Missing The Minimum: What Happens When A Distributor Falls Short?

In last month’s blog [here], we considered the different forms that minimum purchase obligations can take. But a stated minimum provides little unless the agreement also explains how it is measured and enforced.

What counts towards the minimum?

A requirement to purchase £1m products a year may appear clear. However, in practice, it leaves several questions unanswered.

Does a purchase count when the supplier accepts the order or only when the invoice is paid? How should returns, cancellations, and samples be treated?

What if the supplier cannot supply?

A minimum purchase obligation should not be considered in isolation from the supplier’s obligations.

Circumstances can be such as to enable the distributor to argue that it missed the minimum because products were unavailable, deliveries were late, or a product line was withdrawn. Difficult questions can arise if the agreement sets an absolute minimum but does not explain what happens when the supplier is unable to meet orders.

If a minimum purchase commitment is to be adjusted, consideration should be given as to whether the adjustment is to reflect responsibility for the shortfall. For example, should a distributor ordinarily receive relief where an order was placed too late or, exceeded an agreed forecast?

How should the minimum be adjusted?

Sometimes a figure agreed at the outset can become unrealistic as products, prices and market conditions change.

The parties might therefore agree annual targets. This creates its own risk: an obligation to agree a new figure may amount to little more than an unenforceable agreement to agree unless the contract provides a mechanism for resolving any failure to reach agreement. In turn if the agreement goes to the heart of the supply or distribution contract, that too may be void.

Instead the agreement could provide for:

• an automatic percentage increase each year;
• adjustment for inflation by reference to a price index;
• the previous year’s minimum to continue unless another figure is agreed;
• determination by an independent expert; or
• a right to terminate if the parties cannot agree the new minimum by a specified date.

Any adjustment mechanism should be sufficiently objective to produce a result.

Choosing the consequence of a shortfall

The appropriate consequence depends on the purpose of the minimum. If the supplier granted the distributor exclusivity in return for a particular level of investment and sales, loss of exclusivity may be the natural response. If the minimum underpins production capacity or preferential pricing, a financial adjustment may be more appropriate.

Loss of exclusivity

The agreement may allow the supplier to convert the distributor’s appointment from exclusive to non-exclusive, appoint additional distributors, or reduce the distributor’s territory or product range.

The agreement should state whether this happens automatically or only after notice from the supplier.

An immediate loss of exclusivity following a minor shortfall may be disproportionate. The parties may instead require the distributor to miss the minimum by a specified percentage or in two consecutive periods before exclusivity can be withdrawn.

Price and rebate adjustments

The supplier may have agreed preferential prices, rebates, and marketing support by refence to the minimum purchase obligation. If the distributor does not achieve the minimum, the supplier may wish to reduce those benefits. If so the agreement needs to set out how this is to be done.

Shortfall payments and take-or-pay obligations

The distributor may also be required to pay an agreed amount for any shortfall. The formula could be based on the contract price or the supplier’s expected margin.

The agreement should clarify what the distributor receives in return. For example, does payment entitle it to take the missing products later, does title to any stock pass, or is the payment simply consideration for the supplier having reserved production capacity?

The distinction is also important as a matter of law. The legal rule against penalties applies to a secondary obligation imposed following breach, but not to a primary payment obligation. If a shortfall payment is triggered by breach, it may be unenforceable if it imposes a detriment out of all proportion to the supplier’s legitimate interest in performance. The commercial justification for the payment and the way in which it has been calculated should therefore be considered when the agreement is drafted.

Termination or non-renewal

A supplier may want the right to terminate the distribution agreement if the minimum is missed. The agreement should say so expressly rather than relying on an argument that the shortfall amounts to a repudiatory breach of the contract.

The parties should decide:

• whether any shortfall is sufficient or a threshold applies;
• whether the shortfall must occur in more than one period;
• whether the supplier must give notice;
• whether the distributor has a right to remedy the failure; and
• how quickly the termination right must be exercised.

Termination and non-renewal are different. If achieving the minimum is merely a condition of renewal, failure may mean that the distributor has no right to a further term. It does not necessarily give the supplier a right to terminate the existing agreement early or claim damages.

Competition law remains relevant

The consequences attached to a minimum may increase its practical restrictive effect. A substantial rebate clawback or shortfall payment may leave the distributor with little realistic ability to purchase competing products, even if the agreement does not expressly prohibit it from doing so.

The entire arrangement therefore needs to be considered. The Competition and Markets Authority’s VABEO guidance (available here) identifies minimum purchase requirements and as a possible form of “quantity forcing” which may create competition law concerns.

Conclusion

A supply or distribution agreement needs to establish what counts towards a minimum purchase obligation, the assumptions on which it is based, how it can be adjusted and the consequences of falling short. Addressing these issues can pre-empt subsequent dispute.