Colombia enjoys economic and political stability which, together with a sustained economic growth, has attracted foreign investment to our country. As one of the consequences of this pro-investment climate, Colombia has ratified various free trade agreements (hereinafter “FTA”) with countries such as Canada and Mexico, and more recently, the U.S.-Colombia Free Trade Agreement (hereinafter “US-FTA”) was approved by the United States Congress and signed by the President on October 21st, 2011. Colombia is also waiting for the approval by the European Union of the European Union–Colombia FTA, and expecting to conclude the negotiations of the FTA with South Korea.
Within this framework, it is common to find many foreign companies interested in starting a business activity in Colombia offering their goods and services. Not all of them want to initially set up their companies in Colombia (constituting subsidiaries or branches) so they choose to enter into Commercial Agency and Distribution agreements with Colombian companies.
Foreign and domestic companies often negotiate and terminate these agreements and often when this occurs, they end up in litigation, causing negative impacts upon the principal’s business due to the significantly high costs of terminating this kind of agreements. From our experience we should notice that termination of Commercial Agency and Distribution agreements is a common cause of controversy in Colombia.
The negotiation and drafting process of Distribution and Commercial Agency agreements not only affects the development of the relationship between the principal and its distributor/agent, but also the probability to face litigation upon its termination. If the terms of the agreement are clear from the beginning, a Colombian Court will not be able to interpret the agreement otherwise nor will the complainant have a legal basis to claim that the agreement was indeed another kind of agreement (e.g. a distributor claims that the agreement was a Commercial Agency and not a Distribution Agreement), which may cause different economic consequences, as we will explain below.
This Top Ten explains the most relevant aspects of Commercial Agency and Distribution agreements in Colombia as well as gives tips to mitigate the risk of a possible lawsuit upon termination of one of this kind of agreements.
1. Ensure that the agreement you are entering into is the type of agreement you are really looking for.
Colombia’s commercial law establishes a wide range of agreements which prime object is the distribution of products or services. Nevertheless, the differences among these forms of agreements oblige the parties that are willing to commence a distribution relationship to be especially careful when deciding which kind of agreement they are going to execute, in order to prevent an unnecessary dispute over the nature of the agreement in the future.
Within this wide range we can identify two main kinds of agreements: (i) Distribution, and; (ii) Commercial Agency. By means of a Distribution agreement, one party, the “distributor” purchases the products of the other party, the “manufacturer/principal”, in order to resale these products to other merchants or the public in general. The distributor does not have any obligation to conquer a particular market. The distributor’s only benefit is the profit of the resale of products or services. On the other hand, under a Commercial Agency agreement (hereinafter “Commercial Agency”) a merchant undertakes in an independent and continuous manner the promotion and/or exploitation of the services and/or products of a principal in a given territory. The agent has the obligation to conquer a market or enhance the position of the brands and products of the principal within its market. The compensation of the agent may consist in a commission, a royalty or a profit.
The above are the main characteristics of these two agreements, however, the reason why it is important to identify one from the other is that, according to Colombian law, the agent in the Commercial Agency is entitled to claim from the principal, at the termination of the agreement, the following: (i) a Severance Payment, regardless of whether the termination is with or without just cause, equivalent to one-twelfth of the average commission, royalty or profit received by the agent during the last three years of the agreement, multiplied by the number of years during which the agreement was in force, and; (ii) an Equitable Compensation, in case that the agency is terminated without just cause by the principal. The Equitable Compensation is not a compensation of damages but rather compensation to the effort of the agent in enhancing the market of the principal and promoting the brand, products or services under the agreement.
Therefore, principals should be aware of the nature and services that can be requested to the distributor/agent within each of these agreements. Even though we will explain these points below, it is important to express from the beginning that the economic consequences upon the termination of Distribution and Commercial Agency agreements are completely different. Reason why it is so important to understand the activities that can be performed through each of these agreements, in order to ensure that, in case a dispute arise, a Court cannot interpret the nature of the executed agreement otherwise.
2. Take into account the FTAs ratified by Colombia.
As we have said before, Colombia has recently ratified various free trade agreements with several countries (e.g. Canada, Mexico, and Chile) including the US-FTA.
FTAs often involve the obligation for the signing countries to modify its own law in order to adjust it to the regulations set by the treaty. The US-FTA is one of these agreements that oblige one of the parties to modify its commercial law. Specifically, and regarding the matter of this top ten, the US-FTA establishes that Colombia must adjust its law referring to Commercial Agency to the regulation established in its Annex 11-E of chapter 11.
The obligation to modify Colombian law according to the provisions of the US-FTA, will be expressed with the removal of the Severance Payment and the Equitable Compensation. The ramifications of such removal must be analyzed from two perspectives: (i) The effects upon the agreements currently in force, and; (ii) The effects upon the agreements executed after Colombia modifies its law regarding Commercial Agency, according to the US-FTA. On October 21st, 2011 the U.S. President signed the US-FTA. As of that date, the Colombian Congress has six months to modify its law regarding Commercial Agency according to the provisions of the US-FTA. However, we must stress that it is probable that the Colombian Congress takes more than six months to approve the mentioned laws.
For the first point above, the previous regulation set by the Colombian Commerce Code will still be applicable, as it was the law governing the contract when it was entered into; nevertheless, the agreements executed after the new regulation enters into force will be governed by these new provisions (i.e. removal of the Severance Payment and Equitable Compensation). For the second circumstance, the agreements executed after Colombia modifies its law regarding Commercial Agency, will be governed by the new dispositions. However, in regards to the Equitable Compensation, the future new provisions established by Colombia in accordance to the US-FTA will be applicable also for the contracts that were executed before this law enters into force.
Therefore, in order to prevent litigation, companies willing to execute Commercial Agency agreements in Colombia should be aware of the changes and take into account any new provisions on Commercial Agency when negotiating and drafting such agreements. Likewise, companies with agreements that are in force should take into account how the new provisions will affect such agreements, and if it is the case, be aware of applying the new regulation upon the termination of the agreement.
3. Do not rely on the title of the agreement.
Pursuant to Colombian commercial law, in order to interpret an agreement, the judge will have to analyze it as a whole, searching for the reality of the contractual relationship between the parties and not only to the “title of the agreement”. In order to ensure the aforementioned, the Colombian Supreme Court has established a number of requirements to consider that an agreement is a Commercial Agency, which may not be all together in a relationship, but help Courts when deciding which kind of agreement was performed between the parties. These requirements could be sum up as follows:
1. The agent will be remunerated through commissions, royalties or profits.
2. The agent acts on behalf of the principal.
3. The agent acts independently from the principal.
4. The agent's activities are aimed at promoting/exploiting the products and/or services of the principal.
5. The agent carries out its activities within a defined territory.
If a contractual relationship includes activities described in numbers 2 and 4, the agreement will be considered a Commercial Agency, regardless of the title that the parties choose. As per numerals 1, 3 and 5 above, these are also taken into account by Colombian Courts when determining the nature of the agreement performed by the parties to the agreement but do not necessarily imply by them the existence of a Commercial Agency. For the reasons explained above, parties must not rely on the title rather than in the content of the agreement and the activities performed by the distributor.
Not relying on the title of the agreement will prevent litigation. In doing so, and when drafting the agreement, the parties will be especially careful of the clauses established within it and the way the parties will perform such agreement. Courts will not have to determine the nature of the agreement performed by the parties if all obligations and the kind of agreement are duly established from the beginning.
4. Take into account the just causes to terminate a Commercial Agency.
According to Colombian law, as we have explained before, the commercial agent is entitled to an Equitable Compensation in case of an unjustified termination of the agreement. Pursuant to article 1325 of the Colombian Commerce Code, the just causes to terminate a commercial agency agreement are: i. Gross breach of the contract (e.g. the agent represents different enterprises, even in violation of the exclusivity established in the contract in favour of the principal); ii. Any action or omission of one of the parties that affects the interests of the other (e.g. the agent does not promote the products or services of the principal); iii. The bankruptcy of one of the parties (e.g. the agent or the principal enters into a bankruptcy or restructure of its debt proceeding); and iv. The termination of the activities (e.g. the principal or the agent enters into a liquidation proceeding).
Companies entering into Commercial Agency agreements as principals shall be aware of the fact that terminating an agent without a justified cause will trigger the payment of the Equitable Compensation. Said compensation will be set according to the importance, extension and volume of the businesses developed by the agent.
However, do not forget that as a consequence of the US-FTA, the Equitable Compensation will also be repealed from the commercial law by the Colombian Congress, instead, any indemnity upon termination of the Commercial Agency by the principal without just cause, shall be determined in accordance with the general principles of contract law (e.g. lost profits, costs that have not been recovered, etc.) or the provisions voluntarily agreed by the parties.
It is important to note that according to the provisions set by the US-FTA, the modifications regarding Equitable Compensation established by the Colombian Congress in compliance of the US-FTA will be applicable even to the agreements executed before the modification entered into force. Therefore, agents will only be able to claim an indemnity according to the general principles of contract law.
If principals consider the just causes to terminate the Commercial Agency and, indeed, the Commercial Agency is terminated according to these just causes, it would be possible to prevent litigation, as the agent will not be entitled to claim an Equitable Compensation.
5. If you want to avoid an agency, ensure that the distributor does not act on behalf of the principal.
As considered before, one of the elements that Colombian Courts take into account when deciding whether an agreement is a Commercial Agency or not, is the representation of the principal by the agent. The latter is one of the determining elements of the Commercial Agency, considering that the Commercial Agency agreement is by nature a representation agreement.
Thus, one of the main differences between a Distribution and a Commercial Agency agreement is that in a Distribution agreement, the distributor may not act on behalf of the principal/manufacturer. Hence, in order to prevent that the distributor claims that the agreement executed with the principal was in reality a Commercial Agency agreement, it is important to establish within the agreement and in practice that the distributor does not act on behalf of the principal. Distributors may be interested to be considered as agents due to the difference of the remuneration upon the termination of a Commercial Agency and a Distribution agreement (i.e. Agents are entitled to claim the Severance Payment and the Equitable Compensation).
Therefore, when drafting and performing Distribution Agreements, it is advisable to refrain from establishing obligations or requesting the distributor to perform activities that may be considered as a representation. Doing so may prevent litigation, as the distributor may not have a solid foundation to claim that the nature of the agreement was indeed a Commercial Agency, considering that one of the main requirements to consider that an agreement is a Commercial Agency is that the agent acts on behalf of the principal.
6. Beware of an undesired change in the nature of the distribution agreement due to the way the contract is performed.
It happens frequently that a Distribution agreement becomes a Commercial Agency agreement because of the fact that the principal begins to request all sorts of services contrary to the nature of a distribution agreement.
For example, the principal requests the distributor to contact certain people, or that the distributor shall sell only in certain stores, or that the distributor performs certain promotions of the brands and products of the principal.
Be very careful on the way principals perform or ask the distributor to perform the services within the Distribution agreement. Do not rely just on the agreement, a Court will decide considering the reality of the relationship.
As it has been explained on this Top Ten, principals to a Distribution Agreement may prevent litigation by avoiding circumstances that may result in the denaturalization of the agreement and preventing that the distributor interprets that it performed the agreement developing activities inherent to Commercial Agency agreements. Distributors may not claim that the nature of the agreement was a Commercial Agency, if the principal never requested services contrary to the nature of a Distribution agreement.
7. Be cautious of clauses that establish the promotion of the principal’s products or services as an obligation by the distributor.
Pursuant to Colombian law and previous decisions issued by the Supreme Court of Colombia, one of the duties of the agent when executing the Commercial Agency agreement is to promote and enhance the market of the brands and products/services of the principal. The promotion obligation comprehends the continuous and stable promotion of the products and services of the principal within the market, having contact with the clients of the latter and, as a consequence, enhancing the business operations of the principal within the market and territory exploited by the agent.
It is not advisable to include a clause with the obligation to the distributor to promote the business of the principal. Sometimes minimum sales obligation may be interpreted as the obligation to promote. If this clause is established in the agreement and the principal terminates it unilaterally and without justification, the agreement may be construed as an agency, considering the obligation to promote, and thus the distributor will be entitled to an Equitable Compensation.
Consequently, in order to prevent litigation, it is prudent to refrain from including in a Distribution agreement clauses that may be interpreted by the distributor as an obligation to promote the products or services of the principal. If not, the distributor may have a basis to claim that the agreement was in reality a Commercial Agency, considering that the promotion of products and services of the principal is one of the main characteristics of this kind of agreement.
8. Try to have multiple distributors within the same territory.
As we have said before, one of the requirements to consider an agreement as a Commercial Agency is that the agent and the principal specify the territory where the agent will develop its activities. Likewise, for that specific territory the commercial agent has an exclusivity right against the principal; therefore, the latter cannot have another agent acting on its behalf within the same territory agreed before with another agent. However, an agent can promote/exploit within the same territory the brands and products of another principal. This requirement does not exist for a common Distribution agreement.
These provisions may be contracted out and to this extent, it is always advisable to include within the agreement that the principal can contract with other distributors to distribute its products or services in the same territory. In order to prevent litigation, the parties in a Commercial Agency can establish in the agreement that a principal will have more than one agent acting within a specified territory and that the agent cannot act on behalf of another principal within the same territory. This will help prevent litigation because the agent may not be able to claim that the principal is breaching the contract due to the multiple distributors or agents acting within the same territory. In consequence it is advisable to include this kind of clauses in Distribution and Commercial Agency agreements.
However, this exclusivity right or exclusive agency will be revised or eliminated by the Colombian Congress as it is one of the compromises made by the Colombian Government with the US-FTA. For this matter, the new regulation that Colombian Congress will have to establish shall provide that a principal to a Commercial Agency may contract more than one agent in a single geographic area for the same scope of activities or products, unless the Commercial Agency contract provides otherwise.
9. Make sure that in a Distribution agreement the distributors purchase the products.
One of the main characteristics of a Distribution agreement is that the distributor purchases the product to the principal in order to resale it. Consequently, the principal won’t have any property rights over the products, considering that it was sold to the distributor. On the contrary, the agent in a Commercial Agency agreement does not have to own the products of the principal, there may not be a sale and purchase obligation between them, and the product may still be property of the principal. The agent will only be in charge of selling it.
Considering the above, the income of a distributor will come from the margin of the purchase-sale. On the contrary, the income of the agent will come mainly from commissions or royalties.
Please note that in certain cases, arbitration awards have decided that even a reseller may be considered as a commercial agent, if the principal requires the agent to carry out activities that restrict the distributors independence (see point 6 above).
In conclusion, principals should refrain from changing in the Distribution agreement the way in which the distributors usually are remunerated (i.e. the margin of the purchase-sale) or that the distributors will not have property rights over the products. Doing the contrary may trigger a dispute over the nature of the agreement, and the distributor may claim a Severance Payment and an Equitable Compensation.
10. Choose the kind of agreement that suits you best.
Considering these tips, you will be able as a principal or agent/distributor to analyze which kind of agreement suits your business the best. Choosing the right agreement for the business relationship you will enter into will prevent unnecessary litigation, as the agreement executed will match the services that will be required by the principal to the distributor/agent, avoiding that the latter claims that it performed activities inherent to a different kind of agreement.
From our experience, a clear agreement that sets from the beginning the duties and rights of the principal and the agent/distributor, that takes into account Colombian commercial law and previous Supreme Court decisions, not only will prevent unnecessary litigation, but also will give stronger defenses to the principal or agent/distributor in case a dispute arises.
Therefore, and as a summary of this Top Ten, parties to Commercial Agency and Distribution Agreements should take into account the following aspects in order to prevent litigation:
i. The US-FTA was recently ratified by the U.S. Congress and signed by the U.S. President. As of that date (October 21st, 2011) the Colombian Congress has six months to modify its law regarding Commercial Agency according to the provisions of the US-FTA. As this Top Ten explains, several dispositions will change, an may raise disputes between principals and agents/distributors;
ii. Review the real nature of the contractual relationship, remembering that Courts in Colombia will analyze the services performed by the Distributor/Agent in order to decide if the agreement was in reality a Distribution or a Commercial Agency;
iii. Do not change the nature of the agreement by establishing clauses typical of other Agreements. Doing so will diminish the possibilities of a distributor to claim that the agreement performed was in reality a Commercial Agency;
iv. The new provisions regarding the Equitable Compensation will be applicable to the contracts signed before and after the date in which these provisions enter into force. On the contrary, the modifications regarding the Severance Payment and the exclusive agency will be applicable only for the agreements executed after the new provisions enter into force.