By Brian D. Kaider, Esq.
Many early stage wineries market their products via tasting room sales, wine clubs, direct-to-consumer shipments and, to the extent permitted, self-distribution to local restaurants, grocery stores, and wine stores. Eventually, winery growth will necessitate working with a distributor, a relationship not to be entered into lightly. A distributor becomes an ambassador for the winery’s brand and, once retained, the supplier may have little control over how its wine is marketed. Further, these relationships can be difficult or financially impossible to break once established.
Supplier/distributor relationships are governed by franchise laws in many states. In the absence of franchise laws, the relationship is defined entirely by a distribution agreement between the parties. But, even in franchise states, the distribution agreement can play a critical role, particularly in the termination of the distributor relationship.
Too often, however, wineries accept a distributor’s “standard” agreement and when the relationship sours, the supplier finds that they are stuck with no viable option to terminate. The best practice is to engage an experienced attorney to negotiate the terms of the distribution agreement. While even the best attorney cannot evade state franchise laws (which generally prohibit a distributor from waiving its rights), there are ways an attorney may help bring balance to the supplier/distributor relationship. Some of the key terms to negotiate include termination, territory, brand scope, and exclusivity.
The most critical section of the agreement sets forth the manner and circumstances under which a supplier may terminate the distributor. In a franchise state, the law typically says that a supplier may terminate for “good cause.” If good cause is defined in the law, it is paramount that the distribution agreement mirror the language of the law, because in many cases, a contract that contradicts the law will be held invalid, leaving the supplier in the position of effectively not having an agreement at all.
For example, the Virginia Wine Franchise Act states that good cause includes “failure by the wholesaler to substantially comply, without reasonable cause or justification, with any reasonable and material requirement imposed upon him in writing by the winery.” Further, the Act provides, “good cause shall not be construed to exist without a finding of a material deficiency for which the wholesaler is responsible.” Tracking that language, a distribution agreement in Virginia should clearly define the distributor’s obligations, such as meeting certain performance goals, as “material requirements” and explicitly define certain actions, such as mishandling of the product, as “material deficiencies.”
When the law does not define good cause, and in non-franchise states, it is essential for the distribution agreement to do so. The contract should clearly set forth the distributor’s requirements that are critical to the business relationship and for which failure to perform will be grounds for termination. Examples of common requirements include: meeting specified sales and marketing goals, maintaining appropriate records and reports regarding inventory and sales, transporting and storing the product under specified temperature and lighting conditions, exercising adequate quality control measures to ensure product freshness, and paying invoices within a specified time frame. It is also common to include termination rights if the distributor is declared bankrupt, enters a voluntary petition for bankruptcy, enters into a compromise or agreement for the benefit of its creditors, or fails to maintain in good standing all Federal and State licenses and permits necessary for the proper conduct of its business.
In some cases, sale of the distributor or even a change in the ownership structure may be justification for termination. For example, if an acquiring distributor has a much larger portfolio, especially if some brands are direct competitors, the supplier may have grounds to object to the acquisition. While not always allowing a supplier to terminate the distributor, this period during which a supplier may object can provide an opportunity to negotiate with the new distributor to sign a more favorable agreement.
In some franchise states, a supplier must compensate the distributor for the lost business even if the supplier is able to terminate for cause. Sometimes the law simply says the supplier must pay the distributor the “fair market value” of the distribution rights. There can be an expensive battle just to determine that compensation if fair market value is not defined in the distribution agreement. Often, the value is defined as a percentage of the prior year’s case volume multiplied by some dollar amount per case. The “standard” contracts pushed by some distributors can be very severe in this section. In the beer industry, it is not uncommon to see values set at an entire year’s worth of profits times a multiplier that can range from 1.5 to many times higher. In practice, often a new distributor will buy out the distribution rights from the old distributor, but if the supplier wants to return to self-distribution, this buy-out provision may be cost prohibitive.
Depending on the size, experience, and reach of the distributor, there may be an opportunity to creatively carve out different territories. Territories are most commonly limited to certain states. However, a supplier may be able to limit a smaller distributor to certain counties or even specific types of establishments (grocery stores, but not restaurants, for example). One of the clearest breaches of the distribution agreement, that may constitute good cause for termination, is for a distributor to make sales outside of its contracted territory.
The growth of direct-to-consumer (DtC) sales is one of the biggest threats to the distributor’s business model in the wine industry. According to the 2017 Direct to Consumer Wine Shipping Report (www.dtcreport.com), the 2016 volume of direct-to-consumer wine shipments increased by 17.1% to 5.02 million cases. To mitigate this risk, it is becoming increasingly common for distributors to seek limitations on such sales within their territories in the distribution agreement. Since small wineries make up the fastest-growing segment of these DtC sales, they should carefully evaluate the business case for this type of restriction.
Generally, when a distributor is hired to carry a winery’s brand, it has the right to all of the products in that brand. But exactly what constitutes a “brand” is unclear both in the statutory language of most state franchise laws and in many distribution agreements. For example, Boordy Vineyards, the first commercial winery in the State of Maryland, sells three “series” of wines, a Landmark series, a Chesapeake Icons series, and a Sweetland Cellars series. The labels on the first two series includes the Boordy Vineyards logo (the name in gold lettering in a black rectangle), but the Sweetland Cellars wines do not (see below). In fact, the only indication that the Sweetland Cellars wines are made by Boordy is a statement to that effect in small print on the back label.
The question is whether the Boordy wines are all a single brand, two brands (one that includes the Landmark and Chesapeake Icons series, since they both carry the Boordy logo and the other being the Sweetland Cellars series, which does not), or three separate brands. Since Maryland does not have a franchise law with respect to wines, the parties are essentially free to define the brands as they wish in their distribution agreement. Failing to make an explicit definition can leave open to interpretation whether the agreement covers the winery’s entire repertoire of products or only a subset. That vagueness can be costly if a dispute arises between a winery and distributor. For what it’s worth, all of Boordy’s wines are managed by a single distributor, though it does hold back a few of the Landmark series wines for sale exclusively through the winery.
Maryland does, however, have a beer franchise law and while “brand” is not explicitly defined, the law appears to favor the distributor in terms of brand scope. Specifically, section 105 of Maryland’s Beer Franchise Fair Dealing Act prohibits a brewery from entering into a beer franchise agreement with more than one distributor for “its brand or brands of beer” in a given territory. One might argue that the language “or brands” means that the first distributor has the right to all brands of the manufacturer in a given territory. In fact, that very issue was litigated in the 1985 case of Erwin and Shafer, Inc. v. Pabst Brewing Co., Inc. and Judge Couch, writing for the panel of The Court of Appeal of Maryland, disagreed. The court held that if a brewery retained a distributor to handle one or more of its brands within a territory, it could not then contract with a second distributor within the territory for those same brands. It could, however, contract with a second distributor to carry a different set of brands.
How far the court would take its interpretation of what is a “brand” is unclear, however. In the Pabst case, the first distributor was given the right to distribute Pabst brand beers, but Pabst later merged with Olympia Brewing Company and gave the second distributor the right to sell its newly acquired Hamm’s brand beers. Whether the court would have allowed the brewery to contract with one distributor for Pabst and another for Pabst Extra Light it did not say.
Even if rights under a distribution agreement cannot be divided by brand (as in the case of the beer franchise law in Maryland), some states may nevertheless allow a supplier to contract with more than one distributor within a territory. If permitted in their state, a winery should ideally enter into all of its distribution agreements for a given territory simultaneously, providing notice to each distributor. At a minimum, the winery should ensure that the first agreement entered into is explicitly designated as non-exclusive. Otherwise, the distributor may view the agreement as giving it exclusive rights to the territory and could sue the winery for diminishing the distributor’s business if it were to engage a second distributor in that territory.
Whether a winery is in a franchise state or not, it is critical that it review and negotiate its distribution agreements carefully, with the assistance of an experienced attorney. It is also important to remember that the supplier’s diligence does not end when the agreement is signed. No matter how well the terms of the distribution agreement are negotiated and drafted, they are effectively useless if the supplier cannot back up its claims for good cause. Accordingly, thorough documentation is essential. If a distributor is not meeting sales goals, mishandling product, or failing to provide adequate reports, they must be given written notice of those deficiencies each time they occur.
There are great distributors out there who become essential partners in a winery’s business. But, sometimes those relationships can turn sour and signing an agreement without anticipating complications down the line can make it virtually impossible to sever those ties. A little forethought and planning and a lot of diligence will go a long way toward a successful termination of a bad relationship.
Brian Kaider is a principal of KaiderLaw, an intellectual property law firm with extensive experience in the craft beverage industry. He has represented clients from the smallest of start-up breweries to Fortune 500 corporations in the navigation of regulatory requirements, drafting and negotiating contracts, prosecuting trademark and patent applications, and complex commercial litigation.