Morgan Russell Solicitors

A Guide to Distribution Agreements

This guide will consider the following: 

  1. The Nature of Distributions Agreements;
  2. Types of Distribution Agreements;
  3. Tax Issues;
  4. The Law and Distributions Agreements; and
  5. Common Terms in Distribution Agreements.

1.            THE NATURE OF DISTRIBUTION AGREEMENTS

A distributor is someone who takes title to goods supplied by the supplier and resells them either to a retailer, another wholesaler or the final consumer. The distributor's profit is the difference between the price at which he has purchased and the price at which he has sold the goods less his expenses.  The distributor is essentially an independent contractor.  His actions do not create contractual relationships between the third party customer and the supplier.

An agency occurs when one party (the agent) has authority from another party (the principal) to create a legal relationship between the principal and a third party.  The agent may enter into a direct contract with the buyer, or introduce the buyer to the principal.  The usual remuneration of the agent is commission.  By contrast, in a distributorship, a distributor buys on his own behalf, and resells as principal.  The distinction between agency and distribution is important because different legal rules apply to each type of arrangement.

The distributor has rights of distribution with respect to the supplier's goods in his territory.  It is, therefore, of the utmost importance that the supplier's contract with a distributor confirms that the distributor is not entitled to act for, on behalf of, or in the name of, the supplier.  If when in the hands of the ultimate customer the goods prove to be defective, the customer would then have a claim only against the distributor (unless the supplier extends a warranty).  There may however be a direct claim by the customer against the supplier on the grounds of product liability and the wise supplier will insure against that contingency.

A distributorship is suitable for products of a standard type, normally produced in large numbers and without numerous variations to suit individual customer requirements.  If the market is unfamiliar to the manufacturer, it may be preferable to appoint a distributor familiar with it and who is prepared to take the risk of operating as a supplier within it. 

2.            TYPES OF DISTRIBUTION AGREEMENTS

Distribution agreements cover a host of contracts between a manufacturer or supplier and the distributors or re-sellers who are at different stages of the production and marketing process.  The normal course of business is for the supplier to enter into a framework contract with the distributor and on the basis of that framework contract, to enter into individual contracts of sale.  The framework contract will, for example, indicate the total amount of goods which the distributor will buy from the supplier each year and will also lay down the conditions of delivery and payment.  In performance of this framework contract, the distributor will then place orders with the supplier who will in turn accept the orders and such individual contracts of sale will be made usually pursuant to the supplier's standard terms and conditions.

A distributorship may take any one of the following forms:

Sole distribution

Where a 'sole' distributor is appointed to sell products in a territory or to a customer group, it will be a condition of the governing agreement that no other distributor is appointed in that territory or for that customer group.  However, the manufacturer will be entitled to sell the products in the territory or to that customer group.

 

Exclusive distribution

In an exclusive distributorship, the manufacturer/supplier is precluded from selling the contract goods direct to the territory or the customer group and may not appoint another distributor to do so, except for any specified 'house accounts'.

 

Non-exclusive distribution

A 'non-exclusive' distributorship allows the manufacturer/supplier to sell directly and to appoint further distributors within the territory or to the customer group of the non-exclusive distributor.

 

Selective distribution

Selective distribution agreements are those in which a network distribution system is established through outlets that meet certain minimum requirements as regards premises, ability to provide proper sales and after-sales service, levels of staff training etc. Selective distribution agreements are often used for hi-technology goods where specialisation is important.

 

Exclusive purchasing

Exclusive purchasing agreements are those in which the distributor agrees to purchase certain goods for re-sale only from the supplier.

 3.            TAX ISSUES

In a distributorship, where the supplier appoints a distributor who buys and sells on his own account, there is little risk of the supplier being taxed by being decreed to have set up a permanent establishment in the distributor's territory.  The supplier will thus be taxed on the profits of his trade with the distributor at his home tax rates.

By contrast in an agency arrangement, where a principal appoints an agent to operate in another country, there is a risk that such appointment will constitute the creation of a "permanent establishment" and the principal will be liable to taxation at the rates applicable in that local country on all the profit generated through that permanent establishment.  This risk is reduced where there is a double tax agreement between the two countries based on the OECD model treaty.

4.            THE LAW AND DISTRIBUTION AGREEMENTS

When considering entering into a distribution agreement, the most important point to be decided is the type of distribution agreement to be entered into: sole, exclusive, non-exclusive or selective.  Unlike under the agency laws of many countries, most notably within the EU, the parties have a relatively free hand when it comes to negotiating distribution agreements, which are governed by ordinary contract law.

When the distributor is in the UK and the agreement is subject to English law, no-default compensation will be payable on termination (unlike the case of an agent).  If the distributor is based outside of the UK Inland Revenue the law of another European country applies, care may well be needed.  For example, under German law the distributor is treated in a similar way to that of an agent on termination of the agreement.  As a result a distributor can claim no-default compensation.

Notwithstanding, the main legal constraint for distribution agreements is ensuring that the agreement is not in breach of any competition laws. A breach of these laws may give rise to substantial penalties and render the agreement, or at least certain clauses of it, unenforceable.

This section of the guide will consider the following:

4.1       UK Competition Law;

4.2       EU Competition Law; and

4.3       The Laws of Distribution around the World.

4.1          UK COMPETITION LAW

The Competition Act 1998 (the "Act") which came into force in March 2000, introduced a new regulatory regime within the UK.  The Act prohibits the same agreements as Article 81(1) does below, which have an effect on trade within the UK or which have as their object or effect the prevention, restriction or distortion of competition within the UK.

Distribution agreements are exempt from the provisions of the Act as they fall within 'vertical agreement' exclusion, i.e. agreements between businesses operating at different levels of the chain, such as the supplier and distributor. However, distribution agreements cannot benefit from this exclusion if they contain provisions, which directly or indirectly fix prices, impose minimum or resale prices or share markets.

Notwithstanding, if an agreement benefits from a European Commission block exemption (see below), that agreement will automatically be exempt from the provisions of the Act. Therefore, you should seek to ensure that your agreement benefits from the European Commission's block exemption in order to avoid the burden on businesses of scrutinising a large number of agreements for compliance with the Act.

4.2          EU COMPETITION LAW

The basic EU prohibitions on anti-competitive practices are contained in Articles 81 and 82 of the Treaty of Rome, which provide as follows:       

  • Article 81(1) prohibits agreements or concerted practices between
    undertakings which may affect trade between Member States and which have as their objective or effect the prevention, restriction or distortion of competition within the Common Market.
  • Article 82 prohibits the abuse by one or more undertakings of a dominant position within the Common Market or a substantial part of it insofar as it may affect trade between Member States.

Generally exclusive distribution agreements are thought to be prima facie anti-competitive and contrary to Article 81(1) due to the restrictions on the supplier to prevent him form competing with the distributor.  On 1 June 2000, a new Commission Regulation on the application of Article 81 to categories of vertical agreements and concerted practices was brought into force (the "BER").  The BER exempts a wide range of "vertical agreements" from Article 81(1).  Vertical agreements are agreements between two or more parties, which operate at a different level of the production or distribution chain and relate to the conditions of purchase, sale or resale of certain goods or services.  This definition therefore includes a wide range of distribution agreements, which shall be exempt from Article 81(1) if the following conditions are met:

(1) Non-Competing Parties

The parties must not be competitors or if they are competing parties:

the distributor must have a total annual turnover not exceeding EUR100 million; or the supplier must be a manufacturer and a distributor of goods and the buyer must only be a distributor.

 

(2) Market Share

Having satisfied the "competitor" requirement, the next point to consider is the market share of the relevant party.  Generally, the market share held by the supplier must not exceed 30% of the relevant market on which it sells the contract goods or services.  If the distribution agreement contains "exclusive supply obligations", the market share held by the distributor must not exceed 30%.  "Exclusive supply obligations" are defined as any direct or indirect obligation causing the supplier to sell the goods or services only to one buyer inside all the European Community for a specific use or for resale.

 

(3) Non-Compete Obligations

The non-compete obligations must not exceed 5 years.

 

The non-compete obligations cannot continue for more than one year after termination of the agreement.

 

In the case of selective distributorships, the distributor must be free to sell the brands of particular competing suppliers.

 

(4) Competing Undertakings

The distributors' total annual turnover does not exceed EUR 100,000,000 or the distributor does not manufacture competing goods.

 

POINTS TO NOTE

(1)        Anti-Competitive Objects

The BER will not exempt agreements which contain certain anti-competitive objects, namely: 

  • resale price restrictions – but recommended and maximum prices can
    be applied;
  • the restriction of the territory into which, or of the customers to whom, the distributor may sell the contract goods or services. However, the following limited restrictions on resale are permitted:
  • the restriction of active sales into another distributor's exclusive area or exclusive customer group, or a territory or customer group reserved to the supplier,
  • the restriction of sales to end-users by a wholesaler,
  • the restriction of sales to unauthorised distributors by selective distributors, and
  • the restriction of the buyer from selling components to the manufacturer's competitors.
  • the restriction of active or passive sales to end-users by selective distributors operating as retailers;
  • the  restriction of cross supplies between distributors within a selective distribution system, and
  • the restriction between a supplier of components and a buyer who incorporates those components, which limits the supplier to selling the components as spare parts to independent repairers not entrusted by the buyer with the repair or servicing of its goods.

(2)          Network Distribution Agreements 

The Commission can withdraw the exemption where parallel networks of distribution agreements have an appreciable effect on competition with the European Community.

Active and Passive Sales

It is noteworthy that the BER refers only to restriction of "active sales" into exclusive territories or to exclusive customer groups, and not to "passive" sales.  The Commission has issued Guidelines on Vertical Restraints as to how to interpret and apply the Regulation.  They are lengthy and detailed, and give considerable assistance in interpreting BER.  The Guidelines explain that passive sales should always be permitted to exclusive territories or customer groups.  The Guidelines define "active" and "passive" sales as follows: 

"Active" sales

  • actively approaching individual customers inside another distributor's exclusive territory or exclusive customer group by, for instance, direct mail or visits, or

 

  • actively approaching a specific customer group or customers in a specific territory allocated exclusively to another distributor through advertisement in media or other promotions specifically targeted  at that customer group or targeted at customers in that territory, or

 

  • establishing a warehouse or distribution outlet in another distributor's exclusive territory.

 

"Passive" sales

  • Responding to unsolicited requests from individual customers, including delivery of goods or services to those customers.  General advertising or promotion in media or on the Internet that reaches customers in other distributor's exclusive territories or customer groups, but which is a reasonable way to reach customers outside those territories or customer groups, are passive sales.

Internet Sales

It follows that, generally, every distributor must be free to use the Internet to advertise or to sell products.  The Guidelines also state that a restriction on the use of the Internet by distributors can only benefit from the BER to the extent that promotion on the Internet or sales over the Internet would lead to active selling into other distributor's exclusive territories or customer groups.  It would appear that this might be the case where a web site is specifically targeted at reaching customers outside the exclusive territory, for instance, with the use of banners or links in pages of providers specifically available to those customers. Further, sending unsolicited e-mails to customers outside the territory would be considered active selling.  The supplier cannot reserve to itself sales and/or advertising over the internet.

What does this mean for Employers?

Suppliers and distributors should review their agreements now to ensure that they are not in breach of European Competition law.  All new distribution agreements should be prepared to comply with the new law.

4.3         LAWS OF DISTRIBUTION AROUND THE WORLD

Distribution Laws diverge from one country to another.  For this reason, it is particularly important to take detailed local legal advice when entering into an agreement under the law of an overseas country.  Morgan Russell is able to obtain such advice on your behalf through its international connections with lawyers around the world.

5.          COMMON TERMS IN DISTRIBUTION AGREEMENTS

5.1       Parties

  • Sets out the identity of the parties.
  • Sets out the identity of any party giving a guarantee on the obligations
    of the distributor.

5.2       Interpretation clause which sets out:

  • The Territory covered by the agreement.
  • The Products which are the subject of the agreement.
  • If there are any trade marks involved.

5.3       Appointment of distributor clause sets out:

  • The scope of the appointment i.e. whether the distributorship is
    exclusive/sole/non-exclusive.
  • The distributor's obligation to purchase annual minimum quantities of 'products' and consequences of failure (termination or change of scope of appointment).
  • The non-compete obligations on the Distributor (not to deal in competing products during the agreement/not to manufacture the Products/not to sell the Products outside the Territory etc.).

5.4        Supply of the products clause sets out:

  • The ordering terms.
  • The supplier's right to refuse orders.
  • The supplier's right to improve or modify Products.
  • That the supplier's condition of sale are to apply.

5.5        Payment for the products clause sets out:

  • The delivery terms.
  • The prices and provisions for ascertaining prices.
  • The pricing provisions on resale (subject to EU and local laws).
  • The terms and means of payment.

5.6        Marketing products clause sets out the obligation of the distribution to:

  • Promote sales.
  • Keep sufficient stocks of the Products and of parts.
  • Comply with local laws.
  • Conform to the supplier's marketing policies.
  • Pass back to the supplier market information and provide reports and returns.
  • Minimum advertising.
  • After sales services.

5.7       Support and training clause sets out

  • That the supplier is to provide know-how, technical support and training.
  • That the distributor is to maintain sufficient qualified staff. 

5.8        Intellectual property clause sets out

  • That all of the trade are to remain with the supplier.
  • That the distributor is not to endanger application for registration of intellectual property.
  • The provisions relating to the control of prosecution/defence of infringement proceedings.

5.9        Confidentiality clause sets out:

  • The obligation of confidentiality upon the distributor in respect of know- how disclosed.
  • The obligations to continue after the termination of the agreement.

5.10       Warranties and liability clause sets out:

  • The warranties relating to the quality of the Products and title to the
    trademark. 
  • The limitation or exclusion of the supplier's liability.  

5.11     Force majeure clause sets out:

  • That neither the distributor nor the supplier shall be liable for any failure to perform their obligations in the event of a force majeure.

5.12     Duration and termination clause sets out:

  • Any initial probation period.
  • The duration of the agreement.
  • The right to renew.
  • The right to terminate by notice.

5.13     Consequences of termination clause sets out:

  • The rights and liabilities of the parties to survive the termination.
  • The resale of merchantable stocks to the supplier.
  • That all other stocks to be destroyed.
  • That the distributor is to cease use of the trade marks.
  • That the distributor is to supply his customer lists.

5.14     Nature of agreement

  • Whole agreement provision.
  • No joint venture or partnership. 

5.15     Proper law and whether arbitration

  • This clause sets out the parties' choice of governing law and any arbitration provisions.

5.16     Notices and service

  • Sets out the address for service of notices. 

5.17     Schedule 1 – List of Products 

5.18     Schedule 2 – List of Trade marks

Further Information

If you require any further information or assistance, please contact Paul Morgan or Debbie Turner on +44 (0)1372 461411.

The data contained within this document is for general information only. No responsibility can be accepted for inaccuracies. Readers are also advised that the law and practice may change from time to time. This document is provided for information purposes only and does not constitute legal advice. Professional legal advice should be obtained before taking or refraining from any action as a result of the contents of this document.
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