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Bulletin

What You Need to Know Before Terminating a Distribution Agreement

Fasken
Reading Time 9 minute read
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Litigation and Dispute Resolution Bulletin

I. Introduction

As is the case for all contracts, distribution agreements may need to be terminated. This bulletin will provide an overview of the current law governing the termination of distribution agreements in Canada.  The provisions of Quebec Civil Code, which govern the termination of distribution agreements in that province, will be discussed separately.

II. How Difficult is it to Terminate for Cause?

Under Canadian law, in the absence of an express agreement between the parties regarding the termination of a distribution agreement, the parties must give reasonable notice before terminating the contract.  However, there are limited circumstances under which the parties will be able to terminate the distribution agreement for cause without notice.

Parties are free to negotiate express conditions which, if breached, provide one or both parties an excuse for non-performance of their obligations under the contract.  Thus, if a distribution agreement expressly provides that it can be terminated on the occurrence of certain events, a Canadian court will likely permit the termination of the contract without notice should those events occur.

Further, a distribution agreement can be terminated for cause without notice, even where the distribution agreement failed to expressly address this issue, if the cause amounts to a fundamental breach of the contract. The threshold for establishing a fundamental breach is high, given that such breach is considered a breach that "goes to the root of the contract". To determine whether a breach of contract amounts to a fundament breach, Canadian courts will consider the following factors:

  • the ratio of the party's obligation not performed to the obligation as a whole;
  • the seriousness of the breach to the innocent party;
  • the likelihood of repetition of the breach;
  • the seriousness of the consequence of the breach; and
  • the relationship of the part of the obligation performed to the whole obligation.

III. What Happens When the Agreement is Unwritten?

Canadian courts will recognize the validity of unwritten distribution agreements if there is some evidence that the parties intended to be bound by a distribution contract.  However, a failure to reduce the agreement to writing will affect the parties' ability to govern the terms upon which the agreement can be terminated and as such, a reasonable notice of termination period will likely be imposed on the parties. Nevertheless, if a party to the contract challenges the existence of an unwritten distribution agreement, the party seeking to enforce the agreement will have to submit evidence before the court to establish the existence of an oral contract.  A failure to prove that the parties had agreed to the essential terms of a distribution agreement is generally fatal to the plaintiff's claim for reasonable notice of termination.

IV. What Constitutes Reasonable Notice?

In cases where Canadian courts imply a term of reasonable notice to the termination of a distribution agreement, they will look to the circumstances of each case to determine what is "reasonable."  Factors to be considered in determining the appropriate amount of notice include:

  • the length of the association between the parties;
  • the dependency of the distributor on the principal's line of business;
  • the level of investment made by the distributor to distribute the principal's product, and the volume of business derived from the sale of the principal's product; and
  • the established practice, if any, in the trade or business.

The determination of what constitutes reasonable notice is highly dependant on the facts of each case, and as such, implied reasonable notice periods can vary widely. Nevertheless, a review of the jurisprudence reveals that Canadian courts most frequently imply a reasonable notice period in the order of twelve months, with 24 months generally being the upper limit.

V. Is there an Obligation of Good Faith?

Canadian courts have recognized the existence of a duty of good faith in a variety of contractual relationships, thus requiring the parties to exercise their contractual rights honestly and fairly. Two established categories where the courts have been willing to recognize a duty of good faith in the execution of contracts are:

  • when there is inherent vulnerability or a power imbalance in the contracting parties' relationship; and
  • in circumstances where the parameters of the parties' contractual relationship and conduct give rise to a duty of good faith.

Consequently, the termination of a distribution agreement on bad faith premises has the potential to attract judicial scrutiny in Canada.

However, Canadian courts have been hesitant to recognize a stand alone duty of good faith that operates independently from the express terms of the contract. Furthermore, the courts have emphasized that an implied duty of good faith should not be used to alter the express terms of a contract, including the right to terminate a distribution agreement on notice. In light of this, a manufacturer who terminates a distribution agreement in accordance with an express contractual provision that permits the termination of the agreement is likely to be protected from allegations that the contract was terminated on bad faith principles. However, given the courts' likely desire to protect the interests of distributors in the face of arbitrary or high-handed conduct by manufacturers, it is always prudent for a manufacturer to consider good faith principles when considering termination of a distribution agreement.

VI. When is an Injunction Available?

A distributor who disputes the circumstances under which a distribution agreement was terminated may seek an injunction to restrain the manufacturer from terminating the contract pending the determination of the dispute at trial. The availability of an interlocutory injunction will depend on whether the applicant can demonstrate the following:

  • there is a serious issue to be tried;
  • the party seeking the injunction will suffer irreparable harm if the injunction is not granted; and
  • the balance of convenience favours the granting of an injunction.

Under the first prong of the test, the threshold to establish a serious issue to be tried has been described as a low one.  However, subsequent cases have held that the standard to be applied will vary dependent on whether the injunction sought is characterized as a mandatory injunction or a prohibitory injunction. A mandatory injunction is an order that establishes a new right the parties had never agreed to, whereas a prohibitory order is simply an order requiring the parties to act in accordance with their agreement.  In circumstances where the injunction is characterized as a mandatory order, the applicant will be required to demonstrate a higher standard of a strong prima facie case under the first prong of the test.

In the context of distribution agreements, the jurisprudence regarding the standard to be applied under the first prong of the test has been divided. Some courts have held that an injunction preventing the termination of a distribution agreement was a mandatory order because it would have the effect of forcing the parties to continue to do business together. However, there is another line of decisions in which the courts have held that an order restraining the manufacturer from terminating the agreement pending trial was simply a continuation of the rights that had been agreed to under the existing agreement, and therefore, a prohibitive order. Evidently, a manufacturer who seeks to oppose an injunction will attempt to characterize the order as mandatory.

Under the second prong of the test, the party seeking the injunction must demonstrate that it will suffer irreparable harm if the injunction is not granted.  Irreparable harm is harm that cannot be quantified in monetary terms or which cannot be cured by damages, such as damage to a distributor's reputation or continued viability as a business.

Finally, the third prong of the test requires the court to determine which party will suffer the greater harm if the interlocutory injunction is either granted or denied pending a resolution at trial.  The factors considered at this stage of the analysis will vary. The courts have been reluctant to bind a manufacturer to a distribution contract when the relationship between the parties has clearly deteriorated, thus making it unlikely the distribution agreement would benefit either party.  However, in cases where the distributor's business relies almost entirely on the manufacturer's products and where the distribution agreement has been executed profitably over a number of years, it may be difficult for the manufacturer to tip the balance of convenience in its favour.

VII.  The Situation in the Province of Quebec

As Quebec is a civil law jurisdiction, there are therefore some important differences as a result of the provisions of Quebec Civil Code (CCQ) which govern distribution agreements.

As in the rest of Canada, parties in Quebec are free to negotiate express conditions which, if breached, provide one or both parties an excuse for non-performance of their obligations under the contract.

In Quebec, the right to terminate a distribution agreement is necessarily governed by the duty of good faith. Article 2805 of the CCQ assumes the existence of a duty of good faith. Furthermore, articles 6 and 7 of the CCQ state that "every person is bound to exercise his civil rights in good faith" and "no right may be exercised with the intent of injuring another or in an excessive and unreasonable manner which is contrary to the requirements of good faith."  Finally, article 1375 of the CCQ provides that the parties "shall conduct themselves in good faith both at the time the obligation is created and at the time it is performed or extinguished." (emphasis added).

Pursuant to this mandated duty of good faith, the courts will look for a material reason (a "serious reason" in the language of the CCQ) for termination, such as a fundamental breach of the contract by the distributor. Moreover, as in the rest of Canada, the parties must give reasonable notice of termination in Quebec. This too is derived from the obligation to exercise one's rights in good faith.

However, there are certain circumstances where the parties will be able to terminate the distribution agreement without notice, such as where specifically provided for by the parties.  Determining whether reasonable notice has to be given and what constitutes reasonable notice will depend on the facts and circumstances of each case. 

Consequently, the termination of a distribution agreement in bad faith, whether by the manufacturer or by the distributor, will attract judicial scrutiny in Quebec.  The party which has acted in bad faith will be liable as a result of the termination.

VIII. Conclusion

In the absence of an express provision in the distribution agreement that deals with the termination of the contract, Canadian courts will look to established contractual principles to govern the relationship between the parties. Examples of various tools that inform the analysis are the doctrine of fundamental breach, implied reasonable notice of termination, and an implied duty of good faith. Many of these doctrines will protect the distributor by preventing the manufacturer from terminating the distribution agreement on its terms. To avoid uncertainty and to maintain a greater degree of control over the contractual relationship, it is always preferable for manufacturers to clearly and expressly delineate the circumstances under which their distribution agreements can be terminated, entering into the relationship.

The author acknowledges with thanks the contributions of Noah Boudreau, associate, and Dylan Chochla, student-at-law.

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