The lesser of two evils: is compensation or indemnity better for principals on termination?

For principals, the general rule is that providing in the agency agreement for the agent to receive on termination an indemnity payment under the Commercial Agents Regulations is safer, because an indemnity payment will be capped at the average annual commission received by the agent in the last five years of the agency.  It follows that this usually results in a lower payment being made to the agent than if compensation is due, because compensation is uncapped.  

Another advantage of the fact that indemnity payments are capped is that on or approaching termination of the agency, a principal will have a clear idea of its maximum exposure to the agent.  Such financial certainty will obviously be attractive to principals.  In addition, if the agent brings a claim for an indemnity payment, the cap means that it is usually easier for the parties to reach a settlement of the claim, which in turn minimises legal costs and management time spent on litigation.

In order for the principal to ensure that the agent is entitled to an indemnity payment on termination (and not compensation), the parties must have agreed to this.  The best way to prove agreement is for the parties to provide in the agency agreement that indemnity will apply.  If nothing is said, the default rule is that compensation applies.

Whilst the indemnity system is best for principals in most cases, there are some instances where compensation under the Commercial Agents Regulations is a better bet.  Compensation is calculated by reference to the value of the agency business at or immediately before the date of termination.  This calculation requires the costs of the agency business to be deducted from the total commission income, and then a multiplier to be applied to the net earnings figure.  You would think that this would always produce a positive figure, but we come across agency businesses where the costs of running the business are higher than the annual commission income.

This may sound unlikely – after all, who would run a business at a loss?  Part of the problem for agents can be that the value of the agency business is determined by reference to the costs which would need to be spent by a third party purchaser of the agency business, not the costs which are actually spent by the agent.  An example is if the agency business is an owner-managed business, it is often the case that the sole director/shareholder has not paid himself a salary, but instead has taken a dividend from the company.  In such cases, there would need to be deducted (as a cost to the agency business) a “notional salary” of the director/shareholder.  If the director/shareholder is a very experienced salesperson, with years in the relevant industry, the deduction for a notional salary could be considerable.

Similarly, if the agent’s spouse has been providing administration services to the agency business but has not been paid for this work.  In such a scenario, there would be no cost for administration services to the actual agent.  However, for the purposes of the compensation calculation, there would need to be a deduction for what it would cost a third party purchaser for equivalent administration services.  
In some cases, therefore, the calculation of the value of the agency business can produce a negative figure.  This will mean that the agent is not entitled to compensation, and the agent will have an uphill struggle to prove otherwise.

So is there any way in which a principal can assess in advance which of compensation or indemnity would prove cheaper?  The answer is that it may be possible to take a calculated guess as to which would prove cheaper in some instances.  These would only be instances where the principal can come up with a realistic estimate of the approximate value of commission which is likely to be generated by the agent each year.  An example would be if an employed sales representative were to be appointed as an agent of his former employer for the sale of the same products in the same territory.  In such a scenario, the principal would have an idea of the value of sales that the agent would be likely to generate at the start of the agency (and therefore his commission).  What is unknown, however, is the value of sales (and therefore commission) which the agent will be generating at the end of the agency.  This is where the risk lies.  If the agent grows the sales in its territory substantially during the agency and the principal has gambled on compensation applying, it could prove to be a very expensive gamble.  

Without a crystal ball the principal will not know at the outset of an agency relationship how it will end or the likely commission income generated by the agent when it does end.  Therefore, the best way for the principal to limit its risk is to have a comprehensive written agency agreement with the agent which provides for indemnity to apply.  

 

The contents of this article are intended for general information purposes only and shall not be deemed to be, or constitute legal advice. We cannot accept responsibility for any loss as a result of acts or omissions taken in respect of this article.
Emma Roake
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