A recent House of Lords decision has clarified the approach to be taken when assessing the compensation due to a commercial agent on termination of their agreement

The Commercial Agents (Council Directive) Regulations 1993 (as amended) give a commercial agent the right to a payment on termination of the agency agreement.

The decision of the Court of Session in King v Tunnock Ltd 2000 SC 424 is the only appellate case in Scotland containing a full discussion of the way compensation should be calculated. Mr King sold cakes and biscuits for Tunnock Ltd. He had taken over the agency from his father in 1962. It was his full time occupation. In 1994 the company closed its bakery and terminated the agency. The evidence was that over the previous two years he had earned gross commission amounting in total to £27,144. The sheriff held that he was not entitled to compensation because the principal, having closed the business, would not enjoy any benefits from the goodwill generated by the agent. But an Extra Division of the Court of Session reversed this interlocutor and awarded compensation in the sum of £27,144.

Much emphasis was placed on the French “two year rule”. In France a commercial agent can ordinarily expect to receive two years’ worth of gross commission earned over the last three years.

In an English decision in 2003, Tigana v Decoro, the judge took an alternative approach and listed a number of factors to consider when assessing the “just and equitable” sum that an agent would be entitled to by way of compensation for the loss of the agency. Whilst this approach (identifying factors) sought to “value” the agency and provided a more stable basis for calculating the sum due, differences of interpretation remained between agents and principals.

The Lonsdale decision

In Lonsdale v Howard & Hallam Ltd [2007] UKHL 32 the House of Lords sought to reconcile the various approaches to valuation.

Mr Lonsdale sought to argue that, when assessing the “just and equitable” sum to be paid in compensation using the factors listed in Tigana, courts should adhere to a guideline compensation value equating to two years’ average commission. This approach (as in King v Tunnock) was based on the judicial approach in France from whose system the compensation provisions in the regulations came about (via the harmonising EU directive).

The House of Lords agreed with the judgments of the courts below, including that of Moore-Bick LJ in the Court of Appeal, and in particular rejected the approach in Tigana. In relation to King v Tunnock Lord Hoffmann said:

“I am bound to say that I do not find the reasoning of the Extra Division, delivered by Lord Caplan, at all convincing… the Court of Session appears to have arrived at the figure of twice gross commission without any evidence at all. Lord Caplan said that he was ‘reassured’ that this would be standard compensation in France, but, for the reasons I have explained, the French practice is of no evidential value whatever.”

The decision in Lonsdale means that the approach to calculation of the termination payment will be to undertake a commercial valuation of the agency as at the date of termination to assess the loss incurred by the agent in losing the agency. This process will be analogous to the valuation of a business in a sale situation, as it will involve assessing the value that a notional purchaser would pay to acquire the agency on the hypothetical basis that the agency agreement were to continue in force. Whilst the court emphasised that in many small agencies the valuation process will be relatively straightforward, it offered little guidance on the valuation process itself.

So how then might an agency be valued?

Assigning the agency agreement

One of the limited exceptions to the requirement to pay compensation on termination is where the agent assigns the agreement to a third party. This clearly has an advantage for the principal, as the agent and third party are left to negotiate the value of the agency without input from the principal.

From the principal’s perspective there may be some work required to assess the suitability of the third party, particularly where consent is required to the agent’s assignation. In addition, it would be prudent to ensure that there is a clear understanding of each party’s rights and obligations pre- and post-sale. For example, the right to commission generated by activity pre-sale but payable post-sale will need to be clearly documented.

The sums paid by incoming agents will be extremely useful in assessing the value of agencies during termination negotiations. Principals will benefit from understanding sale values on assignation, as there may be a need to compensate the agent for that agency in the future. This market information is likely to be scarce initially but it must be hoped that it becomes more readily available over time.

Risk of double payment

Where a principal cannot broker an assignation to an incoming agent, the valuation exercise will result in a payment being made to the agent.

But what does the principal get for its money?

The courts have made it clear that the main benefit to the principal is the goodwill generated by the agent. So is there a risk to the principal that this goodwill is passed to an incoming agent and then “re-acquired” at the end of that agency?

The answer must be yes. The principal would effectively be purchasing substantially the same goodwill twice. The more difficult question is how to protect the principal’s position in such circumstances, particularly as the regulations prevent derogation from the compensation provisions to the detriment of the agent before the agency contract expires.

The simple answer would be to require an incoming agent to purchase the “agency” already acquired by the principal – the valuation will already be settled from the initial “purchase” from the outgoing agent. However this approach is likely to cause problems for a number of principals and may stifle agent recruitment.

It is more difficult and complicated to conceive an alternative approach.

One approach would be to structure the commission arrangements over the initial term of the agency agreement to pay off in instalments the final value of goodwill generated. For example, instead of the principal’s usual commission rate of 5% being paid to the agent, 3% could be paid with the remaining 2% being allocated to repay the debt. The advantage to the agent is that the goodwill (and thus the right to a higher termination payment) is acquired earlier; the obvious downside is the reduced commission flow. From the principal’s perspective, the benefit is the avoidance of possible double payment for goodwill; the risk is a possible successful legal challenge to the arrangement by the agent leading to a liability for a sum that the arrangement was designed to avoid.

The approach laid down in the House of Lords decision will inevitably lead to a period of uncertainty in the level of compensation to which an agent is due. The position may well improve as the market becomes more alive to the value of an agency as a saleable “business”. In the interim, guidance will have to be taken from the valuation approach to other businesses.

Essential protection

Increased thought and planning are required when appointing and terminating agencies, to ensure that agency valuations are properly factored into provisions for payments and cost/benefit analysis.

The Lonsdale case has emphasised the need for agency arrangements to be properly documented. Whether this is to ensure election of the indemnity method of calculation, or to document agreed methods for dealing with goodwill on agreement commencement and termination, the benefit of clear contractual agreements will prove invaluable to companies seeking to protect their position as regards their sales agents. Those companies without effective agency agreements risk the uncertainty of compensation liabilities and the potential for multiple liabilities for the same “goodwill”.

John MacKenzie is a partner in international law firm Pinsent Masons

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