In this article we look at the differences between the use of Restrictive Covenants in employment contracts and commercial contracts such as share purchase agreements.
Restrictive covenants have been in the headlines recently, triggered by the government’s consultation on whether their use stifles entrepreneurship by preventing workers from starting up their own business after leaving a job.
Restrictive covenants are commonly used in employment contracts to prohibit ex-employees from competing with their previous employer by soliciting or dealing with their clients or poaching their remaining staff.
As a matter of public policy, restrictive covenants are considered a restraint of trade by the courts and will be unenforceable unless they go no further than reasonably necessary to protect an organisation’s legitimate business interests. Protectable business interests include; preserving client connections, confidential information, goodwill, retaining key employees and maintaining a stable workforce.
Restrictive covenants are not just found in employment contracts. They are also commonly used in commercial contracts such as business transfer agreements, share sale agreements and partnership deeds.
Restrictive covenants in contracts of employment are viewed more stringently than restrictive covenants in commercial agreements. The courts are more likely to question the reasonableness of a restrictive covenant in an employment contract because of the unequal bargaining position between an employee and an employer. The length and the geographic scope of a restrictive covenant will be carefully scrutinised by the court when assessing the reasonableness of the restrictive covenant.
If the period of restraint is unreasonably long or the geographic area covered is unreasonably wide, the court will not enforce the restrictive covenant.
Whilst every case turns on its own facts, it would be very unusual for a period of restraint of longer than 12 months to be enforced. The court will be looking at factors such as how long it might reasonably take an employer to re-establish a client relationship or the shelf life of confidential information when considering what a reasonable period is.
Restrictive covenants are commonly found in business or share sale agreements as the buyer will want to protect the goodwill of the business it is buying.
The approach taken by the courts when assessing the reasonableness of restrictive covenants in a business or share sale agreement is different from that which applies to employment contracts. There are a number of reasons for this.
One is that the use of restrictive covenants in business/share sale agreements will facilitate trade as opposed to restraining it – a buyer will not pay for a business if it has no way of protecting it from the seller setting up in competition immediately after completion.
Secondly, the parties’ bargaining position is likely to be more equal. If one party is not satisfied with the scope of a restrictive covenant, the parties can negotiate the terms of the deal by adjusting the price accordingly.
The court therefore generally takes the view that the parties are the best judges of what is deemed to be reasonable and is less likely to scrutinise the reasonableness of the restrictive covenant as it would do in an employment context.
It is far more common therefore to see the duration of restrictive covenants in business/share sale agreements as anything up to two or three years and sometimes even longer.
Fundamentally though, the principle still applies that the restrictive covenant should go no further than reasonably necessary to protect the business’ legitimate interests. For example, a court may decide that a non-compete restrictive covenant in a business/share purchase agreement which protects a buyer’s pre-existing business or has worldwide application where the business being bought only trades in the UK is unenforceable. The commercial backdrop of the deal agreed between the parties will be all important.
Equity partners who are selling a share in their partnership are likely to be treated the same as the seller of a business, ie that the parties themselves will be the best judges of what is reasonable. Other types of partner on the other hand may be considered more akin to employees by the court.
Whatever the relationship between the parties, it is always sensible for express restrictive covenants to be included in the contractual documentation in order to protect legitimate business interests. It is essential to ensure that such terms are drafted carefully, taking into account the specific circumstances and factual background in each case.