Distribution Agreements - Part 3: Rights and obligations to be considered (do’s and don’ts)

When software is distributed via distributors or sales representatives, there are a lot of rights and obligations to be considered and stipulated. It is important to structure the contractual relationship in such a way that these rights and obligations and in the interaction between the manufacturer and the distributor largely harmonize with those of the distributor and the respective customer. But this is not always possible. After I gave an overview of the distribution models in the first part of our series, and described distribution via the App Store in the second part, this third part deals with the challenges in drafting distribution agreements.

Who updates the software?

Software is constantly updated. The reasons for this are not only technical innovations but also statutory and regulatory changes and security aspects. This must also be taken into account when distributing the software. Many manufacturers maintenance and license agreements at the same time, often in the same contractual document. If the manufacturer offers to enter maintenance agreements, the manufacturer undertakes internally either to provide the entire maintenance for the distributor or to support him (second level). Depending on the share that the distributor has in this process in the context of warranties, maintenance, incident management and updating, the revenues from maintenance agreements with the customer are shared between the distributor and the manufacturer.

Pass through?

In addition to the rights, the distribution agreements between manufacturers and distributors usually contain very extensive restrictions that a distributor must pass through to customers. These restrictions can cause problems in terms and conditions law and copyright law.

Many distribution agreements often describe only a minimum set of rights that the distributor may grant to the customer. Much more space is usually given to restrictions, including use only for the customer's own internal purposes (very problematic), use only with a maximum number of named users, or use on a specific type of hardware.

Enforceability of such restrictions – obstacles of German law?

Such obligations and restrictions may be enforceable in the distribution agreement, whereas they are not enforceable towards the customer even if the distributor passes them on verbatim. German law deals very restrictive with standard terms and conditions and courts do often consider clauses as not enforceable. This is determined on the one hand by the type of contract – perpetual or time-based license - and on the other hand by the copyright provisions. Copyright law provides statutory minimum rights which cannot be withdrawn from the customer by provisions of the law of obligations. For example, an authorized user of a software may copy and edit the software if this is necessary for the intended use of the software. Accordingly, the GTCs cannot restrict those actions that are undertaken by the user for the intended use. But what exactly is the intended use? Here, the manufacturer has the right to determine for which use its software product is actually intended.

Locks and License Keys

Program locks and similar technical precautions, such as license keys, are installed by manufacturers to control distribution channels, possibly without effective agreement with the respective customer. For example, program locks are used to ensure that customers do not use the software product until it has been activated or until a buffer period has elapsed. In this way, serialization takes place at the same time. For this purpose, the customer/distributor contacts the customer after execution of the contract, including installation, and obtains the transmission of the activation from the manufacturer.

In his relationship with the customer, however, the distributor has not fulfilled the contract if he must first have the use of the software product activated in a way that he, as a distributor, does not control for the future. In the event of renewed activation - e.g. after changes to the hardware components - the customer is dependent on the manufacturer, with whom, however, he has no contract. The question is therefore whether the distributor can fulfill the contract at all, where the software product locks itself either after a certain period of time has elapsed or after a certain number of starts.

Caution with liability for defects

A practical difficulty arises in cases where a software product is imported from the Anglo-American legal sphere and the Anglo-American manufacturer insists that the distribution agreement in Europe, and especially in Germany, be based exactly on the U.S. distribution agreement. Here, distortions arise at the expense of the distributor because the warranty period (limitation period for material defects and defects of title), which the German distributor must enter into and can restrict only to a limited extent, may not even have begun to run, while in the relationship with the manufacturer this would already have expired due to the 90-day period of liability for defects. Under German law, the obligation to remedy defects within a reasonable period of time with the purchaser's right to choose cannot be regulated differently in general terms and conditions. If the number of attempts to remedy the defect were kept open, the clause would be invalid.

In this case, the warranty right exist in a different way than is usually provided for in U.S. contracts. Under German law, the distributor is also exposed to secondary claims such as reduction of the purchase price, rescission, and damages. In mass business with consumers, these rights cannot be effectively excluded, and there are limits even in B2B transactions. Individually negotiated agreements can exclude the right to claim for defects, but what customer would allow himself to be limited to the removal of defects in a complex, business-critical software product?

Transfer of customer data

With regard to a possible claim for compensation according to § 89b of the German Commercial Code (HGB), it plays a significant role that distributors are required to notify the manufacturer (without delay) of the names of the customers, possibly even the names of interested parties to whom offers have been made.

In the case of distribution agreements, the distributor is required to refer to the manufacturer and the customer. This will make the chain of transfer of rights of use clear to the customer even in the software product itself, for example in the preamble or menu mask. It will be a serious breach of contract if the distributor either changes or omits the entry of the manufacturer and/or the customer.

This can be seen by the customer as an impairment of his dispositions, for example to pass on the software product. The impression of serialization is created, possibly similar to a lock. The third party would not agree to the registration, which reduces the value of the software product, at least implies additional work without remuneration in the case of change in favor of the third party.

Special fiduciary duties

In general, a distribution agreement, which is a continuing obligation, is subject to special duties of loyalty. There should be a relationship of trust between the contracting parties, which also obliges them to show mutual consideration. Part of this obligation to show consideration may be, for example, that the manufacturer may not change its product and service portfolio at will, but must take the interests of the distributor into account. This applies in any case if the distributor is obligated to provide a certain software product on the basis of existing customer relationships. Taking into account the interests of both parties, the distribution agreement should contain provisions on the notice periods with which the product and service portfolio can be changed and how the interests of the affected end customers can be adequately taken into account.

Termination of the contractual relationship

Upon termination of the contractual relationship, a compensation claim may also be considered for authorized dealers. One of the conditions is that the customer base must be transferred to the manufacturer. A special moment can be the direct conclusion of the care contract on the part of the customer with the manufacturer.

The standardized distribution agreements of large manufacturers generally provide for customary contract terms (e.g., one or two contract years as a minimum term) and notice periods (e.g., three or six months to the end of a contract year or calendar year). This also appears appropriate.

However, this assessment does not apply if the authorized dealer has to make substantial investments that he can no longer amortize in view of a termination after one or two years, which are often only start-up periods. Accordingly, a termination before the end of the amortization period could be invalid if high investments were required.

Regulate rights and obligations

When distributing software, very complex issues arise for the manufacturer and the distributor. Not all rights and obligations can be easily passed on in the contractual constellations from the manufacturer via the distributor to the customer. Therefore, before deciding to distribute, manufacturer should clarify which constellation best suits their software and which risks they are willing to bear. We advise manufactures and distributors of software products on contract design and help them identify and contractually regulate the relevant issues.

Michaela Witzel, LL.M. (Fordham University School of Law), Certified Expert for IT Law