By Megan L. Petrus
I. Introduction
Distributors seeking to satisfy the maxim: “the customer is always right,” can quickly land in another truism – stuck between a rock and a hard place. The distributor’s troubles begin with the false assumption that legal obligations can simply be flowed down to the party that is most capable of compliance or most culpable, as the case may be. For example, suppose a supply chain consists of a European Union customer, a United States distributor and a Chinese manufacturer. The European Union’s REACH1 regulation requires that the importer of any product containing more than .1% of a substance of very high concern (“SVHC”) into the EU must register the SVHC with the European Chemicals Agency. As the importer, the European customer may not have first-hand knowledge of the chemical composition of the product. Therefore, the European customer will seek to contractually obligate the US distributor, which sold it the product, to supply this information; however, the US distributor also lacks independent means of establishing the product’s chemical composition. Consequently, the distributor will in turn seek to contractually obligate the Chinese manufacturer to provide information to it regarding the presence of SVHCs. The Chinese manufacturer will resist assuming the contractual obligation to comply with REACH on at least two bases. First, the Chinese manufacturer is not legally bound to comply with REACH as REACH only applies to EU manufacturers and importers. Second, compliance is going to be administratively cumbersome and costly. On the other hand, the EU customer is certainly not going to waive the requirement because it is the party ultimately facing legal liability for failing to comply with REACH. When the distributor’s bargaining power with the manufacturer is not commensurate to the customer’s bargaining power with the distributor, which by way of example could be attributable to: business size, volume of product being sold, or a lack of alternative supply sources, then the distributor must either assume the risk imposed by the customer or risk getting cut out of the transaction altogether.2 The remainder of this article will address contract negotiation techniques that a distributor can employ when placed in a situation similar to the REACH example, which will appease the customer without betting the farm by accepting liability for factors beyond the distributor’s reasonable control.
II. Compliance
Distribution contracts will address compliance with laws and regulations.3 A standard clause in a customer’s form distribution agreement will provide: “Distributor shall comply with all laws, regulations and ordinances where the customer has facilities or the product is manufactured or sold.” Under this clause, a small domestic distributor could find itself liable for breach of a French labeling requirement. The most advantageous re-draft of this clause for the distributor would be: “Distributor shall comply with United States laws, regulations and ordinances applicable to it.” If the customer will not accept the foregoing, the distributor could add: “and the applicable laws, regulations and ordinances for locations for which the customer has provided prior written notice that it will sell the product.” This at least limits the sphere of laws to those of which the distributor has been given notice, as opposed to the laws of any country where the product may be sold to an end user through the stream of commerce.
III. Notice
A customer’s form distribution agreement often mandates that: “no changes shall be made to the place, process or materials of manufacturer, unless the customer is given 90 days prior written notice and approves such changes in writing.” These factors are under the control of the manufacturer. The distributor can limit the liability imposed to factors within its control by redrafting the clause as follows: “To the extent the distributor is given notice by its supplier of any changes to the place, process or materials of manufacture, it will provide such notice to the customer within a commercially reasonable time of its receipt of the notice.” If the customer will not accept that revision, a second option is to add: “Notwithstanding the foregoing, the distributor shall only be required to provide notice of changes in manufacturer that affect the form, fit or function of the product.” This addition is feasible because if the manufacturer makes a change that affects the form, fit or function, the product will no longer comply with the specifications, which is one area in which manufacturers willingly assume responsibility.
IV. Payment Terms
In any business cash flow is a problem. The customer will seek to extend the payment time frame to as long as possible, while the manufacturer will want payment as quickly as possible. To avoid having a negative cash flow, distributors often incentivize the customer by granting a 1% discount on invoices paid within 10 days. Another means by which the distributor can obtain faster payment from the customer is to only accept payments by wire transfer. The customer will attempt to extend its time frame to pay by using clauses such as: “Customer shall pay distributor within 30 days of a receipt of a correct invoice or inspection and acceptance of compliant products, whichever is later.” This gives the customer the opportunity to claim that an invoice lacked some formality or that products have not yet been “accepted.” A further device employed by customers to delay payment is to use the following language: “The customer shall pay the distributor within 30 days following the end of the month in which the invoice was received by the customer for the products.” Often distributors send out invoices at the end of each month. Under this clause, if products are delivered on May 15th, the distributor will send out an invoice on June 1st, and payment will be due on July 30th. This is actually 77 days after the products were delivered to the customer. It is important to read the payment provisions carefully to ensure that what initially reads as “30 days” is in fact 30 days.
V. Confidentiality
Distributors do not manufacture products themselves and as such will have to share the customer’s technical information regarding specifications and designs with the manufacturer. Customers are understandably protective of their intellectual property and want to control who receives it. A typical provision reads: “The distributor shall not share the customer’s Confidential Information with any third parties without the customer’s advance prior written approval. If such consent is given, Customer shall ensure that the third party is contractually bound by the provisions of this section.” For a distributor, the burden of having to obtain permission from the customer to share technical information before any order can be placed with the distributor’s manufacturer ranges from administratively cumbersome to outright impossible. The sales representatives on both side of the transaction will understand this. In fact, the sale representatives for the customer will be just as reluctant to expend time enforcing this provision as the distributor’s own sale representative. Nonetheless, the customer, through its attorney will aggressively work to include this sort of confidentiality provision. The customer’s end game is that if its intellectual property is misappropriated by an unscrupulous manufacturer, with whom the customer is not in privity, it retained a remedy against the distributor, with whom the customer is in privity. The ideal redraft for the distributor is as follows: “The customer acknowledges that the distributor is not a manufacturer and, as such, hereby consents to the distributor sharing customer’s confidential information with its suppliers without further need for written approval.” If the customer rejects that redraft, a workable solution may be to provide that the distributor can share confidential information, without the customer’s prior written approval; provided, there is a non-disclosure agreement in place between the distributor and the manufacturer.4 In the event the customer insists on keeping the pre-approval requirement in the confidentiality provision, then to protect its own confidential information, the distributor should insist on including the following clause: “To the extent the customer becomes aware of the identity of the distributor’s suppliers, such information shall be deemed confidential information.”
VI. Warranties
The negotiation of the warranty clause in a distribution agreement follows a predictable pattern. The customer will ask the distributor for every express and implied warranty that could possibly come into play. Unfortunately, the manufacturer will only warrant that the products meet the specifications as published in the manufacturer’s product catalogue. Therefore, the best position for the distributor is not to provide any specific warranty itself but to merely provide that it will pass along to the customer whatever warranty it receives from the manufacturer. The customer is unlikely to accept this. After some back and forth a compromise is reached. The customer usually concedes to eliminate the warranty of merchantability and fitness for intended purpose, and the distributor agrees to warrant that the products will meet the specifications, be free from defects in design, workmanship, handling, materials and manufacture; and be free from all defects of title. Given the ramifications of a breach of warranty that results in a product defect that causes damages, both the manufacturer and customer may be particularly obstinate in negotiating the warranty clause. Since the distributor is unlikely to successfully fend off onerous warranties beyond its sphere of control, it can instead protect itself by limiting the remedies available for breaches of the warranty, as discussed below.
VII. Indemnities, Remedies, and Damages
The ramifications of a distributor delivering a non-conforming or defective product to a customer can range from a damaged reputation to financial losses capable of putting the distributor into bankruptcy. The same holds true for the manufacturer, who will consequently seek to contractually limit its liability for non-conforming goods to: “repair, replacement or a credit, at the manufacturer’s option.” The customer, however, will seek to impose liability on the distributor for “any damages, liabilities, costs and expenses (including reasonable attorneys’ fees) arising from: the distributor’s breach of this agreement or failure to comply with any applicable law; and/or any third party claims of injury or damage to a person or property as a result of the use of the products or a claim that any product infringes on any copyright or patent, misappropriates a trade secret; or otherwise violates an intellectual property right of a third party.”
The first thing a Distributor should do is eliminate amorphous provisions such as “any damage…from the distributor’s breach of this agreement.” A “breach of this agreement” would include breaches of the warranty that are discovered by the customer after delivery and prior to acceptance, use or resell. In that event, the distributor would want the customer’s remedies limited to “repair, replacement or a credit, at the distributor’s option.” This limits the customer’s remedies to the remedies that the distributor can pass back to the manufacturer. Additionally, it prevents the customer from seeking reprocurement or campaign costs5 for non-conforming goods.
If a non-conforming product is accepted, placed into the stream of commerce and ultimately causes damage, a crippling amount of liability could fall onto the distributor. The distributor should narrow the realm of damages for which it can be held liable. First and foremost, the distributor should eliminate consequential or indirect damages. This removes damages such as the customer’s loss of goodwill or unrealized profits. The distributor should then try to place a cap on the dollar amount of damages for which it is liable. One way to make a cap more palatable to the customer is to make the customer an additional insured under the distributor’s insurance policy and then set a cap only for amounts not covered by the distributor’s insurance. Ideally, the cap would be set at: “no more than the total amount paid for the non-conforming products under the purchase order issued in connection with such products.” A more generous (and more likely to be accepted) cap would be: “no more than the total dollar amount of sales to the customer for the trailing 12 months.” As a last resort, the distributor could offer a specific dollar amount, which would be large enough to comfort the customer but which would not threaten the distributor’s solvency.
In the unlikely event that the customer will not agree to the removal of consequential and indirect damages, the distributor should work to limit the situations in which consequential damages are available. A fair compromise could be to give the customer consequential damages for breaches of the confidentiality provisions or misappropriation of the customer’s intellectual property – two areas that can be controlled to some extent by the distributor - but not for defectively manufactured parts that fail and cause damages.
VII. Conclusion
When inequities exist between the ability of the customer to negotiate against the distributor compared to the ability of the distributor to negotiate against the manufacturer, responsibility for legal compliance and accountability for errors cannot simply be passed down the supply chain. For this reason, distributors should be careful to not readily accept their customers’ form contracts, which often appear on the back of purchase orders, and will be deemed automatically accepted by the distributor by its delivery of the products to the customer. A distributor should instead negotiate such contracts to narrow its responsibilities to factors that the distributor can control and, where this cannot be done, to liabilities that do not threaten the distributor’s ability to continue its operations as a solvent business.
1 Registration, Evaluation, Authorization and Restriction of Chemicals (REACH)
2 Further difficulties faced by distributors include: (i) seeking remedies from undercapitalized shell companies lacking adequate assets or insurance, and (ii) obtaining and enforcing judgments against foreign entities.
3 Distribution contracts will also address compliance with industry standards; however, since industry standards are usually self-imposed by the largest players in an industry, the distributor may not be successful in avoiding contractual liability for compliance; however, it also will not face significant obstacles in imposing the same requirement back onto the manufacturer, who will usually already be abiding by such standards.
4 As a general practice, distributors should negotiate and keep on file non-disclosure agreements every time they set up a new vendor. This avoids the need to continually chase vendors to sign non-disclosure agreements before an order can be placed, which slows down the process of placing orders and can result in late deliveries to the customer.
5 Campaign Costs are the expenses incurred by the customer in the process of rectifying the harm done from selling non-conforming goods. These can include: the cost of sending the customer’s employees to the facilities of the manufacturer, distributor, and any parties to whom the customer sold the non-conforming product, inspection and testing of the products.
