Divorcing Your Distributor

Artisan Spirit Summer 2018As originally published in the Fall 2018 issue of Artisan Spirit.

In these United States, it is now generally possible to end your marriage without having to prove that your soon-to-be ex did something horrible.  And so while you may want to show a divorce court proof of your spouse’s bad acts — it isn’t actually required.  You can get what is commonly referred to as a “no-fault divorce” and go on your merry, unmarried way.

But this ability to escape what we occasionally refer to as the marriage contract without too much legal difficulty is the exception, rather than the rule, when it comes to actual contracts.  In most cases, if you’re a party to a contract that you want to leave behind, your ability to escape will depend on the language of the contract itself and (potentially) your legal pain tolerance.  For one type of contract near and dear to spirits brands — the distribution agreement — it may be even worse.

Finding a distributor is often viewed by young brands as a rite of passage — something to aspire to and potential indicia of success.  This can be accurate.  But just as marriage at a tender age (or at any age for that matter) doesn’t always succeed, the same is true with respect to the relationship between a brand and a distributor.  The affianced, therefore, is well advised to move cautiously into this relationship and, if appropriate, to enter into a prenuptial agreement.  [Note: For purposes of this article, we will assume the existence of an actual written agreement between the brand and the distributor.  However, readers should be advised that a distribution agreement may exist under state laws even in the absence of such a document — often to the delight of the distributor and the dismay of the brand.]

There are many excellent resources for brands to consult when considering entry into a distribution agreement, so we will not repeat those items here.  Instead, we will focus on one particular concept, that of “cause” for termination of the agreement and how it is implemented in several states.

As a component of the three-tier system, the vast majority of states regulate the relationship between an alcohol distributor and the brands carried by that distributor.  In nearly all of those states, the law of the state in which the distributor is selling the brand (i.e., the law of the “territory” covered by the agreement) will provide the distributor with some rights that are to its benefit — and to the detriment of the brand.  The primary benefit?  The lack of an easy no-fault divorce approach for the brand to escape the relationship.  Rather, if the brand wants to leave the distributor behind, it generally has a choice to make.  It will either need to demonstrate “cause” (or in some cases “good cause” or “just cause” or some similar standard) under state law, or write a big check.

The states that follow this model all approach the issue slightly differently, but there are certainly some thematic similarities.  We will consider several in turn.

Some States Allow Termination for Cause (But Don’t Define It) 

Some might argue that a draconian standard for demonstrating cause is the most challenging approach for a brand.  Although a cogent argument can be made that the most challenging state of affairs for a burgeoning brand is the situation where the law is unclear.  A few states’ laws create exactly that conundrum.  In those states, the relevant legal regime requires that a brand demonstrate some variant of cause in order to escape a distribution agreement without penalty, but fail to provide a definition for cause.  My home state of Washington is among these.  Specifically, RCW 19.126.040 provides that a brand may exit without penalty in one of a few specific scenarios:

  • If the distributor has failed to live up to the terms and conditions of the distribution agreement;
  • If the distributor’s conduct has run afoul of any of the provisions of a corollary statute (RCW 19.126.030 – fraudulent dealing with the brand or its products, bankruptcy and similar financial problems, or certain problems relating to the distributor’s license to operate in the state); or
  • For cause.

Note that except with respect to the items in the second bullet, Washington still requires the brand to provide the distributor with sixty days’ notice of the intent to terminate the agreement.  That notice must include the reason for termination.  Further, if the reason is something that can be cured within the sixty days — and the distributor does in fact cure the deficiency — then the statute provides that the termination notice is null and void.  All this means that even if you do everything correctly, Washington may require you to either end up staying married to your distributor or paying for the privilege of escape.

Going back to the third bullet, it is meaningful to note that the statute does not define “cause.”  Similarly, there is no relevant definition of cause in any of the regulations promulgated by our friendly local Liquor and Cannabis Board.  So, the intrepid brand is forced to go searching for what the term might mean.  It can’t mean failure to comply with the distribution agreement, because that is listed separately as grounds for termination without penalty (i.e., if it is in the first bullet, it can’t be in the third).  Similarly it can’t mean failure to comply with the various other items, which RCW 19.126.030 states are “deemed included” within every distribution agreement (e.g., the requirement that the distributor maintain the financial and competitive capability necessary to act as a distributor for the brand).  What does it mean then?

Borrowing from Washington cases interpreting similar statutes, we find a few likely candidates.  For example, serious distributor misconduct (e.g., conviction of a felony) is likely cause for termination.  But your distributor need not be a felon in order for you to find cause.  Washington cases also suggest that a brand may have cause to terminate a distribution agreement if the distributor is simply engaging in business practices that are detrimental to the consumer or the brand, or has inadequately represented the brand over a measured period causing lack of performance in sales.

The primary point, however, is not that there are methods of demonstrating cause, but rather that the failure of the statute to provide clarity on the definition means that any brand seeking to terminate for this reason faces uncertainty with respect to the potential outcome.  As a result, a brand seeking to terminate its distributor for cause really can’t know at the outset whether it is actually heading down a path that will allow it to escape the relationship without penalty.  Since the penalty is in most cases picked up by a successor distributor, this means that the brand will likely have difficulty getting that successor distributor on board and excited about the prospects of selling the brand in the marketplace.

Some States Give a Bit More Clarity on Cause (But Not Enough) 

Not every state is as lax as Washington when it comes to statutory guidance.  Look closely at a few that seem to go the extra mile and you may decide that the additional effort is just window dressing.

Connecticut is a good example.  In The Nutmeg State, a brand can terminate a distributor for “just and sufficient cause” which according to Conn. Gen. Stat. § 30-17(a)(2) is found when circumstances “in the opinion of a reasonable person considering all of the equities of both the [distributor] and the [brand] warrants a termination.”  This seems like it provides helpful additional guidance for what constitutes cause in Connecticut.  But in fact, this is simply a recipe for litigation.

The cited statute provides that the termination will only occur once notice has been given to the distributor by the brand, with a copy to the Connecticut Department of Consumer Protection, and the Department holds a hearing to determine that just cause actually exists.

Let’s play out that string for a moment in a hypothetical scenario.  The distributor will — by definition — be operating within Connecticut.  It will have employees in Connecticut and pay taxes in the state.  The brand may or may not be operating within the state.  In fact, it probably isn’t because although there are some excellent craft spirits being made within the state there simply aren’t that many manufacturers that call it home.

Why should we care?  Because when the good folks at the Connecticut Department of Consumer Protection consider the equities of the proposed termination (i.e., consider what is fair under the circumstances) there is a reasonably likely chance that they’ll be influenced at least in part by the idea that an out-of-state party is kicking an in-state employer to the curb.  If the brand is picking up a new distributor within the state, this issue will obviously be mitigated a bit.  Still, the jilted distributor may be especially sympathetic in the eyes of the state, with the result being that the brand (or its successor distributor) will likely be forced to pay to escape the relationship.  In fact, if the brand is unsuccessful in convincing the Department that it should be entitled to terminate the relationship, the only other escape valve provided by the Connecticut statute is for the brand and the distributor to agree to terminate the relationship.  As you might expect, that agreement is likely to come at significant cost to the brand.

Brands should note that Connecticut is not alone in requiring that a state regulator approve termination of a distribution agreement.  For example, Georgia law requires that the State Revenue Commissioner approve any termination of a distribution agreement in that state after the brand has filed a Notice of Intention to replace the brand’s existing distributor.  Ga. Comp. R. & Regs. 560-2-5.10.  That Notice must include the brand’s specific reasons for wanting to escape the relationship, and before the Commissioner will grant the termination it is required to give the distributor an opportunity for a hearing to object to the termination.  The Georgia statute provides additional clarity on the nature of cause for termination (e.g., the distributor’s failure to maintain sales volume of the brand reasonably consistent with sales volumes of other distributors or that brand). However, as with Connecticut the only way for the brand to achieve freedom other than going through the notice and hearing process is for the brand to obtain from the distributor a voluntary release of the distribution rights.  That means a negotiated release, which means a payment to the distributor.

Most States Likely Require Prompt Action to Terminate for Cause 

The franchise laws of many states with respect to beer require a brewer to take quick action if it is going to terminate its distributor for cause.  For example, South Dakota provides that a beer distributor must be informed of its shortcomings within two years of the brewer learning of the problem in order for the brewer to have cause to terminate the agreement.  While we are not aware of a specific state regulatory scheme that imposes such a requirement with respect to termination of a spirits distributor, the general legal principle here likely applies.  The applicable legal doctrine is known as laches, which is generally applicable to contract disputes.  Essentially, the doctrine holds that if a party to a contract breaches the contract, and the other party doesn’t complain about the breach within a reasonable period of time after discovering the problem, then the non-breaching party has waived the breach.

Some form of the laches doctrine is in place in almost every state.  So a brand that is internally complaining about difficulty with its distributor should make sure to voice those concerns with the distributor itself — and take appropriate legal action — in order to keep from waiving its rights.

So What to Do? 

Rounding back to our marriage metaphor, brands should carefully consider the laws of the states in which they engage distributors and prepare accordingly. The distribution relationship is a marriage that can be difficult to annul.  To the extent that a particular state allows the recitation within the distribution agreement of the specific responsibilities of the distributor — such that those may be pointed to by the brand as evidence of cause for termination — all the better.  Nevertheless, be wary that some states may refuse to enforce certain parts of that prenup (e.g., performance requirements) as being against public policy.  Moreover, nearly all state franchise laws are constructed to favor the distributor over the brand.  Tread carefully.

This is intended to be a source of general information, not an opinion or legal advice on any specific situation, and does not create an attorney-client relationship with our readers.

 

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