Ten Considerations when Terminating a Distributorship Relationship

September 2, 2015 Publications

It is always a difficult decision to terminate a distribution relationship, especially if it was long-standing and previously profitable. When making a termination decision, a manufacturer/supplier must be careful to ensure that it complies with the terms of the distributorship agreement, as well as applicable statutes and common law that may govern the relationship. Beyond contractual and legal implications, a supplier must also consider more practical issues, including servicing customers in the terminated territory, notice to other distributors in the network, and external communications, both with the terminated distributor and customers. 

To assist suppliers contemplating the crucial decision to terminate a distributorship relationship, the following are issues that a supplier should consider:

1. Is the decision to terminate the relationship within the terms of a written distributorship agreement?

The distributorship agreement should be reviewed first and foremost to ensure that the reasons for termination are set forth in the terms of the written agreement. For example, does the agreement provide that sales goals must be met, or that a distributor must comply with certain reporting requirements or payment terms? To the extent a supplier can pinpoint the specific terms of the agreement that have not been fulfilled by the distributor, the less likely a supplier will be challenged for its decision to terminate or, conversely, the better the defenses are for a supplier if challenged.

2. Is there an applicable statute requiring “good cause” as a basis for termination?

Dealership and distributorship relations are often provided additional protection pursuant to state statutes. Specific dealership statutes covering farm implements, motor vehicles, or intoxicating liquors often exist that provide additional legal protections for distributors/ dealers doing business in those states when a “community of interests” is present, requiring “good cause” before an agreement can be terminated with a requisite notice period and an opportunity to cure. Oftentimes, good cause will be defined statutorily as a bankruptcy action filed by the distributor or moral turpitude or other immoral conduct taken by the distributor. Sometimes, the simple failure to abide by the terms of the agreement can also suffice for good cause under some statutes. Of course, federal law may also prescribe additional protections for a distributor/dealer depending on the industry and characteristics of the relationship. See 15 U.S.C. § 2801 (the Petroleum Marketing Practices Act); 15 U.S.C. § 1221 (the Federal Automobile Dealer Day in Court Act).

3. Is the basis of the decision to terminate supported by objective and quantifiable data?

If a supplier’s decision to terminate is based on a written term in the agreement and/or “good cause” pursuant to a statute, then it is imperative to possess objective criteria and quantifiable data to support the decision. For example, if a distributor has not met objective sales requirements, or has failed to pay invoices within the agreed-upon time frames, these reasons should be supported by documentation. If termination is based on poor performance such as customer complaints, the supplier should have written documentation of the complaints and any admonishments sent to the distributor. If such documentation exists, ensure that the documentation is correct, authentic and preserved. Also, it is a good idea to make sure that all knowledgeable and relevant representatives of the supplier agree that the documentation is accurate, and the basis for termination is correct and supportable. Documentation is critical in the event that a terminated dealer pursues litigation to show that the termination was unauthorized or unlawful.

4. Have other distributors in the network acted or performed in a similar manner as the terminated distributor?

Reasons for termination should be consistently applied within a distribution network. If another distributor has acted or performed in a similar manner as a distributor receiving notice of termination, but that distributor was not terminated, this fact will likely be revealed during discovery if litigation is pursued. Inconsistent reasons for termination are a terminated distributor’s best friend, and the supplier’s worst nightmare, especially in front of a jury. If a particular reason is proffered for termination, but the “real reason” is exposed in discovery, defending a supplier’s decision can be extraordinarily difficult. If the reason for termination is based on particular conduct or nonperformance, that conduct or non-performance should not be tolerated within the distribution system by other dealers or distributors. A supplier’s consistency lends to credibility.

5. Once termination has been decided, notice of termination must comply with the distributorship agreement terms and/or applicable statutes.

Providing notice of termination within a distributorship relationship often must comply with a particular time period. Notice requirements typically provide the terminated distributor with sufficient time to get its business affairs in order, provide notice to customers, sell existing inventory purchased from the supplier, and, perhaps, allow for time to find alternative suppliers.

A supplier must ensure that those notice requirements comply any written agreement, as well as applicable statutes or common laws. For example, in Missouri a relationship statute requires that a 90-day notice must be provided to a franchisee in the event an agreement is terminated. See §407.405, R.S.Mo. That statute is applicable only to franchisors/franchisees, which implicates the possibility that a distributorship relationship could meet the legal definitions of a franchise. Careful legal analysis is required to ensure that a distributorship relationship, as opposed to a franchise relationship, exists to avoid liability for non-compliance with the statute. Under Missouri law, a franchise relationship exists if a trade name or trademark is licensed by the supplier/franchisor, an oral or written agreement for a definite or indefinite period exists, and a “community of interest” in the marketing of goods or services exists. See §407.400, R.S.Mo.; Missouri Beverage Co., Inc. v. Shelton Bros., Inc., 796 F.Supp. 2d 988, 995 (W.D. Mo. 2011), aff’d 669 F.3d 873 (8th Cir. 2012). Legal analysis is required to determine if a community of interest exists, which is not easily discernible. A community of interest is often expressed by courts as a substantial investment that is specific to the franchise business and/or investments that are required by the parties’ agreement or the nature of the business. See Cooper Distr. Co., Inc. v. Amana Refrigeration, Inc., 63 F.3d 262 (3rd Cir. 1995). But a community of interest has also been defined as generally as the franchisor benefitting from the franchisee’s marketing of the product, or the franchisee benefitting from the franchisor’s marketing of the product. See C&J Delivery, Inc. v. Emery Air Freight Corp., 647 F.Supp. 867, 872 (E.D. Mo. 1986).

If a distributorship relationship exists without any definite duration, sometimes referred to as an “at-will distribution agreement,” the recoupment doctrine may apply. Newco Atlas, Inc. v. Park Range Constr., Inc., 272 S.W.3d 886 (Mo. App. W.D. 2008). The recoupment doctrine imputes duration of time to a terminable at-will dealership equal to the length of time that is reasonably necessary for a dealer to recoup its investment in the business. See id.; Ernst v. Ford Motor Co., 813 S.W.2d 910, 918 (Mo. App. W.D. 1991).

6. What potential claims may exist for the terminated distributor?

A prudent chess player thinks two steps ahead of the current move. Similarly, prudent suppliers must consider the potential of a lawsuit filed by a scorned terminated distributor/dealer. A supplier should always consider what potential causes of action exist in litigation for the terminated distributor. Depending on the jurisdiction, terminated distributors may have claims under state law, including the implied covenant of good faith and fair dealing, which is implied in all contracts in Missouri. A terminated dealer may also have a claim for tortious interference with contracts and/or tortious interference with future business expectancy if a new distributor is appointed and allowed to sell during the notice of termination period or before the termination actually occurred. A terminated distributor may argue that “good cause” did not exist, if required by law, or that insufficient time was provided under a statute or a common law doctrine like the recoupment doctrine. Or, a terminated distributor may argue that the relationship was a disguised franchise relationship, which could potentially provide additional legal protections preventing quick termination or providing additional causes of action.

7. How will you handle post-termination issues?

Once notice of termination is provided to a distributor, a supplier must analyze the thorny business issues regarding post-termination. For example, does a distributor possess trademarks or trade dress of the supplier? If so, how will the distributor’s use of those trademarks be rescinded and returned in an orderly fashion? If trade secrets were provided to the distributor, how will those trade secrets be returned in an orderly and verifiable fashion? With respect to the distributor’s inventory supplied by the supplier, will the distributor be permitted to continue selling the product in his or her inventory after termination? Will the supplier repurchase that inventory, and at what cost? Will a new distributor be appointed to replace the terminated distributor within the same geographic area? If so, when will the new distributor begin selling to customers in that area? Can the newly appointed distributor or supplier compete with the terminated distributor during the notice of termination period? Will the newly appointed distributor attempt to hire the terminated distributor’s employees or salespersons? If so, is there potential liability for the supplier? These business issues can also implicate legal problems with dire consequences.

8. Have a plan for post-termination discussions.

Once notice of termination is provided to the distributor, the decision to terminate will inevitably be learned by customers, as well as other distributors within the network. Intra-company discussions should occur before any public communications are distributed to ensure that all personnel within the supplier’s company are aware of the termination and understand an appropriate response. All communications should be factually accurate and not defamatory with respect to the terminated distributor. All written communications should be considered discoverable in litigation. Finally, communications with the terminated dealer are inevitable, as terminated distributors often seek clarification for their termination. However, any communications from the terminated distributor to a supplier’s personnel should be referred to a particular person or persons at the supplier to ensure that the same message is conveyed to the terminated distributor. In addition, anything communicated beyond that which was provided in the notice of termination is risky and not advisable.

9. Plan for litigation.

A supplier who has terminated a distributor should expect the possibility of litigation, especially if the relationship is long-standing, the distributor had substantial investment in the relationship, and the distributor’s on-going business could be jeopardized without the relationship. Oftentimes a terminated distributor will seek injunctive relief from a court to preserve the status quo and prevent termination. To prevent that, a supplier should consider termination. To prevent that, a supplier should consider all defenses to injunctive relief when preparing the notice of termination. Defenses to injunctive relief include the availability of liquidated damages in a contract, monetary damages are available as an adequate remedy, and/or that the distributor is not entitled to equitable relief because of past misconduct. Similarly, courts loathe having to monitor business relationships, which is typically what is required between the time when injunctive relief is entered and a decision on the merits is reached. Disputes that often occur during that time frame include: whether the supplier is shipping product on a timely basis; whether payment terms can be or were altered; and if the terminated distributor is slandering the old supplier while soliciting customers to purchase a new supplier’s product.

10. Consult with legal counsel before terminating a distributor.

Finally, legal counsel should always be consulted to ensure proper analysis occurs before terminating a distributor. A legal eye is necessary to ensure that a proper basis exists for termination, proper notice requirements are provided, and that there are no hidden defenses or claims for the terminated party, including franchise protections or common law protections such as the recoupment doctrine. Armstrong Teasdale attorneys in the Franchise and Distribution practice area work with manufacturers and suppliers to successfully guide suppliers through their decision to terminate an underperforming or noncompliant distributor. Our attorneys have defended those decisions made by suppliers and manufacturers at trial in state and federal courts, in private arbitrations, and through skilled settlement negotiations.