USA – Distribution Agreements

Understanding the interplay between federal and state statutory and common law in the US legal system is important to understanding the regulation of exclusive distribution agreements in the US.

Under the US Constitution all power not specifically reserved for the federal government remains with the states. Federal law has exclusive jurisdiction only over certain types of cases (e.g., those involving federal laws, controversies between states and cases involving foreign governments), and share jurisdiction with the states courts in certain other areas (e.g., cases involving parties that reside in different states). In the vast majority of cases, however, state law has exclusive jurisdiction. Similarly, the doctrine of freedom of contract under US law also directly affects how distribution agreements are regulated in the US.

Furthermore, because a distributor is typically an unaffiliated third party acting on its own account rather than on behalf of the supplier as principal, distribution agreements are subject to greater regulation under US federal and state antitrust law. Such law, among other things, (i) regulates whether and the degree to which a supplier in a distribution arrangement may seek in a contract or otherwise to dictate the price at which the distributor will resell products supplied; (ii) imposes restrictions on suppliers that engage in “dual distribution” (selling product directly as well as through a distributor); and (iii) may limit the suppliers’ ability to sell product to different distributors at a different price. Antitrust law also regulates exclusivity and selective distribution arrangements, as well as distribution relationships in certain industries (e.g., federally: automobile manufacturers and petroleum; at the state level, heavy equipment, liquor and farm equipment industries). Furthermore, distribution agreements often may resemble franchise arrangements, subjecting those arrangements to extensive federal and state regulation.

Under the law of most states (including New York), exclusive distribution exists when a supplier grants a distributor exclusive rights to promote and sell the contract goods or services within a territory or to a specific group of customers. Exclusive rights in a distribution arrangement are often granted by the supplier for the distribution of high quality or technically complex products that require a relatively high level of expertise by the distributor, including staff that is specially training to sell the goods or specialized after-sales repair and maintenance or other services. Distribution agreements differ from commercial agency agreements in several respects. In contrast to a distributor, a commercial agent does not take title to product, does not hold inventory and typically has no contractual liability to the customer (including risk of customer non-payment). Conversely, a distributor, in line with the greater risk of its activities, typically can expect greater upside economically in terms of margins on resale relative to an agent’s profit through earned commissions.

Sub-distributors

Under the law of most states (including New York), a distributor may appoint sub-distributors absent any restrictions to the contrary in the agency agreement. Commercially, the appointment of a sub-distributor may have an adverse effect on the supplier by reducing the supplier’s control over its distribution channel activities or increasing the supplier’s potential liability exposure given the increased number of distributors whose actions may be attributed to the supplier. A supplier that does not manage properly the appointment of sub-distributors may also lose valuable product knowledge with respect to the distributed goods (particularly if the goods are novel or complex in nature). Advantages to sub-distributor appointments for the supplier may include a more effective overall marketing presence with enhanced local market knowledge, a broader geographic scope, a potentially lower costs as a result of the sub-distributors’ expertise and efficiencies, etc.

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Rights and Obligations of the Exclusive Distributor

• Sales organization: suppliers are not required to establish sales organizations in exclusive distribution agreements.
• Sales’ target: there are no mandatory rules under federal law or state law (including New York) generally regarding sales targets in exclusive distribution agreements. However, such provisions are common in exclusive distribution agreements.
• Guaranteed minimum target: minimum sales requirements are common in exclusive distribution agreements. As a commercial matter, a supplier as a requirement to give, or maintain, exclusivity with one distributor, will seek through such requirements to ensure that economically the distributor is performing satisfactorily. Often failure to meet sales targets may entitle a supplier to rescind the exclusivity, terminate the agreement or reduce the portion of the territory to which the exclusivity applies. We note that minimum sales requirements in an exclusive distribution arrangement may, in certain cases, be subject to challenge under antitrust law as having an undue anticompetitive effect by preventing a distributor from purchasing products from a competitive supplier.
• Minimum stock: there are no mandatory rules in federal law or the law of the majority of states (including New York) regarding minimum stock. A supplier may seek to have the distributor agree, contractually, to maintain adequate levels of stock relative to market demands as well as to store the product properly.
• After-sales service: the parties to a distribution agreement are generally free to agree as they deem appropriate with respect to after-sale service regarding products.
• Resale Prices: the Exclusive Distributor is free to fix the resale prices. State law (including New York law) generally does not limit the ability of an exclusive distributor to fix resale prices. […] A supplier’s ability to set resale prices for distributors is subject to limitations under federal and state antitrust law. Many state antitrust laws (including New York’s) closely resemble the federal antitrust laws. However, differences exist such that certain conduct may be found not to violate federal antitrust law but still be found to violate state antitrust law (or vice versa). Because the distributor (contrary to an agent) is acting on its own behalf, an agreement between supplier and distributor to maintain certain prices (or if a distributor is deemed to have been coerced by the supplier to follow certain prices), may be a per se price-fixing violation under federal and state antitrust law. Under federal antitrust law, vertical price-fixing until 2007 had been illegal per se. This per se rule was overturned by the Supreme Court. Horizontal price fixing remains per se illegal under the Sherman Act (see below).

Rights and Obligations of the Supplier

• Exclusive Distributor undertaking to supply: generally, state statutes do not specifically provide that a supplier in a distribution relationship has a duty to supply specific levels of product to a distributor, with such obligations generally be established by contractual provision. However, a supplier does have an implied covenant of good faith and fair dealing toward the distributor under state law generally, which generally requires that a party to a commercial agreement not do anything which injures the right of the other to receive the benefits of the agreement). Under the foregoing, a supplier may be deemed to have an obligation to supply product to a distributor (or be found to have violated the implied covenant of good faith and fair dealing in the event that the supplier, although able, decided not to provide a distributor with product without any other contractual justification for not doing so). However, even where such a duty were found to exist, the quantity and frequency of product supply and other details often remain unclear. To avoid uncertainty, distributors often seek to have a specific provision included in the distribution agreement, providing at least for the supplier to be required to use some degree of effort (e.g., “best efforts,”, “reasonable best efforts” or “reasonable efforts”) to supply product responsive to distributor’s submitted purchase orders. On a related topic, generally a distributor typically is only required to inform the supplier of lower purchase estimates if the distributor undertakes to do so (or undertakes a more general obligation with respect to the market) in the distribution agreement. However, even if the supplier is not, under an exclusive distribution agreement, required to supply the distributor with product, the supplier may still be subject to a contractual or common law obligation not to sell to third parties in the territory. New York courts held that suppliers that make direct sales to customers in the territory under an exclusive distribution agreement have breached their duties to the exclusive distributor.
• Retention of title: typically, in sales transactions on credit in the US, title is passed at the moment of initial sale. The buyer typically grants the supplier a security interest in the goods purchased, which if proper perfected under state law, affords the supplier with a priority position relative to other creditors with respect to the products provided (inventory) in the event of non-payment and enforcement.

Construction defects warranty

The law of “products liability” in the US is based on the law of torts. Under New York law, in cases of where an end user is injured by a defective product which was sold by the distributor under a distribution agreement, the end user generally is able to sue the distributor and the supplier of the product under one or more of the following theories: (i) strict liability; (ii) negligence; or (iii) breach of warranty. The usual theory of recovery against a distributor is strict liability. Under a strict liability theory, a supplier or distributor that sells a defective product while engaged in its normal course of business shall be liable for injuries it causes to customers, regardless of privity, foreseeability or the exercise of due care. Product liability cases also are brought under breach of warranty claims. Breach of warranty claims can be based on express warranties (e.g., from advertisement or a product label) and on implied warranties (typically, warranties of merchantability and fitness for a particular purpose under the provisions of the Uniform Commercial Code as adopted by the states). Lastly, negligence claims brought by plaintiffs are based on the improper conduct of the defendant, whether supplier or distributor or other participant in the distribution chain, with respect to the manner of distribution or care of the product sold (examples include improper storage or transport).

Under New York law, exceptions based on misuse, neglect or abuse by the suing party generally apply as defenses against liability under theories of strict liability, negligence or breach of warranty.

The supplier and distributor can allocate third-party liabilities (e.g., potential losses to be paid to plaintiffs in a products liability law suit) and related attorneys fees as between themselves through warranty and other indemnification provisions. Parties to a distribution agreement in the US often seek to put in place such re-allocation provisions not only because of potential liability resulting from a final, unfavorable judgment, but also because of the sizeable legal fees that litigants in the US often incur. In this regard, we note that in the US litigation costs are generally born by all of the litigating parties and not by the losing party as is common in many other countries. Such provisions may include indemnification provisions relating to product liability or trademark infringement claims brought by third parties, limitations on liability provisions (based on monetary caps and exclusions as to the types of damages that may be recovered, such as consequential, punitive, special and indirect damages) and disclaimers in respect of express or implied warranties that may otherwise apply under state law applicable to the distribution agreement.

Exclusivity

Exclusive-dealing provisions – under which the distributor undertakes not to distribute competing products in the territory – are quite common in distribution agreements. However, although it is not easy for a plaintiff to prevail, such a provision may be subject to challenge as an unlawful restriction on competition under federal and state antitrust law, typically under the following federal antitrust laws: (i) section 1 of the Sherman Act, which prohibits contracts “in restraint of trade;”; (ii) section 2 of the Sherman Act, which prohibits “attempt[s] to monopolize” and monopolization; (iii) section 3 of the Clayton Antitrust Act of 1914 […], which prohibits exclusivity arrangements that may “substantially lessen competition” or tend to create a monopoly; and, finally, (iv) section 5 of the Federal Trade Commission Act […], which prohibits “[u]nfair methods of competition.” In deciding these cases, typically courts apply the “rule of reason analysis” under which the exclusive dealing arrangements is analyzed considering a host of factors, including: (a) the defendant’s market power; (b) the degree of foreclosure from the market and barriers to entry; (c) the duration of the contracts; (d) whether exclusivity has the potential to raise competitors’ costs; (e) the presence of actual or likely anticompetitive effects; and (f) legitimate business justifications.