CIRCUMVENTING DISTRIBUTORS’ RIGHTS Exclusive Rights, the Grey Market and Contractual Interference

A notable judgment rendered by the Quebec Court of Appeal on October 15, 2020 may be of considerable assistance to distributors who are bypassed in the sale of products within their exclusive territories. Indeed, the Court of Appeal judgment confirms that distributors have certain recourses to fight the sale of merchandise sold and acquired on the grey market.

In this case, the appellant, Costo Wholesale Canada Ltd. ("Costco"), appealed against a judgment in 2017 rendered by the Superior Court, which granted, in part, the application of respondent, Simms Sigal & Co. Ltd. ("Simms"). Simms petitioned the Court requesting that Costco compensate it for all losses and damages sustained as a result of Costco's decision to import products from a supplier who was operating in violation of Simms' exclusive right to distribute those products within the territory Costco operated.

Context

Simms is a Canadian business specialized in the importation and distribution of high-end apparel to retailers. Rock & Republic (hereinafter "R&R") is an American clothing manufacturer: primarily jeans. In 2006, Simms and R&R entered into a distribution agreement granting Simms the exclusive right to distribute R&R jeans in Canada.

The dispute arose when, in January 2009, Costco, the Canadian membership warehouse club, acquired R&R Jeans on the grey market through Abfi Inc., another Canadian distribution company. As the jeans were purchased at a discounted rate, Costco was able to sell R&R jeans at much lower prices than the retailers who purchased R&R products from Simms.

Given Costco was not a party to the distribution agreement between Simms and R&R, the Court, following considerable analysis, characterized Costco's fault as contractual interference.

First, the Court confirmed that the distribution agreement in question granted Simms the exclusive right to sell R&R products in Canada through its approved retailers.

The Superior Court did not accept Simms' argument that Costco had known about Simms' exclusive right to distribute R&R products in Canada as early as January 2009, and should therefore be held liable, in conjunction with R&R, for contractual interference as of that date. However, the judge did conclude that the situation changed the moment Costco received a formal notice in November 2009, whereby Simms informed Costco of its exclusive distribution rights and demanded that Costco purchase directly from Simms (as well as to cease and desist all purchases from its unauthorized distributor). It's this notice the Court considers as the real turning point in terms of recognizing Costco's liability toward Simms.

From the moment Costco was formally made aware of the contract between Simms and R&R, compounded with the fact that the products it sold contained all of Simms' identification numbers, and in continuing to sell R&R's products, Costco committed an extra-contractual fault and was liable for the damages incurred by Simms.

Contractual Interference

A well-known principle in civil law is that of the relative effect of contracts, a principle whereby a contract produces effects only between its parties.

However, this decision of the Court of Appeal affirms that even where there is no contractual relationship between two parties, the moment a third party knowingly incites, assists or participates in the breach of a contract, the latter commits a fault of contractual interference. Therefore, a non-contracting third party commits an extra-contractual fault when it knowingly assists a contracting party in breaching its obligations. This interfering party is then held liable for the damage caused to the other contracting party who is the victim of the breach of contract.

The primary elements for a finding of fault of an interfering third party, barring the preconditions to considering such a fault, such as the existence of a legally binding contract and the breach of valid contractual obligations, are: (1) the third party's knowledge of the contractual rights in question; (2) incitement to or participation by the third party in the breach of the contractual obligations; (3) some form of bad faith or disregard for the interests of others.

The fact that the interfering party did not receive a copy of the contract or was not aware of the clause that was violated cannot be invoked as grounds to circumvent liability. The test for knowledge as to the scope of the contractual rights is a question of fact and studied on a case by case basis.

In this matter, it was determined that Costco had sufficient knowledge of the contractual obligations being contravened, after receipt of the first formal notice in November 2009 whereby Costco was asked to cease and desist all unlawful distribution of R&R products. The manner in which the formal notice was drafted left no room for ambiguity with respect to the existence of a contractual relationship between Simms and R&R and Simms' exclusive distribution rights.

The Court accepted that Costco had knowingly decided to ignore the distribution agreement between Simms and R&R, regardless of having been made aware of it. The judge analyzed Costco's behaviour through the standard of the normally prudent and diligent person. It concluded that, even if it did not have an active duty to be informed of the content and extent of the contractual obligations that bound R&R, Costco breached its duty to not cause injury to another and to act in good faith.

Costco is a giant in the Canadian retail market and is presumed to be very familiar with the rules and practices of the industry. As a major retail player, Costco knew or should have known that R&R products were subject to certain exclusive distribution rights. All Costco needed was sufficient knowledge of the exclusivity granted to Simms.

The Bad Faith Test

The third criterion of contractual interference is the bad faith of the interfering party, and Costco argued that the evidence did not demonstrate the presence of any bad faith.

However, the Court emphasized that the criteria for contractual interference are not to be taken and analyzed in isolation, but rather must be studied contextually as a whole.

Although knowledge of the contractual rights is the main criterion to prove, it must be accompanied by an intention on the part of the interfering party to harm the other contracting party. Such an onus does not bestow upon the victim the obligation to prove the direct intention to harm, as sufficient knowledge may be implied with respect to the interfering third party's understanding of the negative impact of its interference. Thus, Costco, in taking into consideration its experience in the field, could not have been unaware of the consequences the sale of R&R products in its stores would have on Simms.

For these reasons, the Court of Appeal confirmed and recognized Costco's extra-contractual liability towards Simms for contractual interference.

This judgment rendered by the Quebec Court of Appeal is therefore a landmark decision in the field of commercial law and more specifically for distributors who hold exclusive distributorship rights. A retailer who is reckless or wilfully blind to evident signs of a breach of contract commits an extracontractual fault and risks legal liability to compensate for damages suffered by the aggrieved distributor.

For any questions or if you would like to learn more about how this decision, we invite you to send us an email,

• Me Robert Faguy
• Me Elizabeth Cullen
• Joelle Rousseau