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The Fragile Nature Of Distributor-Manufacturer Relationships

Tue, 01/18/2011 - 9:14am

Last month, Starbucks announced its intent to end a 12-year distribution agreement with Kraft, setting off a massive contract dispute. Arbitration proceedings have begun between the two companies, and Kraft is also seeking an injunction after stating that Starbucks had violated terms of the agreement. Martin Hyman, a general commercial litigator for Golenbock Eiseman Assor Bell & Peskoe LLP, recently discussed the case and how manufacturers and distributors can protect their relationships.

Q: What is your take on the Starbucks/Kraft situation?

A: The contract between Starbucks and Kraft Foods, as I understand it, is automatically renewable for ten year periods unless one of the parties elects not to renew it. There appears to be no restriction on a party's right to give notice of non-renewal toward the end of the term. Consequently, this is not a “perpetual” contract, as Kraft has tried to characterize it. Starbucks has said not only that it does not wish to renew the contract when it expires in 2014, but also that because Kraft has breached the contract, Starbucks has the right to terminate it now, for cause. For its part, Kraft is asserting that Starbucks has no valid basis to terminate the contract prior to the 2014 expiration date. The automatic renewal provision is really not an issue at this time.

Starbucks apparently has been unhappy with Kraft's services and wants to make a significant change in the way in which its products are distributed to supermarkets, grocery stores and other independent retail outlets. Whether that unhappiness gives rise to a viable breach of contract claim will depend on the wording of the contract and the alleged deficiencies in Kraft's performance. If the relevant provisions are subjective in nature and Starbucks’ complaints are found to be non-material or pre-textual, Starbucks is not likely to prevail on its breach of contract claim and could be liable for damages through the term of the contract (2014). In this regard, Kraft will point to market penetration and the tenfold increase in sales over the past twelve years. On the other hand, if the provisions that define Kraft’s obligations are more objective in nature (specific sales quotas, marketing expenditures, opening of new outlets, etc.) and Starbucks can demonstrate that Kraft did not meet those material requirements after having been informed of the deficiencies and given an adequate opportunity to correct them, Starbucks’ position will be stronger.

In all events, it is unlikely that Kraft will obtain a court order compelling Starbucks to continue the business relationship. Such an order would require a showing of “irreparable harm”—which generally means harm for which money damages will not provide an adequate remedy to Kraft. Kraft has suggested that an award in the range of $1.5 billion would be an appropriate remedy, and courts generally don't like to force companies to continue doing business with each other after the relationship has irretrievably broken down.  The case will proceed to arbitration and will likely be settled for a sum of money that will reasonably compensate Kraft for some measure of anticipated/lost profits. If the dispute doesn’t settle relatively soon, the parties could incur substantial legal expenses.  But they could also experience bad publicity and disruption of their businesses if the transition is contentious and the details of the coffee dispute start to “drip” out. For these reasons, a prompt resolution that would facilitate a smooth transition would seem to be in the parties’ best interests.

Q: Should manufacturers and distributors have written contracts, and should these contracts be fixed or terminable?

A: There is no “one size fits all” answer to this question. The absence of a written contract may give the manufacturer the ability to declare the arrangement to be terminable “at will.” This means that the relationship can be terminated on short notice for any reason or for no reason at all, by either party. There are, however, significant exceptions to and limitations on the “at will” rule.   

The manufacturer can also prescribe the duration of the relationship—and the acts or omissions that will trigger an earlier termination—by including these terms in a written contract. If the manufacturer wants to reserve the right to terminate on short notice in the event of a material breach, the contract should clearly describe the conduct that will constitute a breach. The more subjective the language, the more difficult it may be to enforce a termination without incurring substantial legal cost. To the greatest extent possible, the contract should include objective terms, such as sales quotas, minimum levels of marketing expenditures, immediate termination in the event of non-payment or certain types of wrongful conduct, etc.

Q: Do you know of similar food contract disputes from the past? What were the results of these disputes?

A: Disputes similar to the Starbucks/Kraft situation are not uncommon. While the dispute is extraordinary in terms of the damages being claimed, the underlying nature of the controversy is fairly typical. Most of these disputes, whether litigated in court or arbitrated, are eventually settled or otherwise disposed of prior to trial. The parties often reach a monetary settlement and move on, thus avoiding significant legal costs and bad publicity that can be exploited by competitors and harm relations with consumers.

Q: How can food manufacturers protect themselves when entering into contracts with distributors?

A: Define your objectives and engage a lawyer who can effectively translate those objectives into a comprehensive and enforceable agreement. Be clear in terms of what you expect from the distributor and present a contract that is carefully written to reflect and manage those objectives and expectations. When preparing a contract, assume that there may come a time when the parties will need to go their separate ways and anticipate as best you can the various contingencies that are likely to arise in the future. It’s generally inadvisable to lock yourself into a long term deal with a party that you don't know very well. Preserve the greatest degree of flexibility in case things don't work out as planned and try to create a reasonable and expeditious exit strategy for both parties.   Whether the contract should provide for mediation or arbitration in lieu of court proceedings in the event of a dispute is another matter that requires thought and analysis.

Q: How should manufacturers address contract conflicts when they arise?

A: First, by communicating with the distributor in a candid and forthright way. If the conflict persists and termination becomes a real possibility, the manufacturer should engage counsel at an early stage. Distributors often allege and claim damages for wrongful termination and sometimes seek to invoke statutory remedies by asserting antitrust, franchise law and other claims. A lawyer who practices in the distribution field can guide a manufacturer through the separation (or reconciliation) process.

Q: How can manufacturers maintain a certain level of control while contracting with a distributor?

A: By writing a contract that clearly specifies the respective rights, obligations and responsibilities of the parties without overreaching and inserting onerous terms that may cause a factfinder to conclude that the manufacturer was somehow abusing its position vis-a-vis the distributor. These considerations are particularly important if the manufacturer’s products represent a significant portion of the distributor’s business. If the products are important to the distributor and the manufacturer is reasonable, the distributor should be incentivized to meet its contractual obligations or promptly cure any areas of deficiency. But if the distributor persists in failing to fulfill its obligations, the manufacturer must position itself to act quickly to protect its brand.

Q: How should distributors work with manufacturers to maintain a mutually beneficial relationship?

A: By communicating during good times and bad. Most distributor terminations occur after there has been a breakdown in communication or a disconnect in the implementation of the marketing strategy. The manufacturer may feel that its ideas are being ignored, its strategy is not being implemented and/or its advice is not being sought. This concern may be exacerbated if the distributor is handling other brands or other product lines and the manufacturer thinks its products are not getting enough attention. The distributor may feel that the manufacturer doesn't appreciate the efforts being made and the insights that the distributor brings to the table by virtue of its close relationship with customers. Sales results often involve more than just volume. Other factors may include margins, customer service, responsiveness, image, etc.  All of these matters need to be the subjects of ongoing discussion and interaction.

Martin Hyman is a general commercial litigator who, for more than 30 years, has counseled many private and public companies (as well as individuals), and has handled a wide range of cases from trial through appeal. He has represented companies and executives in a variety of industries, including consumer electronics, sports and entertainment, banking and other financial services, retailing, insurance, food, chemicals, health care, luxury goods, cosmetics, avionics, publishing and trade associations.

Interview by Lindsey Coblentz, Associate Editor, Food Manufacturing

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