financial and other resources in the development and manufacture of the products covered by the distribution agreement. Consequently, other than in special individual cases that justify a deviation it must be essentially and operationally verified that the IP rights inherent in the products remain the property of the manufacturer/distributor. The importance of precision and of establishing firm contractual protection of present and future IP rights cannot be understated. The right legal way to define the rights of the manufacturer/supplier as well as those of the distributor is to describe the essence and scope of the distribution rights with the requisite accuracy, and, as the offshoot of these rights, also the scope of the license to use the products granted by the manufacturer/supplier to the distributor and its customers.
Rule #6: Warranty and product liability
- Warranty – when the product is defective, this is in fact a commitment by the manufacturer/supplier giving the warranty for the product to repair or replace it. The product warranty issue involves financial exposure on a scale that can be significant to the party giving the warranty. Formulating the warranty and warranty certificate itself is no small matter. Care must be taken to accurately word the product components covered by the warranty, as well as a precise itemization of the acts which, if performed by the customer, will void the warranty. Attention must be paid to the identity of the recipient of the warranty (the distributor and not the distributor’s customer), and it must be verified that the distributor, which often grants a warranty for a product that is broader and longer than the original warranty that the distributor received from the manufacturer/supplier, does so at its own expense and liability.
- Product liability – a product warranty (as described above) is sometimes confused with product liability. In fact, product liability is the manufacturer’s/supplier’s liability (as well as the liability of all relevant elements in the distribution chain) for bodily injury (as a rule) or damage to property (in certain cases), caused as a result of the use of the product. Generally, although many agreements contain an attempt to include stipulations designed to exempt the manufacturer/supplier from such damages, in most cases these stipulations do not stand up to court rulings, which cancel them as a result of their illegality in light of public policy. The right legal way to deal with limitation of liability is by including in the agreement a smart, efficient indemnity mechanism vis-à-vis the distributor, in conjunction with the purchase of a suitable policy to insure events such as product liability. Other legal issues which must be considered are product recall and epidemic failure, both of which have extensive economic implications.
Rule #7: Period of engagement and termination
- Period of engagement – it is highly desirable to determine a clear, defined period for the parties’ engagement in the agreement. Besides the term of the agreement, it is equally essential to define a clear mechanism for the renewal of the agreement for an additional term and/or for its termination. Of course, a passive mechanism can be defined, in which, if the parties have not actively agreed on the termination of the agreement, it will be renewed automatically for an additional predefined period, but the preferable, wiser mechanism is actually the active one, which requires active agreement by the parties to its renewal/extension (e.g. the minimum purchases are revised in order for the distributor’s exclusivity in the territory to be retained).
- Termination mechanism in respect of breach of the agreement – it is vital to make sure in advance to contractually provide for the ability to terminate the agreement with relatively short notice following its breach (whether or not the breach is fundamental).
- Implications of termination – subject to the circumstances in which the agreement was terminated (e.g. end of the term of the agreement, automatic termination, termination following breach, bankruptcy or acquisition of the distributor, etc.), it is important that the agreement will define what is to happen when the relationship between the parties comes to an end, for example – which stipulations will continue to apply to the parties (non-disclosure, warranty, non-competition), the manner in which support and service to end customers of the products will be continued (e.g. in the event of the distributor’s bankruptcy) and what happens to inventory of the products in the distributor’s possession.
Rule #8: Limitation of liability; compensation and indemnity in the event of termination
- It is a major rule that breach of an agreement (including a distribution agreement) entitles the injured party to compensation for the damages it was caused (if caused). However, the need to limit this liability must be understood, and additionally, the amount of compensation for damages due to breach of the agreement must be limited (for example, and as is customary, limitation of the amount of compensation to the amount of the consideration, exclusion of indirect and consequential damage, limitation of compensation to the compensation included in the product liability insurance policy, etc.).
- However, many agreements reach their end naturally, on the designated date, according to their terms and conditions, without being breached by either party. In regard to the natural end of distribution agreements, the distributor may make the argument that although the agreement reached its end on the planned date, without being breached, the distributor is nevertheless caused damage as a result of its termination in light of the many investments that the distributor had made throughout the term of the agreement in building the relevant market (financial resources, time and effort), and in such case the distributor will still argue for compensation or indemnity, as in the future another party will reap the benefits of its investment. As regards this issue, and particularly in light of (but not limited to) the developing European legislation on the subject (at present, mainly in regard – but not limited – to agents), the proper and right course of action would be for the parties to determine clear provisions for compensation/indemnity that contain a clear formula for assured final compensation due to termination of the agreement other than due to breach. There are accepted compensation/indemnity mechanisms that have received, and are receiving, expression in the EU legislation, which is being bindingly assimilated in the domestic legislation of many countries.
Rule #9: Dispute resolution mechanism; jurisdiction and governing law
It is both vital and customary to define the dispute resolution mechanism that will govern the conduct of the parties in the event of a dispute on any matter relating to the manufacturer/supplier-distributor relationship. There are many mechanisms that can be included in the distribution agreement, but the best course of action would be to determine which mechanism is best suited to the parties from the broadest aspect in light of their relationship. For example, in some cases the right thing would be to determine a neutral agreed arbitration proceeding in a known institution, which will be conducted in a country that is “foreign” for both parties, according to the law in that country. In other cases it is preferable to define the manufacturer’s country and its laws as the exclusive forum and law. Another option is to determine that the legal proceeding will be held in the defendant’s country of domicile, according to its laws.
Rule #10: Why is a written agreement necessary?
In light of everything that has been discussed above, the need for an organized, binding written agreement between the parties – the manufacturer/supplier on the one hand and the distributor on the other – seems obvious. In the absence of a written agreement the intentions and conduct of a party will be construed according to the applicable choice of laws. A distribution agreement concerns the sale of goods between business parties that are bound by a contract, and therefore, both the classic international rules, including the treaties that govern such relationships (for example, the United Nations Convention on Contracts for the International Sale of Goods, the Incoterms, and the European Directives which govern the subject of compensation to the injured party) and the choice of laws rules will apply (contract law, property law, etc.). We emphasize that these universal rules may substantively deviate when construing the specific case and may interpret the original intentions of the parties differently in the various aspects of the engagement between them.