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PATHCLEARER
An explanation for business colleagues1
By the in-house legal team
1. Introduction
Pathclearer is a name we have given to a new approach simplifying and
streamlining legal advice and entering into commercial contracts.
Pathclearer can be applied to most contracts that businesses such as ours
enter into.
In this paper, we explain generally how it works and how it applies to a few
typical commercial contracts that your businesses enter into, such as
procurement contracts, distribution agreements or marketing contracts.
2. What is Pathclearer?
The Pathclearer approach involves:

Sweeping away the usual legal verbiage, so that the really key points
of a business proposal can be seen clearly, and then

Creating short, simple contracts which contain the bare minimum of
words needed to deal with the key legal issues, rather than pages of turgid
legal “boilerplate”.
Contracts can secure extremely valuable rights for businesses. But we
believe that in today’s business world, lawyers are using overly detailed
contracts for too many business relationships.
This is not only slowing down businesses, and costing them more money.
It is also introducing new risks, because many commercial contracts have
become so long and complex that businesses do not fully understand what
they are entering into.
Pathclearer is much quicker, cheaper and simpler than the conventional
approach which lawyers tend to take.
It’s also more effective at managing legal risk, because it frees lawyers and
business people from reviewing hundreds of pages of words, which allows
then to think more clearly about real value issues and risks.
1
This was written for business colleagues by an in-house legal team. Last updated
April 2011.
Pathclearer has been developed by your in-house legal team based upon
years of experience and frustration with the conventional approach.
It has been successfully introduced into many parts of our business.
We try not to apply it in a dogmatic fashion – if there are strong reasons for
using a conventional, detailed contract then we will do so. We just start with
the assumption that we should use a short, simple contract, and we ask
anyone who disagrees to demonstrate why the more detailed approach is
truly necessary.
3. It sounds obvious, so why don’t all lawyers deal with contracts this
way?
To answer this, we have to look at how lawyers have historically come to be
involved in commercial contracts in Anglo-Saxon countries (USA and UK) and
in Continental Europe.
3.1 Anglo-Saxon Countries
Going back about 100 years ago, lawyers in Anglo-Saxon countries generally
did not get involved in commercial deals.
Business people often entered into legally binding deals merely by a
handshake. The concept of “my word is my bond” was widely accepted as
being as strong as any written contract.
Where written contracts were used by businesses, they tended to be created
by the business people themselves rather than lawyers. Business people did
not perceive that lawyers could add any value to their deals.
Back in these days, lawyers spent most of their time doing conveyancing of
real estate, wills and executries and assisting barristers in litigation.
It’s not clear when lawyers started to get involved in the world of commercial
deals. However, it seems likely that as soon as one business involved its
lawyer, other businesses felt the need to involve their lawyer, in order to “fight
fire with fire”.
There are now few areas of business in Anglo-Saxon countries where lawyers
do not get involved.
As a result, doing business in Anglo-Saxon countries has undoubtedly
become much more complex, time consuming and expensive than was
previously the case.
Some of this additional complexity has been unavoidable – it has been
caused by the need to pass laws to regulate the more complex relationships
that have arisen from our more developed economies and technological
advances.
For instance, laws to regulate international mergers, the handling of personal
data, money laundering, sophisticated financial transactions and the
protection of employees have all increased hugely over the past couple of
decades.
However, a large part of the additional complexity has been caused by the
over-detailed approach that Anglo-Saxon lawyers take when they get involved
in commercial deals.
This is what Pathclearer seeks to sweep away, in order to ensure that in these
increasingly competitive and fast-paced times for businesses, commercial
deals can be done quickly, simply and cheaply.
3.2 Continental Europe
Meanwhile, in Continental Europe, businesses and lawyers took a much more
sensible approach!
Until very recently, commercial contracts in Continental Europe tended to be
very short and straight-forward. Lawyers tended to allow their clients to rely
on the “common law” which is generally set out in a fair amount of details in
commercial codes of law (deriving from Roman law) in Continental European
countries.
Unfortunately, across the water, the Anglo-Saxon law firms were making so
much money out of their Anglo-Saxon clients, by focussing on minutiae and
creating excessively long contracts, that they were able to take over many of
the law firms of their Continental European cousins!
Firms like Baker & Mackenzie of the USA and Freshfields and Linklaters of
the UK started to buy up large law firms in France, Germany, Spain etc. They
then introduced their Anglo-Saxon approach into these firms.
Even the Continental European firms that remained independent were
contaminated by the Anglo-Saxon approach. Either they felt obliged to do
what the big firms were doing, because it was perceived as “best practice”. Or,
more cynically, they realised that they could also make much more money if
they used longer, detailed contracts which required more lawyer time!!
3.3 Summary
Therefore, there are 2 possible answers to the question “Why don’t all lawyers
deal with contracts in the Pathclearer way?”.

The innocent explanation is that lawyers, particularly Anglo-Saxon
lawyers, have convinced themselves that businesses need long, detailed
contracts to protect themselves from the various things that can go wrong
in business. We explain below why this is generally not true.

The cynical explanation is that lawyers make an awful lot of money out of
doing it the conventional way. For them to change unilaterally and
voluntarily would be like turkeys voting for Christmas! This is why inhouse lawyers and business people need to press of this change. Instead,
we encourage the use of incentives, rather than compulsions. In other
words, if the supplier offers tiered discounts, which give our company
higher discounts for higher volumes, then this is likely to achieve the goals
of both parties more effectively and without any friction in the relationship.
4. But don’t we need detailed contracts to protect ourselves?
To answer this, we must first consider what the purpose of a contract is.
4.1 What is the purpose of a contract?
The only purpose of a contract, as opposed to a general statement of what
a business intends to do with its business partners, is to ensure that the
obligation of each party can be enforced in Court.
Put even more bluntly, the essence of a contract is the ability to get a Court to
force someone else to do something they don’t want to do, or obtain
compensation for their failure.
Lawyers tend to view the ability to enforce obligations in Court as being the
only way to ensure that a business gets the deal it has been promised.
Lawyers therefore advise clients that they need detailed, watertight contracts
that foresee as many potential future scenarios as possible.
But this approach ignores the fact that:

Firstly, there are more effective ways for businesses to ensure that they
get the deals they have been promised. Carrots are often more effective
than sticks.

Secondly, there are many drawbacks of detailed written contracts.
We identified an intangible yet powerful force in successful continuing
business relationships, which we named “commercial affinity”.
Commercial affinity arises in mutually beneficial commercial relationships. It
is the attractive force which keeps the parties together. It results from the
desire by each party to continue doing business with the other, because it is
economically sensible to do so.
A customer will have commercial affinity with a supplier who constantly strives
to meet its needs and who demonstrates that it is the best supplier in the
market.
A supplier may not have any legally binding commitment to continue to supply
at a particular price, or at all. But it will have the strongest motivation known
to man – namely, a desire to continue doing business in order to earn more
profits.
If the customer ceases to be satisfied for any reason at all, it simply tells the
supplier ant they try to find a solution. If not, they just walk away from the
relationship.
There is seldom any need for detailed KPI’s and penalties to be drafted into
the contract. The same effect can be achieved more effectively with
commercial affinity and this ability to walk away.
Another way to think of this is that if you are a customer and you have a big
nuclear button (i.e. the right to walk away, depriving the supplier of future
business) then you don’t need a myriad of tactical rights and obligations in a
contract.
If you are a supplier, you may not like the idea that your customer could walk
away at any time. But you have to face the realities. Would you really want to
try to force an unwilling customer to continue to do business with you? Would
it not be better to accept that the only way you will ensure that a customer
continues to give you its business, is if you continue to delight the customer
with your product and price?
The concept of MAD (mutually assured destruction) applies equally in
commercial relationships as in global warfare – neither party is likely to be
trigger happy with the nuclear button, because walking away is likely to cause
significant disruption for both of their businesses.
But 9 times out of 10, the fact that either party could walk away from the
relationship is enough to keep the other party honest and keep the
relationship running. The fact that there is nothing in writing to state what
must happen in a particular situation means that the parties are free to agree
a mutually acceptable solution, failing which they can walk away without any
impediment.
Clearly, it’s always necessary to capture in writing the key terms of a deal –
the price, specification etc. This applies whether you are buying a company,
entering into a lease, taking out a loan or selling widgets.
However, it is often not necessary to go further and provide detailed contract
terms that place rights and obligations on each party, and micro-regulate the
relationship.
In any continuing business relationship – whether with a supplier, distributor
or customer – it’s actually very difficult to force a partner to continue with a
long term relationship if the contract ceases to be mutually beneficial.
So, if either partner in a continuing relationship ceases to believe that the deal
they originally struck is in its best commercial interests, then regardless of
what a contract may say, the other party would be well advised to address
that imbalance rather than simply try to compel the first party to perform its
contractual obligations.
This may sound defeatist. But consider the alternative: you force your
contract partner to do something it does not wish to do. At best, you will get
begrudging performance or work to rule (e.g. a service provider may deploy
its weaker staff if it is being screwed down on price, or a distributor may sell
just enough of your products to prevent you from terminating). At worst, you
have to take your partner to Court, with all the problems that entails (see
section 5.10 Going to Court below).
In a continuing relationship, neither of these scenarios is satisfactory.
In our view, it’s often better to simply leave a continuing relationship entirely to
the irresistible forces of free market economics, rather than place
continuing contractual obligations on each other.
In other words, commence doing business together, but make no
commitments about the duration of your relationship or the level of
business you will transact together. Simply accept that for so long as the
relationship remains mutually beneficial, you will continue to do business. It if
ever ceases to be mutually beneficial, you will part company, but you will give
a reasonable period of notice to enable an orderly transaction.
This approach simply recognises the fact that economic forces are too
powerful to be restrained by contracts.
If a contract blocks a person from doing something that is economically
necessary for his business, the contract will be overridden. This may be done
lawfully – it’s amazing how easy it is to create credible legal arguments
against apparently watertight clauses (some of the ways in which clauses can
be challenged are set out in section 5.10 Going to Court below).
Or it may be done unlawfully – just breach the contract and face the
consequences.
Either way, it’s unsatisfactory to get into a situation where the contact forces
either party in a continuing relationship to do something they do not wish to,
because it does not make economic sense for their business.
The key thing to acknowledge is that contracts are unlikely to offer any real
solutions when you are faced with an unwilling contract partner in a continuing
relationship. It’s almost always better to simply walk away.
5. The drawbacks of detailed written contracts
Conventional wisdom from the legal profession is that detailed written
contracts are necessary:



To have certainty of the rights and obligations of each party
To avoid future disputes over what was intended
To provide compensation if either party doesn’t do what it said it would do
We discovered that in the vast majority of our business relationships, these
assumptions about the role of contracts were largely wrong.
Here are 10 reasons:
5.1 Certainty
The apparent certainty and protection of a detailed written contract is often
illusory. Our experience showed that the more detailed a contract is, the
greater the likelihood that there will be ambiguity or internal inconsistency
within it.
Given the chance, lawyers are often keen to demonstrate their drafting skills
by trying to predict and provide for every conceivable situation. Yet man’s
foresight is limited and attempts to draft for the future often looks laughable in
hindsight.
This leads to highly complex lengthy contracts which can only be understood
by the lawyers. So the lawyers win twice: they get paid for drafting the
contract and they get paid each time they have to advise on what it means!
The lawyer’s obsession with the pursuit of certainty can be seen in the often
bizarre attempts by lawyers to define industry terms.
There is seldom a contractual dispute which is absolutely clear-cut – almost
always there is scope for dispute over interpretation of contract or evidence,
or other legal arguments (pre-contract misrepresentations, subsequent
variations or waiver through correspondence or actions, authority of
signatories, UCTA, penalties, competition law). A contract is not an insurance
policy – usually have to threaten to go to Court – long and expensive process
and disruptive to business.
5.2 Avoiding Disputes

Birth – as the deal moves from a commercial handshake to a draft
contract in the conventional legal format, it requires a huge amount of
input from the business people involved as they are asked to review
endless drafts of alien looking documents that seem to focus on matters
that are not important commercially. Sometimes, it feels like the lawyers
are trying to cause disputes through the aggressive way in which they draft
the various clauses, rather than simply trying to capture the agreed
position.

Life - Without a detailed contract, business people who become involved
in a dispute will generally discuss the issue and reach a sensible
agreement on how to resolve it. It probably won’t even occur to them that
it is a “legal dispute”, so they are unlikely to involve their lawyers. However,
where a detailed contract exists, the same parties will fee hidebound to
consult their lawyers. This is because they believe that the contract is
the oracle and contains the answers to every conceivable situation that
may arise within their relationship. Also, business people are often
nervous that they may not fully understand the contract, and if they don’t
check with a lawyer then they may accidentally give away some benefit or
right which the company is entitled to. This may expose them, as
managers of the company, to accusations of negligence.
When the parties consult their lawyers, the lawyers have a natural
tendency to support their clients’ position by emphasising the points that
are in their clients’ favour and minimising the points that are against. This
drives the parties’ expectations further and further apart, until only a Court
judgement can resolve the issue.
The whole process sucks in large quantities of management time and can
cost thousands of pounds.

Death – Even if the relationship is not working and both parties know it, if
you’re trapped in a detailed contract with a specified duration, you may not
simply be able to end it, which can produce very negative and
dysfunctional behaviour on both sides.
At a previous company, I was involved with a long term production and
packaging contract linked to a supply contract which, in total, ran to about 150
pages. The contracts were extremely detailed and tried to predict and provide
for every change in future circumstances that might cause a need to adjust
the commercial arrangements in the contracts.
The contracts were almost impossible to fully understand – even the lawyers
disagreed frequently on what the various clauses of the contracts actually
meant.
The parties became so tired of having to consult the contracts, and then their
lawyers, before they could do anything in the relationship, that they both
wished to terminate the contracts and start again. However, because their
respective lawyers could not clearly tell them what rights the existing contracts
gave them, the parties could not place a value on what they currently had.
This meant that they found it impossible to negotiate a new, more flexible
arrangement because they didn’t know what they might be losing or gaining in
the process.
They became trapped and paralysed within labyrinthine contracts, with no
easy means of finding a way out. This was not what was promised by the
lawyers when they created the convoluted arrangements.
5.3 Complexity – Lawyers usurp
As a deal mutates from a handshake or an exchange of correspondence by
business people, into a 20 or more page legal document, the client feels less
and less “ownership” of it.
The client assumes that the lawyer must know what he/she is doing when the
client’s initial letter or email to the other side is turned into the structure of a
legal “Agreement” and all the extra clauses are added in.
The client feels less inclined and less able to check each draft of the
Agreement to ensure that the key commercial terms he has agreed are
properly reflected. It becomes difficult to see the wood for the trees.
This is a dangerous state of affairs, leaving scope for companies to enter
into contracts that are not properly understood by the managers who approve
and administer them.
5.4 Unnecessary – have faith in the general law
In the absence of a detailed written contract, the “general law” will in any
event treat parties as having entered into a contact whenever there is money
paid for goods or services, or some other business relationship is entered into.
The general law will also imply certain legal terms into the relationship.

The general law consists of judge-made law (precedent or common law)
and Parliament/EC-made law (legislation);

Precedent or common law has evolved over hundreds of years with the
objective of providing fair and reasonable solutions to disputes between
parties, including disputes arising in business. It is therefore inherently
“fair” or “equitable” in its substance and approach;

Legislation is generally only created after a long process of intensive
consultation with all affected parties and interest groups and scrutiny by
many experts. So legislation also tends to strike a fair balance between
the interests of various affected parties e.g. suppliers and customers in
case of the Sale of Goods Act.
If anything, the general law which relates to business dealings tends to lean in
favour of the customer. This is because in a market based economy, it is
essential that customers have confidence when purchasing goods and
services. Legislation such as the Sale of Goods Act¹ and the Unfair
Contract Terms Act², and common law such as Negligence³ help to create
this essential confidence.
So, the general law tends to provide a fair middle-ground solution to most
issues, and there are very few aspects of business dealings which are not in
some way regulated by the general law.
So why don’t we just rely on it?!
The beauty of simply relying on the “general law”, rather than trying to set out
the commercial arrangement in full in a detailed written contract, is that there
is no need to negotiate the non-key terms of a deal.
¹ In simple terms, it requires that any goods supplied must comply with their
specification, must be of satisfactory quality and must be fit for the purpose for
which they are intended. It is difficult to see how anyone can object to this
basic requirement.
² In business-to-business dealings, UCTA states that any exclusions or
limitations of liability continued in standard form contracts are void unless they
pass the “reasonable test”. UCTA is currently under review by the Law
Commission.
³ Negligence is a simple, yet hugely flexible, area of law which provides some
reassurance to a client, without placing an unreasonable burden on a
supplier/adviser.
5.5. Anachronisms
We cannot tell the future and attempts to do so often look laughable in
hindsight. Many lawyers have found themselves having to apply a clause
written several years ago to today’s facts and finding that the answer
produced is either nonsensical or arbitrary.
5.6 Time Consuming
Clearly it’s quicker to proceed without a detailed written contract than with one.
With detailed contracts, draft after draft tends to be produced. Lawyers often
find it difficult to fully understand the terminology and practices of certain parts
of our business, making the process slow and cumbersome.
There is a tendency by parties to try and extract extra benefits or protections
in the detailed contract, leading to a protracted tug-of-war.
Often, the arguments revolve around non-essential clauses. Lawyers tend to
exacerbate this confrontational approach.
Sometimes the written contract is still being negotiated when the underlying
job has already been completed!
It’s vital that business can move very quickly when concluding deals. If the
need for detailed written contracts slows us down, this can cost us a lot in lost
business opportunities.
5.7 Expensive
The involvement of lawyers in drafting or reviewing detailed written contracts
inevitably leads to greater costs. Management time must also be factored in
as an expense when negotiating and settling the terms of a contract.
Within a business, every single person is there solely for the purpose of
profitability selling the company’s goods or services. Any time or money
spent on anything which is not necessary to achieve that purpose is an
unacceptable cost and management distraction.
5.8 Souring of relationships – butterfly catching
When drafting a detailed written contract (particularly where lawyers are
involved) there can be a tendency to focus on worst-case scenarios.
Often, the parties can get bogged down in debates over clauses and
situations which, in practice, are unlikely to ever arise. This can lead to the
souring of relationships.
Even if you succeed in negotiating a tough written contract, some of the
goodwill and professional pride of the other party may be adversely affected in
the process. You can de-motivate a third party who would otherwise have
done a good job anyway.
Lawyers have to accept that continuing business relationships are like
butterflies. They are subtle and hard to capture. When you do try to nail
them down, you can kill them in the process.
5.9 Not an Insurance Policy
If entering into detailed written contracts served as a kind of insurance policy,
then it would be a relatively simple business decision to:


Assess the “risk” (i.e. what would happen if you di not have the detailed
contract), and
Calculate the “premium” (i.e. the legal costs and time involved in putting
the contract in place).
However, in our experience, contracts very seldom provide clear-cut answers
to disputes. When a breach of contract arises it is not like making an
insurance claim, with a cheque then popping through the post.
The contract is often ambiguous or silent on the particular matter in question.
Obtaining compensation tends to be a protracted affair usually ending up in a
negotiated settlement which often bears little relation to the merits of the legal
position and is based more on commercial issues such as a desire to continue
doing business.
5.10
Going to Court
Even after overcoming all of those difficulties, there are further problems to
face if you actually try to enforce your contracts in Court:

Interpretation – in our experience, mainly in the UK, there is seldom a
contractual dispute which is absolutely clear-cut. There is almost always
scope for each side to take a different interpretation of the contract. Even
if the contract gives a relatively clear answer, there are many other ways
to challenge its terms, including:
o Pre-contractual misrepresentations
o Subsequent variations through correspondence, or collateral
agreements
o Unfair Contract Terms Act
o Competition Act/Articles 101 and 102

Tactical Battles – even with the simplified procedural rules introduced in
England and Wales, there is plenty of scope for tactical manoeuvres by
each side’s lawyers, in order to wear down an opponent in a war of
attrition.

Cost – the front-loading of cases caused by the reforms to the Civil
Procedure Rules and the introduction of pre-action protocols creates
greater immediate cost for anyone who wishes to enforce their contracts
through the Courts.

Time – it can take years to obtain a judgement, during which time both
management and in-house lawyers will have invested many valuable
hours of work.

Appeals – clearly, there is the possibility of appeals, leading to long
periods of uncertainty about the final resolution of the dispute.

Remedies – the remedies that a Court can offer are limited. Damages are
generally the only remedy and can be very difficult to quantify. We have
seen many cases where a litigant has finally succeeded after many years
in winning his claim, but the damages awarded to him are paltry.

Enforcement – even once you have obtained a judgement, you may have
considerable difficulty in enforcing it, especially if your counter-party is
insolvent or of little financial worth.
6.
So how does Pathclearer work in practice?
Let’s take 2 common examples of commercial contracts that [whisky/spirits]
businesses regularly enter into:
6.1 Glass Bottle Supply Agreements
Some of you will have had to negotiate a Glass Bottle Supply Agreement at
some point. We have seen some agreements which run for 40 pages or more.
Here is how we would apply our Pathclearer approach if our company was
entering into a new Glass Bottle Supply Agreement:

Firstly, we would check that we understood the commercial terms that had
been agreed. For example, the price, discounts, any price freeze/increase
mechanism, the specification of the bottles etc.

We generally encourage both our procurement colleagues, and our
suppliers, not to agree to exclusivity or minimum purchase obligations
(MPOs) in supply agreements. This is because these obligations may
appear simple, but they require a lot of detailed drafting for the
circumstances in which they will not apply e.g. if the supplier’s price
ceases to be competitive etc. This slows down the execution of the deal.

We call this “Commercial Affinity”. We believe it is usually a more effective
force than the “Legal Straitjacket” approach that is conventionally used by
lawyers i.e. Agreements which say “You must do this” and “we must do
that” etc.

We would also explain that the UK Sale of Good Act gives WGS a large
degree of protection from a failure by the supplier to provide us with glass
bottles that are of satisfactory quality or fit for their purpose. It also
protects against failures by the supplier to deliver the bottles on time, any
many other issues. This protection happens automatically, regardless of
whether our company enters into a detailed contract. So there is actually
very little need for our company to have any details in the contact beyond
the price, discounts, specification etc.

However, there are a couple of other key legal issues that we have
become familiar with, which we would need to deal with. Those are likely
to be:
o Ensuring that it is clear that our company owns the design of the
bottles that the supplier produces for it (other than generic bottle
shapes), and that the supplier cannot use a similar design for
another customer. Also covering ownership of the bottle moulds
(which may depend upon how they are funded and amortised).
o Ensuring that if there are any annual retrospective discounts which
accrue during each year, then these will not be lost by our company
if the supplier becomes insolvent during the course of the year. We
can protect against this significant risk by e.g. stating that an
estimate of the discount will be paid by the supplier tour company at
the end of each month “on account”, with an end of year
reconciliation.
6.2 Distribution Agreements
Again, most of you will have been involved in either:

Granting a Distribution Agreement to a third party. Our company enters
into many of these agreements each year.

Receiving a Distribution Agreement from a foreign drinks company. For
example, our company has distribution rights for [brands – deleted for
confidentiality].
These Distribution Agreements can generate a lot of value for our businesses.
But this does not mean that extremely detailed contracts are either necessary
or helpful.
Here is how we would apply our Pathclearer approach if our company was
entering into a new Distribution Agreement. We describe the general
approach that we would take, regardless of whether our company was
granting or receiving the Distribution Agreements:

Most discussions about Distribution Agreements very quickly turn to the
question “How long should the Distribution Agreement last for?”.
Commonly, they are for 3 or 5 year periods.

However, we believe that the answer to this question is “It will last for so
long as it continues to be mutually beneficial. That may be 6 months, or it
may be 100 years”.

In other words, selecting a duration for the Distribution Agreement is an
arbitrary thing to do. The reason that people do it, is because they equate
the length of their relationship with the amortisation of any investment
which either party is making in connection with the relationship e.g.
investing sunk costs in vehicles or warehousing space or marketing
campaigns.

We believe that it is important to separate these two issues. In other
words:

The duration of the Distribution Agreement should be indefinite. If either
party wants to terminate, then it should be required to give a reasonable
period of notice (say 1 year) to the other party, to enable an orderly
transition.

This avoids the unhealthy situation that arises when parties are locked into
long-term Distribution Agreements but, for example, the brand owner
believes that the licensee is not properly developing the brand. This can
often lead to extremely bitter and lengthy litigations, where each party tries
to prove that the other is breaching the agreement.

By allowing either party to walk away if it really wants to, just by giving
notice, rather than having to prove that the other party is in breach, our
experience is that it actually tends to make the parties want to stay
together. They do not take each other for granted. Generally speaking,
neither of them wants to go through the pain of having to start again with a
new partner. But the fact that either party could “press the nuclear
button” at any time tends to make them act more sensibly and fairly. This
is perhaps the concept of Mutually Assured Destruction (MAD) being
applied to contracts, rather than global warfare!

The issue of amortisation of sunk costs should be dealt with by stating that
if either party terminates, then there will be a proper accounting and
reimbursement for such costs. This requires a bit more thought at the
commencement of the relationship about the risks and rewards that each
party is going to take. But this is a much more honest and logical way to
approach this matter, than to simply assume that over the duration of the 3
or 5 year Distribution Agreement, the distributor will be able to make a full
recovery on its sunk costs.

The result of this approach is that the brand owner should generally fund
all marketing investment for the brand, to avoid the distributor having to
incur sunk costs.

Alternatively, the marketing investment could be shared. But in this case
the distributor could legitimately ask that on termination it should receive a
share of any uplift in the long-term brand value which has arisen from its
efforts in the territory during the period.

Apart for structuring the Distribution Agreement to create commercial
affinity, there is little else that needs to be detailed in the Distribution
Agreement. Conventional Distribution Agreements place a myriad of
obligations on each party. But when we use commercial affinity to drive
the relationship, rather than a legal straitjacket, all other matters are just
sorted by the parties commercially and sensibly as they go. This leads to
a stronger relationship, as there is constant, constructive communication
rather than threats of breach of contract. If they cannot agree on an issue,
then they each have their nuclear buttons.
A more detailed explanation of an alternative commercial model for
Distribution Agreements is set out in the following pages.
Distribution Agreements
Can we create a more effective commercial model?
This paper sets out initial ideas for creating a really effective, long-lasting and
rewarding “partnership” between a brand owner and a distributor of its
products.
1. What’s wrong with the conventional model?

The conventional approach by brand owners when appointing
importers or distributors is to:
o Give the importer/distributor exclusive rights to sell a particular
brand in a territory for a fixed period, but then
o To impose a long list of obligations on the importer, including
minimum sales obligations, which enable the brand owner to
terminate the rights if the performance is not satisfactory

In many ways, it is like giving with one hand but taking away with the
other.

Experience shows that this conventional approach often produces a
dysfunctional relationship, because it is based on compulsions rather
than incentives.

The agreement reads as a list of obligations on each party. During the
negotiations, each party’s main concern is to reduce the obligations on
itself and increase the obligations on the other party.

This does not produce truly aligned interests and goals. It does not
focus the parties on jointly growing the value so that whatever slice of
the pie they get, it will be a considerably bigger size to start with.

This conventional model for appointing 3rd party importers or
distributors seems to be out of step with the modern business world.
When a company appoints a senior executive these days, it does not
tend to promise him a fixed term provided that he completes a series of
obligations. Instead, the executive will be given some high level goals
and will be offered significant incentives if he achieves them. The same
model is prevalent in, and indeed probably came from, the private
equity world. There seems to be a general acceptance that incentives
are more powerful motivators of human activity than compulsions.

Incentives, provided that they are linked to the right outcomes, provide
a magnetic pull which needs little supervision, whereas compulsions
are all about push and they tend to produce squirming, begrudging
performance and work to rule. So the idea underlying the conventional
model seems to be an anachronism.

It also ignores the fundamental difference in the parties interests,
namely that:
o
the brand owner has a long-term interest in growing its brand in
a sustainable way. He wants to create a good balance between
value growth (ie healthy margins) and volume growth. He does
not want to sacrifice the long term equity value of his brand in
return for selling a few more cases today at a heavy discount.
o the importer/distributor has a finite period in which to extract
maximum value from the brand. By definition, he has no long
term interest in building the brand because he has no stake in
the equity value that is created. The only value he creates is the
short term profit he gets by selling an extra case. Volume is
inevitably a bigger focus than value. If he has a 5 year contract,
then the economically sensible behaviour for an
importer/distributor would be to build the brand in the first 2
years, milk it for the next 2 years and then be prepared to
gradually “suffocate the baby” during the final year so that when
the brand owner takes it back it cannot be a threat to the
importer/distributor in the hands of a competitor. While
“suffocating the baby”, the importer/distributor will often be lining
up a substitute brand which it can try to convert existing
customers to.
o This results in brands which use a third party route to market
making progress on a “3 steps forward, 2 steps back basis”, as
they lurch from one third party distributor to the next. This can
be very damaging for the credibility of the brand in the eyes of
customers and consumers in the territory – they become tired of
hearing of the latest rejuvenation plans from the latest newly
appointed distributor. And it is frustrating and economically
inefficient for the brand owner to have to keep re-lighting the fire.
o This underlying disconnect in the economic interests of the
parties is seldom voiced between brand owner and distributor.
At the regular review meetings, the brand owner will emphasise
the need for value growth and the importer/distributor will
typically nod along and talk convincingly of its desire to nurture,
build and cherish the brand, in the same way that the
importer/distributor does with its own brands.

We believe that a “partnership” can only succeed if the parties’
interests are truly aligned. That is why we have come up with an
alternative model which we think is more effective.
2. So what’s the alternative model?
 At the heart of the alternative model is the concept that the
importer/distributor is not just rewarded in the short term for selling
another case, but is also entitled to a slice of the long-term value that
he is helping to build.
 Creating a reasonably simple but effective formula for measuring that
long-term value and calculating the importer/distributor’s share is
therefore the key, in the same way as creating the right targets for an
employee bonus scheme are key.
 In simple terms, the formula might look like this:
o Importer takes on a brand which is currently selling 50k cases
and which has a volume:value ratio of 90% compared to a
benchmark market leading brand (ie it has been heavily pricepromoted for the past few years).
o Importer grows that brand to 300k cases over the next 5 years.
The volume:value ratio also improves to 100%. Brand health,
as measured by Millward Brown or similar agencies, could also
be used as a target measure.
o Due to a re-focussing of business priorities, the importer decides
that it has taken the brand as far as it reasonably can and
therefore decides that it needs to end the relationship with the
brand owner.
o Provided that the distributor carries out an orderly handover,
then the brand owner will pay the distributor a reward for the
share of the retainable incremental growth in value that the
distributor has created. Retainable means that the customers
who are buying the brand from the distributor are likely to
continue buying the brand when it is moved to a new distributor.
If there is likely to be an attrition rate of 20% or so, then this will
be discounted from the reward payment to the distributor. This
obviously acts as a disincentive to switching or converting by
the distributor, which as mentioned above can be very
damaging for the brand.
o The actual $ reward per incremental retainable case would
have to be negotiated.
 The second key point in the alternative model is that the agreement will
not be littered with obligations on each side. As mentioned above, we
believe this simply leads to bickering (and then to lawyering!) about
whether or not obligations have been fulfilled.
 Under the alternative model, freed from a long list of obligations on
both sides and consequences of failure, the relationship will become
similar to a marriage. The parties will enter into the agreement in good
faith with the intention that it will last indefinitely. But the truth is that
neither party can foresee the future. It may be that they simply cannot
get on. There may be massive changes in the industry or in the
external environment at large, which they have to respond to.
 Under the alternative model, the parties will not be locked together in a
legal straightjacket which requires lawyers and months of disruptive
and expensive wrangling to extricate them from. They simply have to
look each other in the eyes and decide whether they can work through
their difficulties or whether they are best to part company. In deciding
this, they will be aware of 3 key factors:
o There is nothing written down to tell them what to do. It is not an
exercise in interpreting words that were written years before
and which could not have envisaged the particular scenario that
has arisen. It is simply an exercise in each party expressing its
commercial needs and desires and seeing if they are still
aligned and mutually beneficial.
o Generally, it is less disruptive to work through problems with an
existing partner than to switch in a promiscuous manner to a
new partner. So it is unlikely that either party would hit the
nuclear button without very good reason. Mutually assured
destruction is a concept that works at a commercial level also!
o Most importantly, if the distributor has added value to the brand
(based on the formula agreed at the outset) then it will receive
the reward, regardless of who chooses to end the relationship.
This is just like divorce in a marriage. The couple have to share
the assets or value that has been created during the marriage
(but not the value that they each had before the marriage). If
one party has acted badly to bring about the divorce, then it’s
possible to allow for a discounting of their share (a good
leaver/bad leaver type of clause).
So, that pretty much describes how the alternative model would work. It
would sit in a short agreement, and the main area for negotiation would be
the reward formula.