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What is better – compensation or indemnity?

Where the Commercial Agents (Council Directive) Regulations 1993 (‘the Regulations’) apply to an agency contract, in certain circumstances the agent will have the right to be paid compensation or an indemnity when the agency contract is terminated. The basic objective behind this is to protect the agent against the effects of losing their agency contract when they have worked hard to help the principal build up the business and the principal’s business continues to benefit from the agent’s efforts after the agency contract has ended.

Under the Regulations, compensation is the default option unless the parties have agreed in the agency contract that the indemnity option will apply. The choice between the two options is very important because compensation and indemnity payments are subject to very different calculations, which means there can be a significant difference in their value.

The decision about whether to elect for compensation or indemnity has to be taken at the start of the agency relationship, when the agency contract is entered into. At this point in time, it can be difficult to predict how successful the agent is going to be in generating business for the principal.

How compensation and indemnity are calculated

The value of a compensation claim is assessed by carrying out a theoretical open market valuation of the agency that has been terminated. That valuation is made at the date on which the agency was terminated and is based on the anticipated income stream that would have been generated if the agency had continued. This exercise can be quite complex and often requires specialist assistance from a forensic accountant, but the Regulations do not impose any limit or cap on the amount that an agent can claim by way of compensation.

In contrast, the value of an indemnity claim is assessed by reference to the business generated for the principal from new customers introduced by the agent and existing customers where the agent’s activities have resulted in significant increases in their level of business with the principal. It will also be important to establish that the principal continues to receive significant benefits from continuing to do business with those customers after the agency contract has ended. If customers followed the agent and ceased their business with the principal, this would reduce the value of the indemnity claim. Unlike compensation, however, the value of an indemnity claim is limited under the Regulations, to a maximum of one year’s average earnings (with the calculation of that average being based on the annual earnings of the agent in the 5 year period prior to termination of the agency, or on the relevant number of years where the agency has existed for less than 5 years).

The purposes behind compensation and indemnity

As might be expected from the very different methods of calculation, the purposes behind compensation and indemnity are quite different:

  • A compensation payment is intended to reflect the loss of the value of the agency (i.e. the future income stream for the agent) which results from the agency ending.
  • In contrast, the indemnity payment could be described as ‘buying-out’ the value of the benefits (goodwill) the principal has gained as a result of the agent’s efforts during the agency and continues to receive after the agency has ended.

So which is better?

That obviously depends on whether you are an agent or a principal!

In normal circumstances, in the vast majority of cases an agent could expect to receive a higher payment from compensation than from indemnity (largely due to the one year cap on indemnity claims).

Exceptions might occur where the agent:

  • is likely to saturate the market quite quickly, with sales then reducing quite significantly. It is worth noting that if sales levels do reduce significantly over time, then the sum payable to the agent as compensation or indemnity would also reduce;
  • generates significant volumes of business for the principal from new customers and increases the principal’s dealings with existing customers, but the profit generated by the agent on the agency is low (e.g. because commission rates are low and/or the agent’s expenses are high).

In most cases, compensation is likely to be the better option for an agent (resulting in a higher payment) while indemnity would be preferred by a principal (because it usually results in a lower payment to the agent).

However, it remains to be seen whether the twin impacts of the COVID-19 pandemic and Brexit ‘completing’ on 31 December 2020 will alter the general position. Some industries and sectors have been decimated by social distancing requirements and lockdowns during the pandemic and/or may suffer significantly in the period immediately after 31 December 2020. In such unusual circumstances, there could be more situations where indemnity payments are higher than compensation payments (particularly if the future income stream of the agency is anticipated to be low or non-existent for a period of time while these events continue).