October 200012

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 shelfspace and operating out of their own vans in local, exclusive territories. More recently,with geographic expansion beyond the Mid-Atlantic and facility expansion with newproduction and warehouse space, Lincoln’s distribution has changed in several ways.Lincoln recruits fewer small distributors; no longer grants exclusive territories; sells tolarger, 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 cookiesto stores on Johnson’s route in violation of his exclusive rights. Further, one ofJohnson’s customers asked Johnson to meet or beat Stowe’s price, a price belowJohnson’s cost, prompting Johnson to complain that Lincoln sells cookies to Stowe at alower price. Another one of the original distributors, Frederick Douglas, complains thathe has lost sales on his route to a newer distributor, William Seward, who markets overthe Internet. Lincoln did not tell Seward of any exclusive territories when it recruitedSeward, and Seward contends that he can market anywhere he wants. Douglas alsocomplained that Seward takes unfair advantage of, and is “free riding” on, the advertis-ing dollars that Douglas spends in his territory. Lincoln hates to get involved in inter-distributor rivalries and wishes that Douglas and Seward would work it out amongthemselves, but will resort to distributor termination if necessary.

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

Lincoln is also concerned that many of its distributors have begun selling ThaddeusStevens cookies. Lincoln’s traditional marketing plan is to distinguish its gourmet cook-ies from “discount” cookies of higher-volume bakeries like Stevens. Lincoln does notwant cooperative advertising dollars that it provides to its distributors to be spent onadvertising that may benefit Stevens. Further, Lincoln wishes to ensure that its distribu-tors make a good faith effort to sell its cookies.

F E A T U R E S | A N T I T R U S T , F R A N C H I S E A N D T R A D E R E G U L A T I O N

by Gregory T. St. Ours

Distribution Policies: Choosing ACourse for Manufacturers

Distribution Policies: Choosing ACourse for Manufacturers

In this environment,

risk management

in distribution is

not a luxury but a

necessity . . .

Virginia Lawyer 13

Finally, Lincoln is distressed over the actions of a few distribu-tors who sell Lincoln cookies at lower prices. Lincoln fears thatthe market may perceive that its cookies are no longer

“gourmet.” Lincoln is considering mandatory resale pricing todefend its reputation as a top quality cookie bakery.

Distribution is fraught with these and other problems, compli-cated by common law and federal and state statutes governingantitrust, price discrimination, dealer termination, franchise, salesagency, business relationship, commercial transactions, and othertrade regulation. In this environment, risk management in distri-bution is not a luxury but a necessity, whether the client is amanufacturer of goods or a provider of services, whether theproducts or services include a trademark, patent or other intel-lectual property, whether the client uses distributors, dealers,brokers, franchisees, sales agents, or other middlemen, andwhether the client deliberately plans a distribution network atthe outset, or the client has outgrown, or is frustrated by, itsoriginal, ad hoc network and needs a more sophisticated, uni-form distribution policy.1

This article provides a cursory overview of some of these distri-bution issues for the purpose of ready identification by the gen-eral practitioner (not to cover all of the issues or all of the risksor substantive law associated with these issues); a partial samplechecklist of issues which a manufacturer such as Lincoln can useto evaluate how to handle distribution; and a short-form distribu-tion policy.

Distribution Issues

Pricing

Whether for product reputation, network profitability or otherreason, a manufacturer such as Lincoln often wants its distribu-tors to sell its products at a uniform price. With the exception of“maximum” resale prices, however, mandating resale prices isconsidered illegal price fixing between the manufacturer and itsdistributors.2

A manufacturer, however, may publish a suggested resale price,so long as it does not coerce distributors to meet the price.3

A manufacturer may also require distributors to pass through anyprice discount that the distributors receive from the manufac-turer.4

Advertising

A manufacturer may establish and fund cooperative advertisingand may even require its distributors to advertise the suggestedresale price as a condition to receiving cooperative funds. Amanufacturer may not, however, condition cooperative advertis-ing dollars on distributors actually charging the resale price setby the manufacturer.5 Under Lincoln’s scenario, Lincoln mayrequire that its distributors use cooperative funds to advertiseonly Lincoln’s cookies and exclude competitors from the adver-tising.6

Price Discrimination

One of Lincoln’s distributors, Johnson, suspects that Lincoln soldits cookies to another distributor, Stowe, at a lower cost than thecost 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 ele-ments, that Lincoln sold commodities of like grade and quality tothe two distributors at a different price that lessened competi-tion.7

To avoid this exposure, Lincoln should not charge differentprices unless it can attribute the cost differential to specific costsavings in dealing with Stowe (for example, savings attributableto enhanced distribution services in warehousing, billing, deliv-ery and other areas) or one of the other narrow defenses underRobinson-Patman.

Franchises

In another article in this issue of the Virginia Lawyer, R. ScottCaulkins addresses some of the advantages and disadvantages ofa franchise system. This article will not expand on this beyondnoting that if a manufacturer such as Lincoln elects not to set upa franchise distribution system, it should avoid the trappings of afranchise so that it is not re-characterized as a franchisor subjectto federal and state franchise laws. The three-part FTC test notedby Caulkins in his article offers a useful guide to these elements,including: use of the manufacturer’s trademarks; significant con-trol or assistance by the manufacturer; and a franchise fee orpayment other than the cost to buy the manufacturer’s product.

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A manufacturer, however, may publish a suggested resale price, so long

as it does not coerce distributors to meet the price.

continued on page 14

October 200014

Exclusive Territories

Another decision for a manufacturer, present in Lincoln’s sce-nario, is whether to promise each distributor that it will be theonly distributor of the manufacturer’s product within a givenarea. If a manufacturer promises an exclusive territory, it can fos-ter investment in marketing, service, etc., by the local distributorbecause it has barred other distributors from free riding on thatinvestment. In contrast, non-exclusive territories allow greatersaturation of a product in the market yielding greater exposureand sales for the manufacturer. Generally, exclusive and non-exclusive territories are legal.8

Similar to exclusive territories are location clauses which dictatethe geographic location from which a dealer or distributor maysell a manufacturer’s product. Again, such clauses are generallylegal.9

Areas of Primary Responsibility

Another way to address the free rider problem, short of exclu-sive territories, is to designate an area of primary responsibilityto each distributor while not interfering with each distributor’sability to sell beyond its primary area. Through incentives orrequirements, the manufacturer can promote distributor invest-ment in each primary area, yet the manufacturer can enjoy theadvantages of greater market saturation and increased aggregatesales associated with non-exclusive territories. In the sample pol-icy set forth below, Lincoln assigns zip codes to its distributors,not as exclusive territories but as the reference point for salesand service leads. Lincoln could also hold its distributorsaccountable for various duties such as marketing within theirrespective primary areas. Assignment of areas of primary respon-sibility is generally legal.10

Profit Pass-Over Systems

Short of buying out the exclusive territories from its older distrib-utors 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 pri-mary responsibility for each distributor. If a distributor soldLincoln’s cookies in another distributor’s primary area, that dis-tributor would pay to Lincoln a portion of the profits from thesale. Lincoln could then use all or part of the payment to com-pensate the local distributor, encouraging investment in market-ing and goodwill and preventing the free rider problem. Profitpass-overs are legal as long as the amount that the distributor isrequired to pay is reasonable in relation to the amount of adver-tising, goodwill, etc. performed by the primary area distributor.11

Exclusive Dealing and Royalty Provisions

To prevent a competing manufacturer, such as Stevens, fromusing Lincoln’s distribution network, Lincoln can limit or prohibitits distributors from selling competing products.12 Known asexclusive dealing, this practice is generally legal.13 Significantrisks arise with exclusive dealing provisions, however, ifLincoln’s distributors are the only efficient conduits to the retailmarket and the exclusive dealing effectively blocks competingmanufacturers from the market.14

Corporate/National Accounts—Dual Distribution

Many manufacturers like Lincoln operate a dual distribution sys-tem under which the manufacturer sells to distributors but alsoreserves to itself (or one or a few of its distributors) sales tolarge regional or national customers. Dual distribution systemsare generally legal,15 but since the manufacturer (or national dis-tributor) competes with the other distributors, antitrust issues andprice discrimination under the Robinson-Patman Act are potentialadverse factors.

Credit Policies

Manufacturers often extend credit to their distributors. To mini-mize the legal risks associated with dealer termination andrelated statutes, yet empower a manufacturer to terminate forfailure to pay a credit account, a distribution policy shouldexpressly permit termination for non-payment. Lincoln’s sce-nario, however, is not limited to direct sanctions for violation ofcredit terms. Lincoln also wants to exact reimbursement fromStanton, a former distributor, through leverage against Barton, acurrent distributor, who has set up Stanton as its sub-dealer.Should Lincoln treat Barton unlike other distributors or refuse todeal with Barton altogether, Lincoln could expose itself to breachof contract, antitrust and other dealer termination claims.16

Lincoln may also face exposure for a claim by Stanton of tortiousinterference with contract17 or conspiracy.18

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Another decision for amanufacturer . . .is whether to promise each

distributor that it will bethe only distributor of the

manufacturer’s productwithin a given area.

Virginia Lawyer 15

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

Sample Distribution Policy

The Mary Todd Lincoln Baking CompanyDistribution Policy

Distributor: A distributor of the Mary Todd Lincoln BakingCompany is an independent business entity that purchases andstocks and then resells cookies and other products manufacturedby the Company. The Company has sole discretion in the selec-tion and termination of distributors and in the assignment ofareas of primary responsibility.

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

Areas of Primary Responsibility: The Company assigns a setof adjacent zip codes to each distributor as the distributor’s Areaof Primary Responsibility. The Company refers sales and serviceleads and delegates marketing responsibilities by each distribu-tor’s Area of Primary Responsibility.

Credit: The Company may extend credit to its distributors withthe understanding that, among other remedies, it may terminateand refuse to deal with any distributor who becomes delinquentin credit payments.

Expectations of Distributors: The Company expects its distrib-utors to use good faith and best efforts in striving to market andsell the products of the Company. In order to satisfy theseexpectations all distributors shall:

• Develop and implement a marketing plan within the Area ofPrimary Responsibility.

• Maintain proper inventory of products so as to meet customerneeds expeditiously.

• Follow-up on all sales leads provided by the Company and/orother distributor(s) promptly.

• Participate in any sales/training programs and other seminarsheld by the Company as requested.

Cooperative Advertising: The Company may provide each dis-tributor with cooperative advertising funds. The distribution ofcooperative advertising funds will be at the sole discretion of theCompany, based on need and size of the Area of PrimaryResponsibility. Cooperative advertising funds provided by theCompany are not to be used in any advertisement or other mar-keting device that includes any mention of the name or productof a competitor of the Company.

Corporate and National Accounts: The Company reserves theright to sell its products directly to corporate and nationalaccounts. A corporate account is a customer that purchases theproduct directly from the Company, and the customer dispersesthe product among its own multiple locations regardless of theAreas of Primary Responsibility. A national account is a customerthat purchases the product from a distributor, and again the cus-tomer disperses among its multiple locations regardless of theAreas of Primary Responsibility.

Termination: The Company reserves the right to terminate orrefuse to deal with any person or entity, whether or not a dis-tributor, for any reason or no reason at all. Among other rea-sons, the Company may terminate or refuse to deal with any dis-tributor for failure to adhere to any policy outlined in theDistribution Policy. �

ENDNOTES

1 Manufacturers also face decisions on issues governing warranties, commercialtransactions, etc.

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

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Issues Checklist

With these issues in mind, a sample checklist of issueswhen 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?

continued on page 16

October 200016

3 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). Amanufacturer who engages in coercion in connection with suggested retailprices is guilty of a per se violation of Section 1 of the Sherman Act. In deter-mining whether coercion is present, courts often look to see if the distributoror franchisee’s pricing independence has been infringed, paying particularattention 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.2d1242, 1254 (2d Cir. 1975), cert. denied, 425 U.S. 936 (1976); Girardi v. GatesRubber Co., 325 F.2d 196, 198 (9th Cir. 1963)), use of sanctions for non-com-pliance (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 InterphotoCorp. v. Minolta Corp., 295 F. Supp. 711, 716 (S.D.N.Y.), aff’d per curiam, 417F.2d 621 (2d Cir. 1969)), and the use of short-term leases and contracts (seeSahm v. V-1 Oil Co., 402 F.2d 69, 71-72 (10th Cir. 1968)).

4 Many circuits have held that in doing so, a manufacturer does not violateantitrust law. See Acquaire v. Canada Dry Bottling Co., 24 F.3d 401 (2d Cir1994) (holding that the manufacturer should be allowed to implement rea-sonable procedures to ensure that the discount is in fact passed along to theretailer); 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 him-self that . . . retailers of the supplier’s own product are charging no morethan the price they have represented as being competitively necessary and asrequiring wholesale price support”); Jack Walters & Sons Corp., v. MortonBldg., Inc., 737 F.2d 698 (7th Cir.), cert. denied, 469 U.S. 1018 (1984); LewisService Center, Inc. v. Mack Trucks, Inc., 714 F.2d 842 (8th Cir. 1983) AAALiquors, Inc. v. Joseph E. Seagram & Sons, Inc., 705 F.2d 1203 (10th Cir. 1982).

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

6 To prohibit distributors from actually representing competing manufacturersrisks problems under exclusive dealing. See endnote 14, infra.

7 15 U.S.C.A. § 13.

8 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 competi-tive 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, 433U.S. 36 (1977).

9 See Golden Gate Acceptance Corp. v. General Motors Corp., 597 F.2d 676, 679n.4 (9th Cir. 1979) (holding that a franchise restriction that prohibited theplaintiff from establishing a business anywhere but where the Statement ofDealership Premises dictated was not an unreasonable restraint of tradebecause “the initial location was agreed to by both parties and the manufac-turer’s intent was to provide an effective network of qualified sales and ser-vice dealerships”).

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

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

12 A manufacturer may also use covenants not to compete or non-competition

clauses to preclude a distributor from representing a reasonably defined com-peting product in a reasonably crafted geographic area for a reasonableperiod of time following termination/expiration of the distributor relationship.See Paramount Termite Control, Inc. v. Rector, 238 Va. 171, 174, 380 S.E.2d922 (1989).

13 In contrast to exclusive territories, exclusive dealing arrangements, whereby adistributor 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 productswithin a geographic market. See von Kalinowski et al., Antitrust Laws andTrade Regulation: Desk Edition § 2.04[5][b][i] (2d ed. 2000).

14 Id.

15 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 (5thCir. 1982). A manufacturer need not show that the restriction was the leastrestrictive means to achieving the objective. See, e.g., Graphic Prods. Distribs.,Inc. v. Itek Corp., 717 F.2d 1560 (11th Cir. 1983). Dual distributorships areusually viewed as a vertical restraint subject to a rule of reason analysis. SeeSmalley & Co. v. Emerson & Cumming, Inc., 13 F.3d 366 (10th Cir. 1993).

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

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

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

F E A T U R E S | A N T I T R U S T , F R A N C H I S E A N D T R A D E R E G U L A T I O N

Gregory T. St. Ours joined the firm ofWharton, Aldhizer & Weaver, PLC,Harrisonburg, in December of 1985. Much ofhis practice is in commercial litigation, particu-larly antitrust, business torts, healthcare peerreview, contracts and construction. Personalinjury defense and some professional malprac-tice defense round out his litigation practice,and Mr. St. Ours provides counseling in all ofthese areas and corporate and health care risk

management. Mr. St. Ours was admitted to practice before the District ofColumbia Bar in 1983 and the Virginia Bar in 1984. Before joiningWharton, Aldhizer & Weaver, Mr. St. Ours practiced antitrust and corpo-rate law in Washington, D.C. from 1983 through 1985. Mr. St. Oursreceived his B.A. with distinction and his law degree from the Universityof Virginia.