Compliance: Starbucks’ expensive exit: A wake-up call to inside counsel

These terms will always be challenging to inside counsel no matter how well-crafted the distribution agreement

On Nov. 12, 2013, Starbucks Corp. announced it would pay Mondelez International Inc., a successor to Kraft Foods Inc., $2.8 billion in damages, including interest and attorneys’ fees in settlement of a dispute over Starbucks’ termination of the supply and license agreement dated March 29, 2004 (the Distribution Agreement) between the two companies related to Starbuck’s packaged coffee business. The result is a wake-up call to inside counsel negotiating long-term ventures, supply and distribution agreements and other commercial and strategic alliances.

According to SEC filings, under the Distribution Agreement, Starbucks sold a selection of Starbucks and Seattle’s Best Coffee-branded packaged coffees in grocery and warehouse club stores throughout the United States, and to grocery stores in the United Kingdom, Canada and various other European countries. Kraft was responsible for the distribution, marketing, advertising and promotion of these products.

According to the Wall Street Journal, the dispute began to heat up when Starbucks Chief Executive Howard Schultz complained to the CEO of Kraft that Kraft was not keeping store shelves stocked, was selling outdated packages and was not securing enough shelf space for its products. In the spring of that year, Starbucks offered Kraft $750 million to regain control of their packaged coffee business, alleging material breaches by Kraft of its obligations under the agreement, including Kraft’s failure to involve Starbucks in sales planning, failure to provide detailed budgets, failure to obtain approval for advertising and the promotion of its own premium coffee in violation of the agreement.

Kraft denied it had materially breached the agreement and made it clear that if Starbucks wished to terminate the agreement it would have pay Kraft 135 percent of the fair market value of the agreement. Kraft claimed that since beginning their collaboration, Starbucks’ retail coffee business had grown from a $50 million a year venture to $500 million. According to several reports, Starbucks countered, however, and alleged that sales growth at grocery stores “quickly fell” after 2000 and that its market share dropped from almost 33 percent of grocery store premium coffee sales in 2005 to about 25 percent at the beginning of 2010.

According to Starbucks SEC filings, Kraft notified Starbucks in late 2010 that it was putting the commercial dispute into binding arbitration, pursuant to the terms of the agreement. Kraft sought injunctive relief to prevent Starbucks from terminating the agreement before the dispute was resolved through arbitration. But the request was denied, and Starbucks then unilaterally terminated the agreement and partnered with Acosta, a marketing firm, to distribute its package coffee. Starbucks has been in control of their packaged coffee business since March 1, 2011, and has reported that since regaining control, it has experienced an increase of $3.2 billion in revenue and 47 percent in profitability.

According to Starbucks’ most recent annual report, the arbitration hearing was completed on August 3. At the hearing, Starbucks presented evidence of material breaches on Kraft’s part, and Kraft presented evidence denying it had breached and sought damages of $2.9 billion plus attorney fees. Kraft won.

The result shows the importance of termination provisions in supply and distribution agreements and other commercial alliances. Basic termination events, such as material breaches of the agreement, bankruptcy, change of control and agreed upon business milestones need to be augmented by considering scenarios pertaining to the industry, the market, and the parties to the agreement, such as regulatory issues, market share, sales volume, quality of product, change in objectives or focus of the parties, and other business and financial parameters.

Although the arbitration and the terms of the supply and license agreement are private and confidential, the terms that appear to be at the center of the dispute are the kind of terms that will always be challenging to inside counsel no matter how sophisticated the parties and well-crafted the distribution agreement.

First, when providing the other party with an exclusive, consider the conditions for the exclusivity. Starbucks did not believe Kraft was fulfilling its obligations to grow Starbucks market share in its exclusive market, but either the agreement did not address the concern or the exclusivity conditions were based on business objectives or parameters that proved less important to Starbucks in retrospect.

Second, most supply and distribution agreements have a termination event for a material breach with a cure period, but it is not always clear what is considered a material breach, as seems to have been the case here where Starbucks unilaterally terminated because of the material breaches, but ended paying more than expected for its actions. Inside counsel should consider the ambiguity surrounding the term “material breach” and consider addressing the ambiguity by defining the term. Setting out obligations that a party considers to be material could help avoid disputes down the road.

Third, although a payment for termination for convenience or without cause may be useful, inside counsel should consider the means of determining the value placed on the termination and the method of valuation used. For instance, Starbucks may have been well served by a termination payment that it considered reasonable once it realized that Keurig (and not Kraft) was going to be the dominant player in the market that Starbucks wanted to be in. Although it is doubtful Starbucks would consider the $2.8 billion payment a reasonable payment for that right to terminate, Starbucks does give the impression that market gains resulting from terminating the contract have been worth it, according to the Wall Street Journal.  Kraft, on other hand, did not want to make it easy for Starbucks to disappear after its investment in the distribution arrangement. Inside counsel’s challenge will be to find a reasonable exit agreeable to all parties in advance for when the alliance does not go as planned.

Contributing Author

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Robert J. Gavigan

Robert J. Gavigan is a partner in the Corporate group of Cohen & Gresser LLP.

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Contributing Author

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Andrew M. Por

Andrew M. Por is an associate in the Corporate group of Cohen & Gresser LLP.

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