Problem-Free Distribution Agreements

During many years as a supplier executive, distributor executive, and expert witness, I have observed the deterioration of many distribution relationships. Several of those relationships concluded in arbitration or a courtroom. Unwinding a distribution relationship is costly and litigation can be terribly expensive. Such action diverts suppliers and distributors from focusing on their business. Distribution agreements are sometimes the source of problems between distributors and suppliers. Setting a goal of negotiating a problem-free distribution agreement is certainly worth the effort. I share some solutions that can reduce the opportunity for needless argument and litigation among distribution partners. Tips illustrated here apply equally to suppliers and distributors.

Term

Distribution agreements that include an annual termination clause with semiautomatic renewal are less likely to face litigation upon termination. Such a contract runs until the end of the first full calendar year. Each party has the opportunity to announce that it chooses not to renew at 60 days prior to the end of the agreement. Without notice not to renew, the agreement automatically extends for another full year. The advantage with annual termination is that both parties have an opportunity to review the terms of the agreement once each year. This allows both parties to renegotiate unfavorable terms. More importantly, both parties have a chance to consider what they might do if their partner chooses not to renew. Considering the possibility of termination, however slight the chance, forces suppliers and distributors to calculate the value of each of their partners every year. Annual evaluation is a sound business practice. Annual termination with semiautomatic renewal provides the distributor and supplier an “annual escape clause.”

Cause and Convenience

Distribution agreements usually contain a clause that allows the parties to terminate their relationship for cause. Less frequently, agreements contain a clause that allows the parties to terminate for convenience (without cause). Both are important and both should be included in contracts linking suppliers and distributors. Few people have a problem with inserting a “termination for cause” clause in a distribution agreement.

Gathering agreement from both parties regarding the presence of a problem is easy. Gathering agreement regarding the cause of a problem is not easy. Having both parties agree to responsibility for cause is frequently difficult. Parties can eliminate that difficulty with the inclusion of a statement allowing “termination for convenience.” With such a clause, either party may choose to notify its partner of its plan to terminate the agreement with 60 days notice, without specifying its reason for doing so. The opposing party may not challenge its partner with respect to its intention to terminate the agreement. A contract with a convenience clause allows both parties, upon notice to terminate, to spend resources on their respective businesses, as opposed to investing management time and money in protracted arguing that often leads to litigation. Avoidance of litigation saves both partners resources.

A distribution relationship between a manufacturer of medical equipment and its distributor serve as an example of the need to include language in the distribution agreement regarding termination for cause and convenience. During the first year of the relationship, the manufacturer became increasingly concerned that the distributor placed very few orders with the manufacturer, although the agreement called for the distributor to place routine stocking orders. Without stock on hand, thought the manufacturer, winning customer orders would be difficult. Over time, concern turned into anger and distrust between the parties. When the manufacturer decided to terminate the relationship, it found that the distribution agreement was silent regarding termination for cause or convenience. Upon written notice of termination, the distributor sued the manufacturer for breach of contract, since the agreement did not mention termination. The manufacturer ultimately prevailed, but not until after both parties invested heavily in litigation. The legal proceeding consumed money, executive time, and overall management focus for the distributor and manufacturer. Had the agreement addressed termination, the dispute would probably not have proceeded to court.

Rights upon Termination

When the subject of termination arises, both parties must thoroughly understand their rights and obligations during two periods. The first period is the time from the date when one of the parties sends its partner notice of termination until the effective date of termination. During this period, may the distributor continue to place orders with the supplier? Is the supplier obligated to ship products to the distributor against those new orders? Does the distributor have the right to tell customers that it may sell the supplier’s products? May the distributor return inventory to the supplier for credit? Is the supplier obligated to issue credit for the inventory returned?

The second period is the time following the effective date of termination. During this period, may the distributor sell product held in inventory? May the distributor return product held in inventory? Must the supplier honor a request from the distributor to return inventory? If the distributor accepted customer orders for product prior to notice of termination, does the distributor have a right to demand shipment from the supplier for product on those aged customer orders? If the distributor holds aged customer orders, is the supplier obligated to continue to ship product to the distributor after the effective date of termination?

Eliminate arguments by clearly defining the rights and obligations of both the supplier and distributor during the first and second periods. Clear definition reduces the opportunity for argument and diminishes the opportunity that arguments precede to costly litigation.

Four Eyes

Most distribution agreements benefit from review by people experienced with creating and negotiating contracts. Sometimes attorneys review the contracts. Sometimes sales managers with distribution agreement experience review the contracts. The best results come when both a legal professional and a seasoned sales manager review distribution agreements simultaneously.

When a legal professional and not a seasoned sales manager review an agreement, the resulting document can be legally acceptable, but commercially ineffective. When a seasoned sales manager and not an attorney review a contract, the resulting agreement can be commercially effective, but legally unacceptable. Hence, when only two eyes review a distribution agreement, problems can arise. When, however, four eyes reviews an agreement, two from an attorney and two from a seasoned sales manager, the probability of a legal skirmish upon termination diminishes greatly. Four eyes are better than two.

Due Diligence

Lack of due diligence prior to signing a distribution agreement is the greatest cause leading to the breakdown of a distribution relationship and agreement. Most terminations occur due to the disappointment of one or both parties. Sometimes disappointment is unavoidable. However, much disappointment in distribution relationships stems from inflated expectations of the distributor’s and supplier’s partners while formalizing agreements.

An argument between a distributor and an equipment manufacturer illustrates how inadequate due diligence can grow into an expensive lesson. The American manufacturer dispatched a vice president to set up distributors in Asia. Upon arrival in Hong Kong, the VP was pleasantly surprised to find a distributor that claimed a presence all around Asia. The VP was delighted, and signed a distribution agreement linking the manufacturer and distributor throughout 10 countries. Delight turned to disbelief within six months, since the distributor placed no orders with the manufacturer. Later, the manufacturer stepped up its communications with customers. To its surprise, the manufacturer discovered that the distributor had neither presence nor personnel in nine of the countries listed in the agreement. By the time that the agreement was almost two years old, both parties were in constant argument. When the manufacturer attempted to terminate the agreement, the parties could not agree on a reason for termination or its cause. Neither party accepted responsibility for disappointing sales performance. The manufacturer ultimately filed action against the distributor. The litigation sucked management time, attention, and resources from both companies. The entire problem could have been avoided had the manufacturer performed adequate due diligence prior to signing the distribution agreement. Minimal due diligence could have alerted the manufacturer that the distributor was little more than one salesman and one office in Hong Kong.

Conclusion

When negotiating a distribution agreement, compare it to a model agreement available from a trade association. Ensure that it expires annually and provides for semiautomatic renewal. Be sure that both parties can terminate the agreement for cause and convenience. Clearly define the rights and obligations of both parties during the termination process and thereafter. Be sure that both a sales professional and an attorney review the agreement prior to signing. Most importantly, guarantee that you perform due diligence on your prospective distribution partner.


This article first appeared in the March/April 2010 issue of Industrial Supply magazine. Glen Balzer is president of New Era Consulting, a marketing and sales consulting firm. He has created, upgraded, and managed marketing and sales organizations around the world during the past 30 years. He has integrated divisions of companies upon merger and acquisition. He advises parties involved with contracts linking suppliers, global customers, manufacturers’ representatives and industrial distributors.

Contact him through his Web site: www.neweraconsulting.com