Compensation under the Regulations – what is the calculation?

When an agency agreement ends, what is of most concern to the agent is the amount of compensation (or indemnity) to which the agent is entitled under the Commercial Agents Regulations 1993 (the Regulations). In respect of compensation, and as might be expected, conflicting opinions as to how to quantify the value of the business that the agent has helped the principal build is usually just one aspect of the dispute between the parties.

But now the recent judgment in Green Deal Marketing Southern Limited (“GDM”) v Economy Energy Trading Limited (“EE”) sheds light.

Buy now points

1. Calculation of the value of an agency should be based on a hypothetical situation that the agency would continue, but not forever, and be valued as if it were to be purchased on the date that the agency would have come to an end.
2. Compensation can be reduced for a number of reasons; however, the risk of an exclusive agency agreement can cause the value of the company to be reduced up to 50%.
3. The value of the agency can also be reduced if there have been repeated breaches of the contract that would have allowed the principal to terminate the contract without becoming liable for compensation.

But why did these points arise?

In Green Deal, having decided that the Regulations applied to the relationship (see here), the judge went on to decide the amount of compensation to which the agent would be entitled to under the Regulations.

The accepted principle in respect of compensation is that the agent has a share in the goodwill of the principal’s business that the agent has helped to create. Therefore, at the termination of the relationship the agent should be compensated for the loss of the goodwill that the principal retains. What is of value to the agent is the prospective commission that the agent would have earned as a future income stream had the relationship not been terminated.

EE, as the principal, initially put forward the argument that the agent had not suffered any damage to its ability to earn future commission and therefore was not entitled to any compensation. This was because EE had paid the agent all the commission it was entitled to under the contract. Therefore, any benefits EE had retained from the customers that the agent had introduced had already been paid for.

This, however, was a surprising position to take because, as the judge noted, it did not follow the purpose of compensation under the Regulations. EE had retained the goodwill of the business that GDM had helped to create and so should have compensated GDM for the loss of income stream of commission it would have received had the relationship continued. As a result, the judge had to determine how to calculate the value of the goodwill of the business the agent was losing.

It is accepted that the income stream that the agent would have received in the future should be calculated as if the relationship between the agent and the principal was to continue. However, the length of time that the relationship between the two parties should continue remains uncertain. EE put forward that the agency should be valued in relation to the length of its notice period as the principal could lawfully terminate the agreement in this manner. However, again, this proposition failed to recognise existing case law which provided that the valuation of an agency should be based upon the agency relationship continuing without taking account of any termination provisions.

Given existing case law, the judge decided that the right approach was to calculate the relationship as if it were continuing but that there should be taken into consideration that the relationship would not continue forever. In doing so, he pointed out that relying on the length of the termination provisions to limit compensation was not the correct approach given that the right to compensation only arises at termination of the agreement. Furthermore, the judge noted that in this case any valuation would need to be considered on the basis that the agreement could have been terminated lawfully due to the continual breaches of contract.

In order to assist the judge in making his decision as to the value of the agency, both parties instructed a professional valuer to provide guidance as to the calculation that should be used.

GDM’s valuer adopted a Price/Earnings ratio method, which is most commonly used for making valuations especially of smaller private companies. This method creates a price for the asset by comparing the asset to a range of benchmark companies and adjusting the price in accordance to a range of factors including the risks and prospects of the asset.

In comparison EE’s valuer adopted the EV/EBITDA method (similar to the cash flow method) which values an asset independently of the capital structure of the companies under consideration. Therefore, it has the advantage of being able to compare companies with different debt to equity ratios from the asset and which have different tax rates to the asset. EE’s valuer then discounted the amount in relation to three elements:

1. an amount for the risk associated with operating under an exclusive agreement for a single customer;
2. an amount to reflect the regulatory pressures and scrutiny affecting the market; and
3. an amount to reflect the assumption that the agency could not be assigned once sold to a hypothetical purchaser.

When deciding which valuer had made the correct calculations in relation to the value of the income stream the judge stated that the value of the income stream at the notational date of sale (the date of termination of the agreement) depends on the risks facing the income stream at that time. The judge decided that there were three main risks to GDM’s income stream:

1. the state of the doorstep market for sales – the doorstep market in 2017 was diminishing in the judge’s opinion. When looking at competitor’s doorstep sales, sales were falling and therefore GDM’s growth was unlikely to carry on exponentially.
2. The relationship between Ofgem and EE – there was no communication between EE and the regulator Ofgem that the cessation of doorstep selling was required. However, the judge considered that it was unrealistic to assume that Ofgem’s interest in and investigation of EE would have had no effect and would have been perceived by a prospective purchaser as having no effect on GDM’s doorstep sales business. The judge thought that if the Ofgem investigation into GDM’s and EE’s activities continued, both parties would have looked to a sales cap being introduced for both parties’ protection. This and the potential cessation of doorstep sales, in the judge’s opinion, would have reduced the value of the agency.
3. The position of GDM under its contract with EE – even though a compensation claim should not be limited by the prospective termination of an agency agreement by notice or by expiry of a fixed term, the judge in this case thought that GDM’s repeated failure to meet its Key Performance Indicators (KPIs) should not be ignored. Because of this breach EE would have had the right to terminate the contract and such termination would have not led to an entitlement to compensation.

Therefore, the judge found in favour of the method put forward by EE’s valuer due to the fact that it had the advantage of no distortions resulting from the different debt to equity ratios and tax rates compared to its comparisons. The judge agreed with the valuer’s assessment that the multiplier created by the EV/EBITDA should be reduced. He agreed that the fact that GDM only had one principal should be taken into account when valuing the agency due to the increased risk of not having a fully diversified business. He also agreed that regulatory pressures similar to those mentioned above would be highly relevant in a real-world valuation of the agency. However, he did not agree with the valuer that a further discount should be made for the non-assignability of the agency and that this assumption had been made due to an incorrect interpretation of a historic case.

Finally, when deciding how to calculate the future earnings, GDM’s valuer had based his assessment on the management accounts of GDM for the period May 2016 to January 2017. However, in contrast EE’s valuer used a weighted average. This method was strongly contested by GDM for showing a profit figure for the second year of trading that was lower than the actual profit made and for double counting regulatory pressures into the calculation.

The judge did not agree with GDM. Instead, the judge thought that EE’s valuer was correct in concluding that GDM’s growth was largely due to the increase in territory and that the expansion was on its way to stopping. Therefore, the risk in the diminishing returns should have been taken into account.