AAA ICDR Panel rules that Johnson & Johnson International violated Law 75 and awards damages, fees, and costs to Puerto Rico distributor in excess of $1.1 million plus interest

The proceeding between Claimant Puerto Rico Hospital Supply Group, Inc. (“PRHS”) and Respondent Johnson & Johnson International (“J&JI”) Case No. 01-17-0007-4506 before a three-member panel of the International Center for Dispute Resolution of the American Arbitration Association (referred to as the “AAA arbitration”) presented interesting and substantial questions under Puerto Rico Law 75, including:

«Is a termination actionable for damages when the manufacturer’s purported intention is to terminate all of the distribution agreements except one and its actions are consistent with a complete refusal to deal?

«Do preexisting financial motivations and economic interests of the manufacturer suggest that the business reason it ostensibly gives for a termination is a pretext?

«When is pretext sufficient to overcome the manufacturer’s proffer of just cause for termination?

«Must contractual payment terms that underlie the termination decision be reasonable and adjust to market conditions in the territory at relevant times?

«Does an offer of a payment and performance bond to secure the payment of a debt under the distribution agreement qualify as a payment in cash or its equivalent?

Claimant PRHS is one of Puerto Rico’s oldest and largest distributors of medical devices and products. For decades after 1964, PRHS sold and distributed Johnson & Johnson (and Ethicon) branded sutures and medical devices used in patient-critical surgical procedures by hospitals and other medical providers throughout Puerto Rico. There were various written distribution agreements in effect between the parties: most of the agreements were exclusive, but one was non-exclusive. The non-exclusive agreement had a mandatory arbitration provision while the exclusive agreements did not. J&J’s products represented approximately 20% of PRHS’s total sales, including roughly 5% for the non-exclusive product lines. There was a history of prior federal litigation between the parties that resulted, among other things, in agreeing to 90-day payment terms for all the contracts.

For the past 12 years, Puerto Rico’s economy has slumped leading up to the eventual public bankruptcy. Private and public hospitals have not been immune from this economic downturn and remain exposed to the mass migration of thousands of Puerto Rican residents (many are patients) to the mainland, the closing of beds and aisles in hospitals, and as if that were not enough, to catastrophic damages and business interruptions to the general population caused by Hurricanes Irma and María in 2017.

In 2015, the liquidity of hospitals grew tighter aggravating delays in payments to their suppliers, including to PRHS. While the days sales outstanding (DSO’s) of PRHS’s invoices to hospitals increased to roughly 183 days on average (some public hospitals took over 300 days to pay), PRHS’s distribution contracts with J&JI all had 90-day payment terms. During 2016, PRHS started falling behind in its payments to J&JI but continued making partial payments of millions of dollars.

J&JI decided to make a preemptive move to judicially enforce the 90-day payment terms. In March 2017, J&JI sued PRHS in federal court in Puerto Rico. J&JI requested a declaration that it had just cause under Law 75 to terminate all the agreements between the parties for non-payment of invoices and have PRHS cease and desist from using any of J&J’s brands and trademarks for the sale and distribution of its products. J&JI requested the collection of monies from PRHS exceeding $4.5 million allegedly due for products sold and delivered under all the agreements. What is more, J&JI filed a motion for preliminary injunctive relief to attach PRHS’s bank accounts to secure the payment of the total alleged debt. PRHS opposed the request for equitable relief and moved to dismiss or stay the action in favor of arbitration. J&JI resisted arbitration.

The federal court denied J&JI’s request for equitable relief and granted in part PRHS’s motion to dismiss and stay the case in favor of arbitration concerning the non-exclusive contract. See Johnson & Johnson v. Puerto Rico Hospital Supply, 258 F. Supp. 3d 255 (D.P.R. 2017) (granting, in part, motion to dismiss) and 322 F.R.D. 439 (D.P.R. 2017) (denying J&JI’s motion for reconsideration). The court explained the stay reasoning essentially that an arbitration award could be dispositive of issues and claims in the federal action and there is a possibility of inconsistent determinations if the two proceedings could move forward simultaneously.

Meanwhile, J&JI sent a notice to PRHS in September 2017 unilaterally terminating all the exclusive agreements ostensibly for lack of payment but informing PRHS that it had decided not to terminate the non-exclusive agreement with the arbitration clause (as if that could have prevented PRHS from initiating the court-sanctioned arbitration). The termination of the exclusive contracts would become effective a day after Hurricane María made landfall over Puerto Rico. By the effective termination date, J&JI also took over the direct sale and distribution to customers of all the products previously sold and distributed by PRHS. In October 2017, J&JI informed PRHS that it was not, among other things, authorized to place any purchase orders for any products of J&J’s brands and demanded the return of all the inventory. In November 2017, PRHS complied and returned all its inventory of J&J’s products, including the products sold under the non-exclusive agreement, which J&JI later resold to customers.

PRHS filed a Demand for Arbitration at the AAA alleging a claim under Law 75 for termination without just cause of the non-exclusive agreement and requesting damages over $400,000 plus an award of fees and costs. PRHS also filed a separate action in federal court in Puerto Rico (Civ. No. 17-2281 (DRD)) under Law 75 for termination of the exclusive contracts allegedly worth over $10 million. The federal actions were not consolidated. J&JI responded in the AAA arbitration with a counterclaim for collection of monies which, as amended during the hearings, allegedly exceeded $540,000.

After extensive discovery, seven days of evidentiary hearings, and the lifting of an automatic stay resulting from the distributor’s intervening Chapter 11 bankruptcy petition, on May 2, 2019, the AAA Panel rendered a final reasoned and written award. In a 63-page majority 2-1 decision (joined by Chair José A. Fusté and Manuel San Juan, Esq.) with one panelist concurring and dissenting in part (Edgardo Cartagena, Esq.), the Panel determined that J&JI had terminated the non-exclusive agreement and it had done so without just cause in violation of Law 75. The Panel awarded PRHS five years of lost profits on the line, the cost of the returned inventory, AAA fees, the pro rata share of fees it paid for panel compensation, attorney’s and expert witness fees as the prevailing party under Law 75, and costs and interest at the annual rate of 6.25% for a sum exceeding $1.1 million. The Panel credited fully the testimony on damages of PRHS’s expert Carlos Baralt, CPA. PRHS did not claim a loss of goodwill from the termination of the non-exclusive line. The Panel also unanimously concluded that J&JI had failed to prove the existence of the debt or its amount and dismissed the counterclaim with prejudice.

Whether or not there was just cause for termination was a fact-intensive question and the Panel heard live witness testimony and received in evidence documents relevant to this issue. Having its ultimate burden of persuasion on the issue of just cause and needing to rebut a legal presumption of lack of just cause in P.R. Laws Ann. tit. 10, 278a-1(b)(1) from having sold the products previously handled by the distributor, J&JI argued that PRHS’s breaches of the 90-day payment term, without more, were just cause under Law 75.

First, there is no actionable termination claim under Law 75 unless the manufacturer terminates the contract, but detrimental acts that impair the contract are also actionable. Once the distributor proves a termination or impairment of the agreement, the burden shifts to the manufacturer to prove just cause. The Panel determined that, although the manufacturer may proclaim in writing not to have terminated the non-exclusive agreement, its subsequent actions and course of conduct proved its intent to refuse to deal and effectuate a termination of all the contracts. The Panel found sufficient evidence of a termination of all the contracts from conduct by J&JI prohibiting PRHS from honoring any purchase orders from its customers for the sale of any products of J&J’s brands, from prohibiting the use of any trademarks for marketing purposes, from ordering the return of all products on inventory, and later selling the inventory directly to the distributor’s former customers. The Panel held that J&JI’s “intention in 2017 was simply to terminate all commercial relations with PRHS and move from an indirect to a direct sales strategy, completely cutting out PRHS from the equation.” Award at 31.

Second, the Panel observed that, under Puerto Rico law, lack of timely or complete payments is not just cause without considering the terms of the agreement, whether the payment terms are essential obligations or not, how material are the breaches, and the conduct of the parties. The Panel gave weight to J&JI’s inconsistent conduct alleging the termination of the exclusive agreements but not the non-exclusive agreement when the basis of the distributor’s alleged breaches of contract was identical. The evidence established that the 90-day payment term in the non-exclusive agreement was not an essential obligation because the supplier alleged to have kept the non-exclusive contract in full force and effect despite the defaults in payment.

Regardless, the Panel found that J&JI’s reasons proffered for the termination were pretextual. Pretext can rebut a showing of just cause under Law 75. Before PRHS fell behind in its payments, J&JI’s internal marketing plans and strategies had devised a plan to implement a direct distribution model to bypass its Puerto Rico distributor. The Panel also gave weight to evidence derived from J&JI’s audited financial statements filed as public records proving that its Puerto Rico division had operational losses at relevant times after its parent company divested itself of another franchise causing the loss of millions of dollars in sales. The Panel had sufficient evidence from which to infer that J&JI had a motive to appropriate for itself the market and clientele created by PRHS which gave way to a convenient excuse to terminate the agreements for lack of payment.

It was also highly probative that J&JI’s manager in Puerto Rico took credit in her job evaluation for implementing, after PRHS’s termination, a “PRHS legal strategy” to move the organization from an indirect model to a direct model for the Ethicon franchise. “[The Panel] finds that the need to increase revenue, and not PRHS’s payment delays, was the driving force” behind J&JI’s move to conveniently cut PRHS out of the market. (Award at 39).

The Panel also decided novel issues of Puerto Rico law which should be relevant to any manufacturer or supplier considering the termination of a dealer’s contract for lack of payment in the context of adverse economic or market conditions. Section 278a-1(c) of Law 75 provides that any “rules of conduct” or distribution quotas or goals in a dealer’s contract must adjust to the realities of the Puerto Rico market at the relevant moment of the dealer’s non-performance, or else, are unenforceable.

From plain language, context, and statutory history, the Panel concluded that the prohibition in Section 278a-1(c) was not limited to performance standards set in a distribution contract, but also applied to payment terms. Because J&JI failed to present any evidence that the 90-day payment terms- as standards of conduct- adjusted to the realities of the relevant health care market in Puerto Rico during 2016-2017, the Panel credited the testimony of PRHS’s experts Julio Galíndez, CPA and Gustavo Vélez that the payment terms were unreasonable, and therefore, null and void under Law 75.

In the end, critical to the Panel’s analysis of just cause was sufficient evidence that, a few weeks before the termination notice, PRHS made an offer to J&JI to guarantee payment in full of the total amount of the debt outstanding on all the agreements by posting a payment and performance bond. An internal J&JI’s memorandum prepared contemporaneously with the offer corroborated this evidence. J&JI rejected the offer out of hand without any serious consideration or explanation to PRHS. The Panel found that the payment and performance bond would have operated like cash in hand to J&JI because under Puerto Rico law a surety steps in to pay the creditor for a default in payment by the debtor. The Panel concluded that a payment and performance bond would have obviated any need to terminate the distributor. Accordingly, the Panel held that the rejection of the bond proposal was “unreasonable and ill-considered” (Award at 46) and “adds to the Panel’s suspicions of pretextual motivations.” (Award at 49). The dissenting panelist was of the view that the termination notice, without more, proved no termination of the non-exclusive agreement but concurred with the majority’s dismissal of J&JI’s counterclaim.

On this record, the Award made the distributor whole for the full amount requested of compensatory damages for termination of the non-exclusive agreement, fees, interest, and costs, and the manufacturer took nothing on its counterclaim. The final award is subject to judicial enforcement.

The author is lead counsel for the Puerto Rico distributor in the arbitration and related federal litigation. Heriberto Burgos, Mariano Mier, and Mercedes Rodriguez are part of CAB's litigation team.