A distribution agreement is a contract under which a seller (the "distributor") markets and distributes products which it has purchased from a manufacturer (the "supplier"). A successful distribution relationship can be rewarding for both the supplier and the distributor, but what happens when the supplier wants to escape the arrangement? Terminating a distribution agreement without proper consideration can be a costly process, particularly when some countries' laws are designed to protect the distributor against termination, even at the expense of express contractual terms.1
This newsletter considers the balance between protecting the distributor and freedom of contract in civil and common law jurisdictions, and sets out some basic principles to consider before you pull the trigger on terminating that distribution agreement.
Types of distribution arrangement
Whatever the type of distribution arrangement being negotiated, it is prudent to be clear at the drafting stage what type of arrangement is being entered into and to include express provisions for termination in the agreement. Distribution agreements can last for a specified or indefinite duration and may be exclusive or non-exclusive. Indefinite or open-ended agreements usually provide for termination on an agreed notice period,2 while specified duration or fixed term agreements end on a specified date and often include a clause providing for renewal unless a party objects (termination by "non-renewal"). The number of times a distribution agreement is renewed often impacts on how a distribution agreement is categorised, and can turn a fixed term agreement into an indefinite agreement. Typically, distribution agreements will also provide for termination on a specified event, such as a serious breach of a term or insolvency of a party.3
Protecting the distributor: Civil v. Common law jurisdictions
Whether the termination provisions are valid, however, will depend on the governing law of the distribution agreement. In this respect, a distinction may be drawn in general terms between the laws relating to distribution agreements in civil and common law jurisdictions. Civil law jurisdictions tend to favour the distributor, on the basis that it is commonly in a weaker bargaining position than the supplier and its survival may depend on the supplier's business, particularly where the arrangement is exclusive. Distributors can invest significant sums of money to fulfil the contract, often at the request of the supplier, and should be entitled to recoup that investment from distribution of the supplier's products. By contrast, courts in common law jurisdictions lay more emphasis on freedom of contract and the parties' right to terminate or not renew a distribution agreement in accordance with its terms. Accordingly, before terminating or not renewing a distribution agreement, a supplier should be careful to consider the potential issues that may arise on termination of a distribution agreement and seek advice on the law governing the distribution agreement.
Civil law jurisdictions
The principle of "good faith" is common within the legal codes of civil jurisdictions. It is this principle which could be said to underpin the protections afforded to distributors by many civil law legislatures and courts at the expense of the contractual terms.
By way of example, under Japanese law, a contract is generally enforceable in accordance with its written terms, especially if it is made between sophisticated parties on equal commercial footing. However, rules have been developed to protect the distributor in cases of non-renewal or termination so that, even where a contract is ended in accordance with its terms, the distributor may have a claim for unlawful termination or non-renewal. Various factors will be taken into consideration to determine whether a contract has been lawfully terminated or not renewed, including:
- whether the relationship of mutual trust has broken down;
- which party has a dominant bargaining position;
- whether the distributor has had the opportunity to recoup its investment;
- whether the distributor is solely reliant on this business for its livelihood and if it can compete in the market post termination;
- length of notice of termination or non-renewal;
- the duration of the distribution agreement, its original term and number of renewals.
In a similar way, under French law, suppliers can be liable for terminating a distribution agreement without giving sufficient written notice, irrespective of whether the supplier has complied with the contractual notice period. Sufficient notice is determined by taking into account similar factors to those listed above. In other jurisdictions, like Germany and Italy, reasonable notice periods are dictated by law and range from 1 to 6 months depending on the length of the relationship (including any renewals).
In terms of damages awarded for unlawful termination or non-renewal in these jurisdictions, compensation is usually limited to the loss suffered by the distributor as a result of the termination, including expected profits and compensation for investment which has not been recouped. From our experience, in Japan, the starting point for an award of damages is the expected profit for the period for which the contract should have continued (whether by renewal or notice), usually from 5 months to a year.
The civil law position should be contrasted to that of most common law jurisdictions, where priority is given to the principle of freedom of contract and, by extension, the parties' rights to terminate in accordance with contract terms.
Common law jurisdictions
In common law jurisdictions, courts will generally respect the express terms of the distribution agreement between the parties. In the United Kingdom, Hong Kong, Singapore and Malaysia, the usual rules of contract apply to distribution agreements, so that, if a contract is terminated or not renewed in accordance with its terms and its notice provisions, then courts will very rarely intervene. Only where no notice period is specified will courts infer a duty to provide "reasonable notice", taking into account the circumstances of the case. In terms of damages, in the event that the supplier terminates the distribution agreement in breach of its terms, then the distributor will have an action for breach of contract and may claim for damages for loss caused as a consequence of the unlawful termination or breach. The position is similar in the USA although a number of state (and at least one federal) statutes prescribe minimum notice periods for termination, and often also for non-renewal, of distributorships.4
Knowing where you stand
Given the different approaches to the termination of distribution agreements, it is important to obtain local law advice at the contract negotiation stage and before any termination decision is made. Below are some key points to consider.
- Include clear provisions on when the distribution agreement can be terminated, for example, on a certain date, or if a party breaches a particular term.
- Expressly provide for a notice period, and make it reasonable!
- If a party is entitled to terminate for breach, set out clearly what amounts to a breach, the notice provisions and the remedy.
Terminating the agreement
- Check the terms of the distribution agreement – on what basis can you terminate?
- Consider the circumstances – do you have a justified reason to terminate?
- If not, consider giving reasonable compensation for termination rather than risking expensive litigation for unlawful termination.
- Provide as much notice of termination or non-renewal as possible – the longer the better – and, at the very least, make sure you comply with any notice provisions.
- Finally, and most importantly, obtain local law advice before you pull the trigger on termination.