I. Introduction1

Historically, the Mary Todd Lincoln Baking Company, which bakes gourmet cookies, has sold its cookies to small distributors. These distributors, often sole proprietors, have resold the cookies to food stores of all sizes, making deliveries, maintaining shelf space and operating out of their own vans in local, exclusive territories. More recently, with geographic expansion beyond the Mid-Atlantic and facility expansion with new production and warehouse space, Lincoln's distribution has changed in several ways. Lincoln recruits fewer small distributors; no longer grants exclusive territories; sells to larger, regional distributors with central warehousing, billing and delivery and/or sub-dealer networks; and sells direct to national and regional big box and grocery chains.

Change has brought problems. One of Lincoln's original distributors, Andrew Johnson, complains that another Lincoln distributor, Harriet Beecher Stowe, sells Lincoln cookies to stores on Johnson's route in violation of his exclusive rights. Further, one of Johnson's customers asked Johnson to meet or beat Stowe's price, a price below Johnson's cost, prompting Johnson to complain that Lincoln sells cookies to Stowe at a lower price. Another one of the original distributors, Frederick Douglas, complains that he has lost sales on his route to a newer distributor, William Seward, who markets over the internet. Lincoln did not tell Seward of any exclusive territories when it recruited Seward, and Seward contends that he can market anywhere he wants. Douglas also complained that Seward takes unfair advantage of, and is "free riding" on, the advertising dollars which Douglas spends in his territory. Lincoln hates to get involved in inter-distributor rivalries and wishes that Douglas and Seward would work it out among themselves, but will resort to distributor termination if necessary.

Another concern involves a large regional distributor, Clara Barton, who has engaged a sub-dealer, Edwin Stanton. Lincoln objects because Stanton is a former Lincoln distributor whom Lincoln terminated for bad performance and who owes Lincoln a substantial amount on credit. Lincoln does not want Stanton in its network, and if it cannot keep Stanton out, Lincoln would like to leverage payment of the past due account through Barton.

Lincoln is also concerned that many of its distributors have begun selling Thaddeus Stevens cookies. Lincoln's traditional marketing plan is to distinguish its gourmet cookies from "discount" cookies of higher-volume bakeries like Stevens. Lincoln does not want cooperative advertising dollars which it provides to its distributors to be spent on advertising which may benefit Stevens. Further, Lincoln wishes to ensure that its distributors make a good faith effort to sell its cookies.

Finally, Lincoln is distressed over the actions of a few distributors who sell Lincoln cookies at lower prices. Lincoln fears that the market may perceive that its cookies are no longer "gourmet." Lincoln is considering mandatory resale pricing to defend its reputation as a top quality cookie bakery.

Distribution is fraught with these and other problems, complicated by common law and federal and state statutes governing antitrust, price discrimination, dealer termination, franchise, sales agency, business relationship, commercial transactions, and other trade regulation. In this environment, risk management in distribution is not a luxury but a necessity, whether the client is a manufacturer of goods or a provider of services, whether the products or services include a trademark, patent or other intellectual property, whether the client uses distributors, dealers, brokers, franchisees, sales agents, or other middlemen, and whether the client deliberately plans a distribution network at the outset or the client has outgrown, or is frustrated by, its original, ad hoc network and needs a more sophisticated, uniform distribution policy.2 This article provides (1) a cursory overview of some of these distribution issues for the purpose of ready identification by the general practitioner (not to cover all of the issues or all of the risks or substantive law associated with these issues), (2) a partial sample checklist of issues which a manufacturer such as Lincoln can use to evaluate how to handle distribution, and (3) a short-form distribution policy.

II. Distribution Issues

A. Pricing

Whether for product reputation, network profitability or other reason, a manufacturer such as Lincoln often wants its distributors to sell its products at a uniform price. With the exception of "maximum" resale prices, however, mandating resale prices is considered illegal price fixing between the manufacturer and its distributors.3 A manufacturer, however, may publish a suggested resale price, so long as it does not coerce distributors to meet the price.4 A manufacturer may also require distributors to pass through any price discount which the distributors receive from the manufacturer.5

B. Advertising

A manufacturer may establish and fund cooperative advertising and may even require its distributors to advertise the suggested resale price as a condition to receiving cooperative funds. A manufacturer may not, however, condition cooperative advertising dollars on distributors actually charging the resale price set by the manufacturer.6 Under Lincoln's scenario, Lincoln may require that its distributors use cooperative funds to advertise only Lincoln's cookies and exclude competitors from the advertising.7

C. Price Discrimination

One of Lincoln's distributors, Johnson, suspects that Lincoln sold its cookies to another distributor, Stowe, at a lower cost than the cost to Johnson. Johnson may state a claim under the Robinson-Patman Act and comparable state law for price discrimination. Johnson would base his claim on an inference, among other elements, that Lincoln sold commodities of like grade and quality to the two distributors at a different price which lessened competition.8 To avoid this exposure, Lincoln should not charge different prices unless it can attribute the cost differential to specific cost savings in dealing with Stowe (for example, savings attributable to enhanced distribution services in warehousing, billing, delivery and other areas) or one of the other narrow defenses under Robinson-Patman.

D. Franchises

In another article in this issue of The Virginia Lawyer, R. Scott Caulkins addresses some of the advantages and disadvantages of a franchise system. This article will not expand on this beyond noting that if a manufacturer such as Lincoln elects not to set up a franchise distribution system, it should avoid the trappings of a franchise so that it is not re-characterized as a franchisor subject to federal and state franchise laws. The three-part FTC test noted by Mr. Caulkins in his article offers a useful guide to these elements, including: (1) use of the manufacturer's trademarks; (2) significant control or assistance by the manufacturer; and (3) a franchise fee or payment other than the cost to buy the manufacturer's product.

E. Exclusive Territories

Another decision for a manufacturer, present in Lincoln's scenario, is whether to promise each distributor that it will be the only distributor of the manufacturer's product within a given area. If a manufacturer promises an exclusive territory, it can foster investment in marketing, service, etc., by the local distributor because it has barred other distributors from free-riding on that investment. In contrast, non-exclusive territories allow greater saturation of a product in the market yielding greater exposure and sales for the manufacturer. Generally, exclusive and non-exclusive territories are legal.9 Similar to exclusive territories are location clauses which dictate the geographic location from which a dealer or distributor may sell a manufacturer's product. Again, such clauses are generally legal.10

F. Areas Of Primary Responsibility

Another way to address the free rider problem short of exclusive territories is to designate an area of primary responsibility to each distributor while not interfering with each distributor's ability to sell beyond its primary area. Through incentives or requirements, the manufacturer can promote distributor investment in each primary area, yet the manufacturer can enjoy the advantages of greater market saturation and increased aggregate sales associated with non-exclusive territories. In the sample policy set forth below, Lincoln assigns Zip Codes to its distributors, not as exclusive territories but as the reference point for sales and service leads. Lincoln could also hold its distributors accountable for various duties such as marketing within their respective primary areas. Assignment of areas of primary responsibility are generally legal.11

G. Profit Pass-Over Systems

Short of buying out the exclusive territories from its older distributors like Johnson or Douglas, Lincoln may adopt a profit pass-over system to appease these distributors. Under a profit pass-over system, Lincoln would effectively institute an area of primary responsibility for each distributor. If a distributor sold Lincoln's cookies in another distributor's primary area, that distributor would pay to Lincoln a portion of the profits from the sale. Lincoln could then use all or part of the payment to compensate the local distributor, encouraging investment in marketing and goodwill and preventing the free rider problem. Profit pass-overs are legal as long as the amount which the distributor is required to pay is reasonable in relation to the amount of advertising, goodwill, etc. performed by the primary area distributor.12

H. Exclusive Dealing And Royalty Provisions

To prevent a competing manufacturer, such as Stevens, from using Lincoln's distribution network, Lincoln can limit or prohibit its distributors from selling competing products.13 Known as exclusive dealing, this practice is generally legal.14 Significant risks arise with exclusive dealing provisions, however, if Lincoln's distributors are the only efficient conduits to the retail market and the exclusive dealing effectively blocks competing manufacturers from the market.15

I. Corporate/National Accounts - Dual Distribution

Many manufacturers like Lincoln operate a dual distribution system under which the manufacturer sells to distributors but also reserves to itself (or one or a few of its distributors) sales to large regional or national customers. Dual distribution systems are generally legal,16 but since the manufacturer (or national distributor) competes with the other distributors, antitrust issues and price discrimination under the Robinson-Patman Act are potential adverse factors.

J. Credit Policies

Manufacturers often extend credit to their distributors. To minimize the legal risks associated with dealer termination and related statutes yet empower a manufacturer to terminate for failure to pay a credit account, a distribution policy should expressly permit termination for non-payment. Lincoln's scenario, however, is not limited to direct sanctions for violation of credit terms. Lincoln also wants to exact reimbursement from Stanton, a former distributor, through leverage against Barton, a current distributor, who has set up Stanton as its sub-dealer. Should Lincoln treat Barton unlike other distributors or refuse to deal with Barton altogether, Lincoln could expose itself to breach of contract, antitrust and other dealer termination claims.17 Lincoln may also face exposure for a claim by Stanton of tortious interference with contract18 or conspiracy.19

III. Issues Checklist

With these issues in mind, a sample checklist of issues when promulgating a distribution policy follows.

1. Type of Relationship?

  • Franchisor/franchisee?
  • Manufacturer/distributor?

2. Grant exclusive or non-exclusive territories?

  • Location clauses?
  • Areas of primary responsibility?
  • Profit pass-over system?

3. Pricing restraints?

  • Set maximum resale prices?
  • Establish suggested retail prices?

4. Advertising

  • Advertise at certain prices?
  • Provide cooperative advertising money?
  • Condition cooperative funds on exclusion of competitors?

5. Exclusive Dealing?

  • Royalty provisions on other lines?

6. Credit Policy?

7. Dual Distribution?

  • Corporate accounts?
  • National accounts?

Other issues to be decided include whether or not to use a written distributor agreement (recommended) and addressing the many typical commercial issues such as returns, licenses, labor and service rate schedules, warranties, disclaimers, indemnities, dispute resolution, forum selection, choice of law, non-competition, trade secrets, etc.

IV. Sample Distribution Policy

The Mary Todd Lincoln Baking Company

Distribution Policy

Distributor: A distributor of the Mary Todd Lincoln Baking Company is an independent business entity which purchases and stocks and then resells cookies and other products manufactured by the Company. The Company has sole discretion in the selection and termination of distributors and in the assignment of areas of primary responsibility.

Non-Exclusivity: The Company does not grant exclusive territories to any of its distributors.

Areas of Primary Responsibility: The Company assigns a set of adjacent Zip Codes to each distributor as the distributor's Area of Primary Responsibility. The Company refers sales and service leads and delegates marketing responsibilities by each distributor's Area of Primary Responsibility.

Credit: The Company may extend credit to its distributors with the understanding that, among other remedies, it may terminate and refuse to deal with any distributor who becomes delinquent in credit payments.

Expectations of Distributors: The Company expects its distributors to use good faith and best efforts in striving to market and sell the products of the Company. In order to satisfy these expectations all distributors shall:

  • Develop and implement a marketing plan within the Area of Primary Responsibility.
  • Maintain proper inventory of products so as to meet customer needs expeditiously.
  • Follow-up on all sales leads provided by the Company and/or other distributor(s) promptly.
  • Participate in any sales/training programs and other seminars held by the Company as requested.

Cooperative Advertising: The Company may provide each distributor with cooperative advertising funds. The distribution of cooperative advertising funds will be at the sole discretion of the Company, based on need and size of the Area of Primary Responsibility. Cooperative advertising funds provided by the Company are not to be used in any advertisement or other marketing device which includes any mention of the name or product of a competitor of the Company.

Corporate and National Accounts: The Company reserves the right to sell its products directly to corporate and national accounts. A corporate account is a customer which purchases product directly from the Company, and the customer disperses the product among its own multiple locations regardless of the Areas of Primary Responsibility. A national account is a customer which purchases product from a distributor, and again the customer disperses among its multiple locations regardless of the Areas of Primary Responsibility.

Termination: The Company reserves the right to terminate or refuse to deal with any person or entity, whether or not a distributor, for any reason or no reason at all. Among other reasons, the Company may terminate or refuse to deal with any distributor for failure to adhere to any policy outlined in the Distribution Policy.

Footnotes

1 The author wishes to express his gratitude to Humes J. Franklin, III, William & Mary School of Law, Class of 2001 and R. Johan Conrod, University of Virginia School of Law, Class of 2001, for their assistance.

2 Manufacturers also face decisions on issues governing warranties, commercial transactions, etc.

3 See Dr. Miles Med. Co. v. John D. Park & Sons Co., 220 U.S. 373 (1911); see also State Oil Co. v. Khan, 522 U.S. 3 (1997).

4 See Martindell v. News Group Publications, Inc., 621 F.Supp. 672 (E.D.N.Y. 1985); Engbrecht v. Dairy Queen Co., 203 F. Supp. 714, 719 (D. Kan. 1962). A manufacturer who engages in coercion in connection with suggested retail prices is guilty of a per se violation of Section 1 of the Sherman Act. In determining whether coercion is present, courts often look to see if the distributor or franchisee's pricing independence has been infringed, paying particular attention to threats of sanction for non-compliance (see Yentsch v. Texaco, Inc., 630 F.2d 46, 53 (2d Cir. 1980); Bowen v. New York News, Inc., 522 F.2d 1242, 1254 (2d Cir. 1975), cert. denied, 425 U.S. 936 (1976); Girardi v. Gates Rubber Co., 325 F.2d 196, 198 (9th Cir. 1963)), use of sanctions for non-compliance (see Lehrman v. Gulf Oil Corp., 464 F.2d 26, 38 (5th Cir.), cert. denied, 409 U.S. 1077 (1972)), policing of distributors or franchisees (see Interphoto Corp. v. Minolta Corp., 295 F. Supp. 711, 716 (S.D.N.Y.), aff'd per curiam, 417 F.2d 621 (2d Cir. 1969)), and the use of short-term leases and contracts (see Sahm v. V-1 Oil Co., 402 F.2d 69, 71-72 (10th Cir. 1968)).

5 Many circuits have held that in doing so a manufacturer does not violate antitrust law. See Acquaire v. Canada Dry Bottling Co., 24 F.3d 401 (2d Cir 1994) (holding that the manufacturer should be allowed to implement reasonable procedures to ensure that the discount is in fact passed along to the retailer); Lehrman v. Gulf Oil Corp., 464 F.2d 26, 36-37 (5th Cir.), cert. denied, 409 U.S. 1077 (1972) ("The supplier has a legitimate interest in satisfying himself that . . . retailers of the supplier's own product are charging no more than the price they have represented as being competitively necessary and as requiring wholesale price support"); Jack Walters & Sons Corp., v. Morton Bldg., Inc., 737 F.2d 698 (7th Cir.), cert. denied, 469 U.S. 1018 (1984); Lewis Service Center, Inc. v. Mack Trucks, Inc., 714 F.2d 842 (8th Cir. 1983) AAA Liquors, Inc. v. Joseph E. Seagram & Sons, Inc., 705 F.2d 1203 (10th Cir. 1982).

6 Traditionally, this practice was viewed as per se unlawful by the Federal Trade Commission, however it is now viewed as subject to a rule of reason approach. See Statement of Policy Regarding Price Restructuring in Cooperative Advertising Programs rescinded, 4 Trade Reg. Rep. (CCH) 39,057 (May 21, 1987) (adopting a rule of reason approach).

7 To prohibit distributors from actually representing competing manufacturers risks problems under exclusive dealing. See endnote 14, infra.

8 15 U.S.C.A. § 13.

9 See, e.g., United States v. Arnold, Schwinn & Co., 388 U.S. 365, 376 (1977) (noting in dicta that a supplier may utilize exclusive distributors "if competitive products are readily available to others"); GTE Sylvania, Inc. v. Continental T.V., Inc., 537 F.2d 980, 997 (9th Cir. 1976) (en banc), aff'd, 433 U.S. 36 (1977).

10 See Golden Gate Acceptance Corp. v. General Motors Corp., 597 F.2d 676, 679 n.4 (9th Cir. 1979) (holding that a franchise restriction that prohibited the plaintiff from establishing a business anywhere but where the Statement of Dealership Premises dictated was not an unreasonable restraint of trade because "the initial location was agreed to by both parties and the manufacturer's intent was to provide an effective network of qualified sales and service dealerships").

11 See, e.g. Kestenbaum v. Falstaff Brewing Corp., 575 F.2d 564, 572-73 (5th Cir. 1978), cert. denied, 440 U.S. 909 (1979).

12 See Eiberger v. Sony Corp. of America, 622 F.2d 1068, 1076-81 (2d Cir. 1980).

13 A manufacturer may also use covenants not to compete or non-competition clauses to preclude a distributor from representing a reasonably defined competing product in a reasonably crafted geographic area for a reasonable period of time following termination/expiration of the distributor relationship. See Paramount Termite Control, Inc. v. Rector, 238 Va. 171, 174, 380 S.E.2d 922 (1989).

14 In contrast to exclusive territories, exclusive dealing arrangements, whereby a distributor cannot carry goods or services of another competing manufacturer may be illegal under the antitrust law if it reduces competition, for example, when a given distributor is the only effective distributor of a class of products within a geographic market. See von Kalinowski et al., Antitrust Laws and Trade Regulation: Desk Edition § 2.04[5][b][i] (2d ed. 2000).

15 Id.

16 See Donald B. Rice Tire Co. v. Michelin Tire Corp., 638 F.2d 15 (4th Cir.), cert. denied, 454 U.S. 864 (1981); Sports Ctr., Inc. v. Riddell, Inc., 673 F.2d 786 (5th Cir. 1982). A manufacturer need not show that the restriction was the least restrictive means to achieving the objective. See, e.g., Graphic Prods. Distribs., Inc. v. Itek Corp., 717 F.2d 1560 (11th Cir. 1983). Dual distributorships are usually viewed as a vertical restraint subject to a rule of reason analysis. See Smalley & Co. v. Emerson & Cumming, Inc., 13 F.3d 366 (10th Cir. 1993).

17 See Klor's, Inc. v. Broadway-Hale Stores, Inc., 359 U.S. 207, 212, 79 S.Ct. 705 (1959).

18 See Maximus, Inc. v. Lockheed Information Management Systems Company, Inc., 254 Va. 408, 413, 493 S.E. 2d 375 (1997).

19 See Va. Code Ann. § 18.2-499 (West 1991); Worrie v. Boze, 198 Va. 533, 540, 95 S.E.2d 192 (1956).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.