10 Most Common Mistakes with Distribution Agreements

03
June 2022

Mistake No. 1: Lack of Written Agreement – Not So Fast!

During the negotiations, the distributor and supplier hope to establish a lasting relationship, which will bring exactly what each party aims to achieve – the distributor expects to successfully place goods or supplier services in a particular territory and make a profit on margin, while the supplier expects its goods or services to be placed relatively easily in the new market.

Considering optimism and enthusiasm for establishing a new business relationship, the distributor and supplier often begin cooperation without an adequate written distribution agreement. However, the experience has shown us that this practice leads to the later troubles of opening Pandora’s box. There is no doubt that eventually there will be a multitude of contentious issues when the initial optimism of the contracting parties wears off.

The distribution agreement is of paramount importance for both contracting parties because it enables both distributor and supplier to define their rights and obligations clearly in advance, as well as solutions to potential problems that may arise when the agreement is executed (e.g., damage to goods, non-payment of contracted price, use of intellectual property, dispute resolution, etc.).

Apart from that, when starting distribution, the distributor often invests significant funds in promoting goods and creating a brand, led by the thought that they will remain the exclusive distributor for the agreed territory.

However, it should be noted that without an exclusive distribution agreement, there is no adequate mechanism for the distributor to protect themself from other importers and unfair competition. If the distribution agreement is not concluded in a written form, it is almost certain that the distributor and supplier will have to settle the dispute in court, causing additional costs. Furthermore, once when the issue of unfair competition arises, the distributor often will not be able to count on the help of the other contracting party. That is when the distributor often realizes how costly a mistake was made by missing out on a written distribution agreement.

On the other hand, without adequate regulation of the contractual relationship, the supplier may be in a situation where the distributor begins the unauthorized use of the supplier’s intellectual property, as well as cause serious damage to the supplier’s brand.

Therefore, “short reckonings make long friends” is the right recipe for this contractual relationship and can only be achieved through detailed regulation of all aspects of cooperation through a written agreement.

Mistake No. 2: Doubts on the Type of Distribution

After we have determined that it is still better to conclude the distribution agreement before starting the business cooperation, the following question needs to be answered: what is the subject of the distribution agreement?

In most cases, the subject of the distribution agreement is goods (one or more products or product groups). However, in addition to goods, the subject of distribution agreements can be – services. The services distribution agreement is often concluded in the IT sector, such as for the distribution of cloud services. Bearing in mind the specifics of the services distribution agreement, we will not dive deeper into that particular agreement in this blog post but will focus on the distribution agreement of goods.

The next important question to ask is whether the distributor and supplier will conclude an exclusive distribution agreement or non-exclusive distribution agreement.

If the contracting parties conclude an exclusive distribution agreement, the distributor will be the only one who is entitled to sell the supplier’s goods in a particular territory. On the other hand, in the case of execution of a non-exclusive distribution agreement, the supplier may have multiple distributors in the same territory. This may be the first issue on which the distributor and supplier may have disagreements. Specifically, the distributor’s interest is for the distribution agreement to be exclusive. The reason for this is obvious, the distributor will incur many costs regarding the starting of the distribution (promotion, purchase of products from suppliers, etc.), and the distributor wants to make sure that there will be no other distributors and importers, for which the expected earnings will be reduced. On the other hand, a non-exclusive distribution agreement is much more suitable for the supplier. If a business relationship “goes wrong” with one distributor, the supplier will always be able to rely on another distributor and make sure that the specific market will be provided with its products.

Mistake No. 3: Territory Is Defined Too Broadly

One of the chief mistakes that occur with distribution agreements is to define the territory in which the distributor is entitled to sell goods in an overly broad manner. This mistake may occur even in the case of a written exclusive distribution agreement.

Initially, it seems like the best solution to both the distributor and the supplier to define the territory in which the distributor will have the right to sell the goods as broadly as possible. The distributor sees an opportunity for higher earnings, while the supplier does not need to make additional efforts to find additional distributors. Nonetheless, the practice has shown that, when starting the cooperation for the first time, it is more favorable for both sides to define the smaller territory in which distribution will take place. For the supplier, this is an opportunity to “try” collaboration with the distributor, and for the distributor, this is a chance to examine the market to which it markets goods in practice. If both sides are satisfied with the results achieved, they can expand the distribution territory without much effort.

Mistake No. 4: No Targets Are Set for the Supplier to Reach

Distribution agreements often do not have clearly defined targets that the distributor should reach, i.e., they do not have a defined minimum amount of goods that the distributor should buy from the supplier and market it. Even if the agreement contains a provision of this type, inaccurate formulations often appear, such as “a significant effort shall be made” or similar formulations.

By determining the target, the distributor and supplier can assess whether their business relationship is successful or not: unless the supplier has purchased and marketed the defined quantity of goods as specified in the agreement, the agreement is terminated. On the other hand, if the distribution agreement contained a provision under which the distributor is obliged to make a significant effort to buy back and market a certain amount of goods, and the supplier believes the distributor did not do so, it is almost certain that this leads to the termination of the agreement. Whether or not the distributor has made a significant effort would have to be valued depending on the specific case, and the final decision would certainly have to be made by the court.

Clearly, the supplier has more benefits from setting target goals, and it is very important for the distributor to insist on reasonable target goals during negotiations, which the distributor believes are possible to meet.

Mistake No. 5: Duration of the Distribution Agreement

The question of the duration of the distribution agreement is another issue in which the interests of distributors and suppliers are in direct conflict. On the one hand, the interest of distributors is to conclude the distribution agreement for as long as necessary. On the other hand, the interest of suppliers is to make this period as short as possible, due to possible dissatisfaction with the distributor’s business.

Although the duration of the distribution agreement is primarily a commercial issue on which the distributor and supplier should agree, it is important to take care of the provisions of the Law on Protection of Competition, especially in the case of the conclusion of the exclusive distribution agreement. Namely, the agreements between market participants which aim or result in significant restrictions, violations, or prevention of competition are prohibited and void. The exclusive distribution agreement, by its nature, limits the competition in the market. In certain cases, however, there are exemptions from this prohibition. In order not to violate the provisions concerning the prohibition of competition, it is important to investigate whether there is room in the specific case to apply for any legally permitted exemptions.

Mistake No. 6: Inaccurately Specified Conditions for Price Change

Distributors often insist that the distribution agreement of goods contains a provision that allows the supplier to change the purchase price of goods only once a year. If the price at which the distributor obtains goods from the supplier is changed often, it would inevitably affect the price change towards the end consumer. Such a frequent change in product price could further negatively affect its purchase by the end consumer.

In practice, however, it often happens that because of the change in the price of raw materials, suppliers need to change prices more frequently. If they are not allowed to do so under the distribution agreement, they are practically forced to use lower quality raw materials, which can also affect the success of the placement of goods.

The issue of price change is one of the issues that the distributor and supplier often cannot resolve by mutual agreement and therefore resort to court resolution of the issue. As this is a common problem,  the practice has developed the following solution – a provision that enables the supplier to change the price as needed, but with the prior reasoned notification to the distributor. Of course, such a price change cannot be unlimited, and a mechanism needs to be found that meets the interests of both sides.

Mistake No. 7: Insufficient Regulation of the Right to Use Trademarks and other Service Marks

It is particularly important for the distributor that the distribution agreement clearly defines the distributor’s right to use the supplier’s trademark and other service marks, to be able to place goods on the market in the first place, but also to promote them.

Therefore, it is important to verify that the supplier’s trademark is already protected in the territory in which the goods are placed. If the trademark is not registered, it is advisable to regulate the obligations of the contracting parties regarding this issue. For example, a supplier’s obligation to register a trademark, or the right of a distributor to do so on behalf of and for the supplier’s account, may be anticipated.

Trademark protection should be taken care of by both the supplier and the distributor.

The distributor may find themself at a disadvantage if the supplier’s trademark is not registered in a specific territory, as its protection against unfair competition is drastically limited.

On the other hand, if the supplier does not wish to file a trademark application, and the distributor does so on their behalf and for their account (for legitimate reasons), the supplier may be in a situation where the supplier has permanently lost his intellectual property rights in the territory. In any case, upon the termination of the distribution agreement, these situations lead to numerous disputes between former partners, which always prove to be too expensive.

In the absence of regulation on this issue, infrequently the distributor even registers the same business name of the supplier in the territory, which raises additional issues of intellectual property rights, especially after the cessation of the mutual cooperation.

Mistake No. 8: Applicable Law Has Not Been Defined

In the international distribution agreements, it is particularly useful to define the applicable law. In the absence of this provision, the applicable law would be determined by the application of norms regulating the conflict of laws, so it is more favorable for both sides to immediately determine the applicable law and examine in advance the provisions of the law applied to them. Also, if the applicable law is not agreed upon, it can often happen in practice that one law is applicable for a distribution agreement and the other for a specific agreement on the purchase of goods concluded by the supplier and distributor, following the distribution agreement.

However, as both the distributor and supplier wish to determine the applicable law of the country of their respective seat, it is often resorted to applying international rules as a neutral solution in practice. For example, to overcome difficulties in concluding agreements that stem from differences in national legislation, contracting parties often opt for the application of UNIDROIT principles.

Additionally, if both parties in the distribution agreement belong to the signatories of the United Nations Convention on International Sales of Goods (Vienna Convention), the provisions of this convention will apply by force of law to each specific agreement on the purchase of goods concluded by the supplier and distributor under the distribution agreement. In any case, the distributor and supplier have the right to exclude the application of this convention by stipulating so in the agreement.

Mistake No. 9: Lack of Clear Terms for Termination of Distribution Agreement

Although no one wants to think much about terminating the agreement while establishing business cooperation, not specifying the terms of termination is perhaps the biggest mistake a distributor and supplier can make.

For both sides, the most favorable solution would be that they could terminate the agreement at any time, without specifying the reason for terminating the agreement. However, as a rule, the supplier will insist on a short cancellation period, while the distributor will wish for long cancellation deadlines. The distributor could protect their interests by anticipating the right to termination of the agreement without cited reason only after a certain amount of time (for example, after two years from the day of starting the cooperation).

On the other hand, the unilateral termination of the agreement, which can only follow if the other party fails to meet certain obligations is one of the most important provisions of the distribution agreement. The most common mistakes that occur in practice are insufficiently precise regulations of what is an important breach of the agreement that leads to the other side’s right to seek termination. Unfortunately, contracting parties often unclearly predict that each and any breach of the agreement matters, which can open the issue of numerous violations of the right to termination of the distribution agreement.

Mistake No. 10: Lack of Determining the Relationship Between Distributor-Supplier After the Termination of the Distribution Agreement

Each distribution agreement contains the rights and obligations of contracting parties for the duration of the distribution agreement. However, the distributor and supplier often miss out on regulating their relationships after the termination of the distribution agreement. In this case, questions are being asked that can be disputable in practice. Some of them are:

  • What will happen to the goods the distributor ordered and the supplier has not yet delivered?
  • Does the supplier have the right to sell the goods from stock to end consumers after the termination of the distribution agreement?
  • Does the distributor have a deadline to sell the goods from the stock?
  • Does the distributor have to return the goods to the supplier if it does not sell the goods and within what time frame? In that case, at what price should the distributor return the goods, and who covers the transportation costs?

If the answers are not provided in the distribution agreement itself, the distributor and supplier would have to agree after the termination of the agreement, which in most cases is impossible due to disrupted business relations. In practice, the absence of regulation on these issues usually leads to litigation.

Thus, the first step toward successful business cooperation between distributors and suppliers is the conclusion of a written distribution agreement. But this first step can only lead you in the right direction. What will get your business relationship on track is to make a detailed distribution agreement, following the needs of the specific business. Provisions on termination of the agreement, dispute resolution, and the rules that apply to the agreement are also extremely important – especially when it comes to international agreements for the distribution of goods. In this regard, the parties should also consider subjecting their dispute to arbitration as an alternative dispute resolution mechanism. As we have written in our blog on the benefits of arbitration, some of the advantages of resolving disputes in this way are the provision of a neutral “court” for resolving disputes and more efficient conduct of proceedings.

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