In the legal relationship between suppliers and distributors, the term "diversion" often arises as a type of breach. It's important to understand that diversion is not a formal legal term; instead, it refers to the chaotic distribution of products across different regions, markets, and channels, driven by the interests of various parties, which can lead to confusion about market pricing. In this article, "supplier diversion behavior" specifically describes a scenario where, after signing a cooperation contract with Distributor A that defines an exclusive area and time frame, the supplier allows Distributor B to sell products in the same area or sells products directly toDistributor B, thus bypassing Distributor A.
Legal Relationship
The legal relationship between suppliers and distributors must be thoroughly assessed based onthe rights and obligations delineated in the contract executed by both parties, as well as the actual performance of that contract.
Currently, it is commonplace for suppliers and distributors to engage in a buyout sales model, wherein the distributor acquires products from the supplier at a predetermined price, the supplier delivers the products to the distributor, and payment is settled directly. The distributor subsequently sells the products to end customers or lower-tier distributors, managing payment and assuming responsibility for pre-sale and post-sale services, while profiting from the price differential.
For instance, in a buyout exclusive agency sales contract, the supplier grants the distributor exclusive sales agency rights for products within a specified area, allowing sales during the agreed cooperation period and within the defined regional scope. Upon receiving orders from downstream distributors or end consumers, the distributor pays the supplier for the products in its own name and independently determines the markup before selling to downstream distributors or end consumers, thereby earning profits and assuming operational risks.
Article 919 of the Civil Code defines an entrusted contract as one in which the entrusting party and the entrusted party agree that the entrusted party will manage the affairs of the entrusting party. In this scenario, the distributor's sale of products does not equate to managing the supplier's affairs; thus, even if the contract includes terms such as "agency" or "exclusive agency," it does not necessarily establish a legally recognized entrusted contract relationship. According to Article 595 of the Civil Code, a sales contract is defined as one in which the seller transfers ownership of the subject matter to the buyer, who in turn pays the price. In this cooperative model, the fundamental rights and obligations arising from the contract indicate that the supplier transfers ownership of the products to the distributor, aligning with the characteristics of a sales contract, thereby confirming its classification as such.
In practice, the cooperative models between suppliers and distributors exhibit considerable diversity. Even within the framework of an exclusive agency sales contract, while the primary legal relationship is that of a sales contract, it may also embody characteristics of other contracts due to additional rights and obligations specified within the contract, potentially leading judicial authorities to recognize it as an unnamed contract. Consequently, the nature of the legal relationship between the parties cannot be generalized.
Breach of Contract Liability
Upon establishing that the legal relationship in the buyout exclusive agency sales contract is predominantly that of a sales contract, the determination of breach liability necessitates reference to the contract's provisions, particularly regarding any agreements on liquidated damages or methods for calculating damages resulting from breaches. If such agreements exist, they take precedence; however, should the stipulated liquidated damages be disproportionately high or low in relation to the actual losses, the court or arbitration institution may adjust them based on the parties' requests. In instances where the parties have not reached an agreement on breach liability or where the agreement lacks clarity, the Civil Code stipulates that the breaching party is liable to compensate the non-breaching party for losses incurred as a result of the breach, including potential benefits that could have been realized had the contract been performed, but not exceeding the losses that the parties could foresee or should have foreseen at the time of contract formation. It is evident that the Civil Code delineates the allocation of breach liability in cases where the parties' agreement is ambiguous.
Regarding lost profits, the "Guiding Opinions on Several Issues in the Trial of Civil and Commercial Contract Dispute Cases under Current Circumstances," issued by the Supreme Court on July 7, 2009 (hereinafter referred to as "Document No. 40"), outlines that the assessment of lost profits should consider the following factors:
1. Types of Lost Profits
Depending on the nature of the transaction, the purpose of the contract, and other relevant factors, lost profits can be categorized into production profit loss, operational profit loss, and resale profit loss. Based on the previous analysis of the legal relationship in exclusive agency sales contracts, it is reasonable to classify these as a series of sequential sales contracts, where the lost profits of the subsequent resale contract seller due to the breach by the original contract seller typically fall under resale profit loss.
2. Calculation Method
The formula for calculating lost profits is as follows: Lost profits = total recoverable profits - unforeseeable losses - losses improperly expanded by the non-breaching party - profits obtained by the non-breaching party due to the breach - losses caused by the non-breaching party's own negligence - necessary transaction costs.
3. Burden of Proof
The non-breaching party bears the burden of proof for the total lost profits and necessary transaction costs incurred.
Despite the existence of clear regulations and guidelines, lost profits inherently involve uncertainty in both evidence provision and calculation, thereby granting the court considerable discretion. Consequently, the extent to which the non-breaching party can secure support for lost profits remains uncertain.
Tips and Recommendations
In addition to supplier diversion, if a distributor breaches the contract by selling products outside its authorized area, this also constitutes diversion. Therefore, whether acting as a supplier or a distributor, both parties should prioritize the clear definition of breach liability in cases of diversion and the calculation method for damages arising from breaches when entering into contracts, in order to safeguard their interests in the event of a breach by the other party. Specifically, both parties may consider establishing dedicated diversion clauses to regulate each other's diversion behavior, which should encompass definitions of diversion behavior and stipulate varying breach liabilities for different diversion scenarios.