Using exclusivity arrangements in commercial contracts

by Kurt Wicklund, Senior Associate, Australian Business Lawyers & Advisors

With businesses continuing to face supply chain disruptions and the impacts of inflationary pressures, diversification and investment in new markets remains an important strategy for many companies in supporting growth. A key component of these investments will often be establishing exclusive distribution or supply arrangements. But what are the legal considerations you should be aware of when using exclusivity arrangements in your commercial contracts?

In this article we take a look at exclusivity provisions and consider in what circumstances an exclusivity arrangement (also known as ‘exclusive dealing’) could be considered an unlawful ‘restraint of trade’. We then take a closer look at a recent Victorian case, where the Supreme Court considered this question.

What is an exclusivity arrangement?

Exclusivity arrangements are often agreed in the context of corporate transactions and commercial contracting. They are a key feature of distribution supply chains and franchise arrangements. An exclusivity arrangement is any agreement between two parties where an entity agrees to exclusively sell to, or purchase from, another entity.

What are the legal issues with exclusivity arrangements?

There are two key areas of focus when considering the lawfulness and enforceability of exclusivity arrangements.

1. Competition law. The Competition and Consumer Act 2010 (CCA) provides that each of the following is prohibited IF it has the purpose, effect or likely effect of substantially lessening competition (ss 47(10) of the CCA:

• the acquisition of goods or services from a supplier on the condition that the supplier does not supply to other customers (ie exclusive supply); and / or
• the supply of goods or services to a customer on the condition that the customer does not acquire from the supplier’s competitor (ie exclusive acquisition),

In some circumstances, the prohibitions in the CCA are of critical relevance when considering exclusive dealing, depending on the size of the parties and the nature of the relevant market. However, in most circumstances, exclusivity arrangements are unlikely to have the purpose, effect or likely effect of substantially lessening competition and accordingly do not contravene the CCA.

2. Prohibition on restraints of trade. At common law, all restraints of trade which interfere with the liberty of parties to trade freely are void, unless otherwise demonstrated that the restraint is valid. We consider the application of this principle to exclusivity arrangements below.

What is a restraint of trade?

A ‘restraint of trade’ clause is a provision within a contract which prevents one party from taking certain actions in its trade practices which may be to the detriment of the other party. Restraint of trade clauses are often seen in an employment context but are also commonly encountered in conjunction with the sale of businesses, where the vendor promises to not take certain actions after completion of the transaction.

The most common examples of restraint of trade provisions are “non-compete” clauses and “non-solicitation” clauses. However, exclusivity provisions are also a type of restraint of trade, in that they restrict a party from trading in an unfettered manner.

What is a legitimate restraint?

At common law, a restraint of trade will only be held to be valid where:

• the party imposing the restraint has a legitimate interest which it is seeking to protect by way of the restraint; and
• the restraint affords no more protection than is necessary to protect that legitimate interest.

The party which has the benefit of the restraint has the onus of proving that the restraint is reasonable. The reasonableness of a restraint is determined by taking into account a number of factors, including the location of the business, the geographical scope of the restraints, and the nature of the business activities from which the party is being restrained.

Note the common law position regarding restraints of trade has been modified under statute in NSW under the Restraints of Trade Act 1976. The practical outcome of this is that in NSW an unlawful restraint of trade can be ‘read down’ and need not be severed from the relevant agreement if aspects are considered to be unreasonable.

When will an exclusivity arrangement be a legitimate restraint?

The recent case of Mecca Brands Pty Ltd v Kingdom Animalia LLC provides an example of how the court considers the question of whether an exclusivity arrangement is a reasonable restraint of trade.

Facts

• In 2010, Mecca Brands Pty Ltd entered an exclusive distribution arrangement with Kingdom Animalia LLC (trading as Hourglass), which allowed Mecca the sole and exclusive right to purchase cosmetic products for retail in Australia and New Zealand, for an initial fixed term.
• In 2015, the terms of agreement were varied to allow for termination arrangements, which allowed either party to end the agreement with written notice, with a specified notice period.
• In May 2020, Hourglass gave written notice to terminate the agreement, stating that Mecca had breached their agreement by being unable to distribute the product due to the Covid-19 pandemic.
• In December 2020, Mecca sought declaratory relief on the basis that the termination was invalid and begun proceedings against Hourglass.
• Hourglass argued, in its defence, that the enforcement of the contract term to sell exclusively through Mecca was an unlawful restraint of trade.

Issues

The critical questions raised in court were:

1. Does the restraint of trade doctrine apply to the exclusivity arrangement?
2. If it does, has Mecca discharged its onus of establishing that the restraint is enforceable?

Restraint of Trade Tests

The Court analysed the application of three tests to determine whether the restraint clause was reasonable:

• Pre-existing freedom test: This test provides that the restraint of trade doctrine will only be applicable where a person has contracted to give up some freedom which they might otherwise have.
• Sterilisation of capacity test: This test looks at the nature of the performance required by the restrained party during the period of the contract and considers whether the contract loses its character of a contract for the regulation and promotion of trade.
• Trading society test: This test addresses whether the restraint has become part of the “accepted machinery” of transactions, meaning the application of the particular restraint may have found to have passed into the accepted and normal currency of commercial or contractual relations.

Determination

Justice Osbourne found that the restraint of trade imposed on Hourglass was reasonable in the interests of the parties for two key reasons:

1. The restraint only applied in the markets in which Mecca operated and distributed products.
2. The restraint only applied for the duration of the agreement between the parties.

The Court agreed that Mecca had a legitimate interest in protecting its business, and the restraint was entered into for the consideration of entitlements and benefits provided by Mecca in providing the services and distribution outlet.

Justice Osbourne stated that “the parties were in the best position to judge whether the restraint was reasonable”, reiterating that Animalia Kingdom had considered the reasonableness of this restraint on two occasions, both in 2010 and 2015.

“Hourglass no doubt was perceptive enough to form its own judgment that the benefits that it achieved by entering into the arrangement in 2010 outweighed the opportunity cost of foregoing the ability to distribute itself into Australia and New Zealand”.

“In my view, Mecca has an entirely legitimate interest in ensuring that the benefit of that goodwill remains harnessed to Mecca for as long as Mecca is providing the services and distribution outlet to Hourglass under the [agreement]”.

Implementing restraint clauses

The above case is a timely example of the legal and commercial implications of agreeing to a broad exclusivity arrangement in the early stages of setting up a business. It also serves to remind parties that the ability to agree and include exclusivity arrangements within their contracts is not unfettered; parties should ensure the relevant arrangements do not contravene competition law or the law on restraints of trade.

Before agreeing to a restraint of trade clause in your corporate or commercial contracts, whether as the beneficiary or the restrained party, it is important to:

• review all provisions and ensure you understand the effect the exclusivity arrangement will have on both parties;
• consider the reasonableness of the restraints being imposed, such as the time frame and geographical location of the exclusivity; and
• obtain professional legal advice if you have any concerns regarding the reasonableness of the exclusivity provisions.

If you have any questions or require assistance with navigating exclusivity provisions in your corporate or commercial contracts, get in touch with us at [email protected].