An international distribution relationship ranks among the more important commercial arrangements a corporation may formulate. If the responsibilities of the distributor under its distribution agreement are expansive, the distributor will promote the product, establish a retail network and service the product; as a result, the distributor and its retail network will have great influence over the product’s reputation.
From the distributor’s perspective, the principal is considered an ongoing source of products that the distributor can convert into profits. Therefore, the distributor has a vital interest in ensuring the following:
Just as a principal may have limited control over the activities of a distributor, a distributor may have nominal control over such things as a principal’s product design and the level and quality of production.
Therefore, both the principal and an international distributor have a great deal at stake, and each has limited influence over the other. Accordingly, it is essential for principals and distributors to choose wisely and to negotiate the terms and conditions of their relationship carefully.
Let’s examine three critical elements of these agreements: the roles of the parties, the negotiable aspects of the agreements and the eventual termination of those agreements.
The Roles of the Parties
Distributors, Sub-Distributors, Direct Dealers and Sales Representatives
An international distributor that is fully charged with responsibilities in the foreign market will, in addition to marketing and servicing the product, manage import and compliance, manage relationships with dealers or retailers, maintain inventory and deal with government agencies.
For international tax purposes, it is sometimes better for the principal to manage importation and marketing through a captive subsidiary, in which case a “sub-distributor” may be charged with remaining responsibilities.
If a country-wide distributor would not add value in a market, then the principal might appoint “direct dealers” entitled to sell products at just one location. This arrangement is suitable in small markets where national advertising would not be effective and a significant inventory of products would not be necessary; but the principal must be capable of developing and managing the direct dealer network.
In extremely small markets, or for products that are custom-built, perishable or relatively expensive to maintain in stock, a “sales representative,” who merely promotes the product and takes orders, may be most effective.
Principals may export their products for a variety of strategic reasons; e.g., to prime a market for locally-produced products, to geographically diversify a corporation’s market base or, simply, to grow larger. Furthermore, the principal should pursue exports to strategically-selected markets, as it will want to maximize the return on its investment in a portfolio of export markets. The process of strategic selection involves analysis based upon various criteria, such as fundamental economic variables, political stability and market potential for the product.
Primary Negotiable Aspects of the Relationship
Market Exclusivity: Whether the principal can appoint additional distributors in the market is an issue dear to the heart of most distributors, who would prefer to foreclose competition posed by additional distributors of the principal’s product. In some markets, particularly in the Middle East, distribution relationships are exclusive by law.
Minimum Sales Requirements: A minimum sales requirement should not be viewed as a performance incentive, as distributors already have an economic incentive to maximize sales and corresponding profits. Rather, a minimum sales requirement ought to be viewed as establishing a triggering event for termination of the distribution agreement if a distributor’s sales performance is deficient.
Duration of the Contract: Distributors usually attempt to negotiate agreements of significant duration. The distributor will argue that it cannot, within a shorter period of time, recoup its initial investment and recruit an adequate dealer network. It will also argue that the principal may intend to eventually usurp the distributor’s territory and take advantage of the market development initiated and financed by the distributor.
Contract Renewal: Most distribution agreements expire on a specified date. Some agreements, however, contain so-called evergreen clauses under which the agreement is automatically renewed unless the principal provides notice that it will not be renewed.
Buy Back Option: A buy back option is the right to terminate the distribution agreement, for compensation, and assume distribution in the market. A principal may desire a buy back option if he or she expects to take charge of distribution in the market before the expiration of the distribution agreement.
Termination of the Relationship
Even the most carefully formulated and diligently managed distribution relationships may eventually come to an end. A distributor may confront financial difficulty or devote its financial resources to other endeavors and, as a result, disappoint its principal. A principal may decide to manufacture within certain markets, rather than export to them; or it may find that export sales to certain foreign markets, or all international markets, are unprofitable.
In the absence of a distributor protection law, the terms for separation are governed by the distribution agreement. Most distribution agreements provide that either party may terminate the agreement for failure by the other to perform its obligations. If non-performance of the contract is not a credible basis for termination, then a principal might choose to exercise its buy back option. If a buy back option was not included in the agreement, a principal could attempt to negotiate compensation for early termination of the agreement.
Distributor protection laws vary greatly from county to country. The more protective laws specify that distributors are to be compensated for termination of the distribution agreement without just cause. In addition, distributor protection laws typically specify termination compensation that will be owed the distributor, and the required compensation can be quite significant.
All in all, international distribution can be a profitable venture. But international distribution should be entered into with realistic expectations and careful planning, including with respect the legal relationship between principals and distributors.
William J. Kohler, Esq. is a senior counsel in the Corporate Finance Practice Group of Dykema. His practice is focused on the automotive industry, where he served many years as general counsel for automotive-related companies covering domestic and international matters. Dykema has Texas offices in Austin, San Antonio, Dallas, El Paso and McAllen.
Mar 13, 2017 Comments Off on Business Tax Issues for 2017