United States: Due Diligence in Acquisitions: Focus on Product Distribution Issues

Despite the efficiency and other benefits that would result from a consistent set of regulations governing the relationship between suppliers and distributors, various U.S. states have created a patchwork set of rules that vary not only from state to state but also depending upon the precise nature of the relationship between the supplier and the channel member. Moreover, some states regulate the relationship by statue and some by the common law. Typically in states that regulate the distribution relationship, the state statute will supersede the terms of any written agreement and render void any contractual terms that conflict with the statutory rights. Also, such regulations will require that there be a showing of good cause before the supplier may terminate or non-renew any agreement, even where the written agreement is for a fixed term or is terminable at will. In addition, these state statues will preclude "opting out" of the state statute by the election of the law of another state - or even country - in the contract. Care must therefore be exercised before an acquiror relies on merely the written terms of distribution agreements with the channel members of the seller of the company or product line.

The business entities with the most protection under state laws are "franchisees." In most state franchise statutes, a "franchise" means a contract or agreement, either express or implied, written or oral, between two or more persons by which: (1) a franchisee is granted the right to engage in the business of proffering, selling, or distributing goods or services under a marketing plan or system prescribed in substantial part by the franchisor; (2) the operation of the franchise business pursuant to that plan or system is substantially associated with the franchisor's trademark, service mark, trade name, logotype, advertising, or other commercial symbol designating the franchisor; and (3) the franchisee is required to pay, directly or indirectly, a franchise fee.

The definition of a dealer will vary from state to state, but in general, a dealer is an independent business which buys and resells goods to retail customers, absorbs the expenses of sale, bears the credit risk, stocks inventory, and sets the price for the sale of goods. Although dealers do not receive the same amount of statutory protection as "franchisees," dealers do enjoy statutory protection from several states. Often times, resellers of products, though referred to as dealers or distributors, will nonetheless be considered franchisees.

The state most notable for its breadth of protection is Wisconsin. Other states that provide protection to dealers are: California, Maine, Maryland, and Puerto Rico. The Puerto Rican statute is virtually as broad as the Wisconsin statute. The Maine and Maryland statutes only apply to specific types of dealers. California has a statute that applies to all dealers, but it only prohibits discrimination in terminating, granting, renewing, etc., based on race, color, religion, national origin, ancestry, or sex.

Sales representatives are distinguished from franchisees and dealers based on the way in which they do business. Sales representatives procure orders for the supplier, but do not set price, do not bear the credit risk, and do not stock inventory. Sales representatives receive the least amount of statutory protection. Only one state - Minnesota - and one territory - Puerto Rico - have statutes that require "good cause" for termination of the sales representative.

Given the complexities of the American economy and the way that goods get to market, there are numerous distribution channel members that do not fall neatly into any of these categories. There are non-stocking distributors who buy and sell out of the supplier's inventory, stocking sales representatives, sales representatives who stock parts, and distributors who buy and resell some of the supplier's products and solicit sales for others. There is no way to categorize these channel members until all of the facts are known. At that point, there still may be no certainty until a court or jury decides the issue.

Once the acquiror determines the character of the channel members, the acquiror then needs to determine whether or not it proposes to continue business dealings with the channel members. Sometimes, the supplier wishes to obtain an entirely new system of distribution, and thus the asset of the distribution network is the essence of the acquisition. Other times, the products of the selling supplier are what is most important, and the buyer has no wish to, and in fact conditions the purchase upon, not having to deal with the seller's channel members.

The buyer should assemble all distribution agreements in the possession of the seller. These agreements should be reviewed in detail to determine whether there is a specific provision that permits the termination of the relationship by the seller in the event of the sale of the sale of the company or of a product line. Unfortunately, such contract language is rare. The buyer must then examine the state law applicable to the channel member. State law may give the channel member the right to the continuation of the relationship, even though the written contract may specify that it has a fixed term or may be terminated without cause. The seller needs to be assured that if the buyer does not wish to continue doing business with the channel member, the termination of the relationship upon the sale does not result in liability on the part of the seller resulting from the termination. After all, the channel member is a party to a contract - perhaps for a considerable fixed term yet to come - under which the supplier has agreed to make and sell certain described products to the channel member. Although in some instances it may be persuasively argued that the sale of a product line or the assets of the business constitutes sufficient cause for the termination of a contract or perhaps creates impossibility of performance, basic contract law could lead to a claim by the channel member that the sale of the business without compensation to the channel member constitutes a breach of contract, at least where the buyer does not continue doing business with the distributors who have sold the product line in the past. Thus, the seller will either want to assure itself that it is being relieved of responsibility under the distribution contracts or that the buyer will assume the distribution contracts and continue dealing with the distribution channel. Frequently, this then becomes the subject of considerable negotiation between the buyer and the seller. Both buyer and seller should thus investigate to determine whether channel members are located in a regulated state or do business in a state where the grant of territory triggers a state regulation. The parties should examine whether or not there is an industry-specific statute that could have an impact on whether the distribution relationship survives the asset sale.

As part of the due diligence effort, the buyer should determine whether there is a written contract, whether it is expired, and whether it has been changed by oral agreements or by a course of dealing. This is obviously very difficult to determine, but, from time to time, oral agreements or a course of dealing are referred to or incorporated into correspondence. They also may be recalled by existing employees of the seller. In addition, both parties should determine whether or not there are published terms of dealing, catalogs or product literature that contain potential contract terms.

An additional problem for the buyer in an acquisition is the potential that the distribution agreements to be inherited from the seller do not specifically define which of the seller's products the channel member is entitled to sell. For example, the seller's distribution contract may provide that the channel members are entitled to sell "all of the supplier's products that are manufactured from time to time." This is not an atypical provision in some distribution agreements. Then further suppose that the acquiror wishes to retain the seller's distribution network for the sale of the acquired products, but not for the acquiror's products. The typical result will be that the buyer will receive an assignment of the distribution agreements either as a specific assignment of contract rights or, more frequently, pursuant to the general assignment of contract rights.

This scenario presents a potential problem for the acquiror because the channel members of the seller could conceivably argue that, as a result of the contract assignment, the acquiror steps into the shoes of the seller. The acquired distributor then contends that it is entitled to sell all of the products manufactured by the acquiror pursuant to the granting clause quoted above as contained in the seller's distribution agreement. In such a case, the buyer either needs to secure indemnification protection from the seller or must insist upon the seller modifying the distribution agreements prior to assignment to the buyer.

Many times product liability exposure for past products operates as an impediment to the completion of otherwise sensible acquisitions. The following are several steps that a buyer can take to protect itself against incurring unnecessary product liability risk.

First, the buyer should determine the solvency of the potential seller. If the seller continues in business but is only marginally solvent or if the seller does not continue in business, plaintiffs in product liability suits likely will cast about for successor liability. What constitutes successor product liability is going to vary among the laws of the various states. In general, however, if the product line is carried on under the same trademark using the same facilities and in all other ways appears to the consuming public as if nothing had changed in the process, successor product liability is more likely to be imposed under state law.

A potential buyer should also review the primary terms of all liability-related insurance policies to determine whether or not insurance coverage for existing products is adequate. The buyer should determine whether or not the existing insurance policies are "occurrence" or "claims made" policies. A "claims made" policy will only cover those claims that are actually made during the policy period and does not provide the kind of coverage that a buyer desires and receives under an "occurrence" policy. In any event, the acquiring company should consider purchasing a policy that protects against residual claims made as a result of products manufactured prior to the date of the acquisition. As a practical matter, the acquiror's risk management officers and insurance brokers should be brought into the planning process before the definitive acquisition agreement is drawn up.

As a matter of due diligence, the buyer should review the seller's product liability history and, in particular, claims for the past five years. The buyer should also examine the seller's files of customer complaints to determine whether or not complaints could be related to product problems or defects that would be suggestive of a larger product liability problem. A buyer should also search electronic databases for cases involving the products of the target company and its competitors to see whether or not there are class action cases, industry liability cases, or other incipient claims that could come to fruition after the acquisition.

The potential buyer should also look at the seller's manufacturing processes. Product liability claims can be minimized to the extent that quality control procedures are in place and followed. It also helps in defending against product liability claims if the seller has maintained adequate records of inspection and testing. A buyer should also determine whether or not the manufacturing processes have built into the products the ease of traceability of the product and its components. The buyer should ask whether or not products are coded to show production locale and date to allow for traceability. In particular, the buyer should ask whether or not the seller has instituted systems to differentiate between the sources of component products if the manufacturer utilizes more than a single source for component products.

A buyer should also determine whether or not there are any industry or governmental standards that regulate the products and whether the products comply. Among the regulations that are likely to apply are the warnings standards of the American National Standards Institute. In particular, the potential buyer should determine whether or not the warnings have been made bilingual and the process by which the warnings have been created. Have the warnings been created through the use of a focus group or have they been tested with employees or dealers?

When the acquisition is accomplished by virtue of a stock purchase, the buyer is assuming all potential liabilities that exist with respect to the seller's prior products. While these liabilities could include product liability, they may also include unknown commercial liability for the failure of the products - or groups of products - to work as intended. As a result, a buyer should examine the seller's terms and conditions of sale and order entry process to make sure that the seller has not created contractual obligations beyond those set forth in the manufacturer's stated terms and conditions of sale. For example, does the order entry process deal with purchase orders, the terms of which may be in conflict with the manufacturer's terms and conditions of sale as embodied in quotations or order acknowledgments? The endemic failure of a group of products that was the subject of a master purchase order whose terms varied from the quotation of the seller could create a multi-million dollar claim, which is unanticipated by the acquiror. The acquiror may have a difficult time ascertaining all such potential liability and, therefore, the acquiror may demand a warranty that the obligations with respect to the products are limited to the standard terms and conditions of sale. The acquiror may also demand an indemnification to the extent that such claims are made and create liability beyond the standard terms and conditions of sale.

As an incidental matter, the acquiror should also obtain a representation that the seller has paid all applicable sales and use taxes in connection with the prior sale of the products.

An acquiror must determine whether or not the target company is subject to regulation by an administrative agency. For example, are the seller's products regulated by the Consumer Product Safety Commission, the U.S. Food and Drug Administration, the United States Coast Guard, the National Highway Safety and Traffic Administration, or any one of a number of other agencies? If the target company is subject to such regulation, the acquiror should verify that the target has complied with the reporting requirements imposed by such agencies. Conversely, the acquiror should determine whether or not the target has failed to report a problem in the past and the likely potential exposure for such failure. Beyond simply verifying compliance, the acquiror should also determine the target's reputation with the applicable agency. A telephone call to staff members of the agency or commission may disclose information about the target company's reputation that would be very helpful. An acquiror may also consider making a Freedom of Information Act request for documents related to the target corporation.

Beyond simple agency jurisdiction, the acquiror should also determine whether or not the target has conducted a recall in the past or whether a recall has been discussed for existing products. Has everything been completed? Are there any contingent responsibilities? Is there a regulatory agency investigating the industry as a whole and the target in particular?