When it comes to your commercial contracts it pays to be business savvy and to know how to effectively use restrictive covenants to protect your business interests. In this article we look at how your commercial solicitor can make restrictive covenants work for you in a range of your business agreements.
- What is a restrictive covenant?
- When can you use a restrictive covenant in a commercial contract?
- What restrictive covenants can be used in a commercial contract?
- What laws cover the use of restrictive covenants?
- Are restrictive covenants enforceable?
- What is a reasonable restriction in a restrictive covenant?
- How long can a restrictive covenant reasonably last for?
- How should you define the scope of a restrictive covenant?
- The geography of restrictive covenants
- Can a restrictive covenant be partially approved by a court?
- Restrictive covenants when selling or purchasing a business
- What steps can you take following the breach of a restrictive covenant?
- Can you claim damages for a breach of restrictive covenant?
What is a restrictive covenant?
A restrictive covenant in a commercial contract is a clause that is designed to stop one party to the agreement doing something that they would otherwise have been at liberty to do.
There are many commercial reasons why your contracts should include carefully drafted restrictive covenants in order to protect your business. For example, if you are purchasing a business you will want to include a restrictive covenant that the seller cannot set up in direct competition with you in the vicinity of your newly purchased business.
When you are entering a business agreement it is sensible for your commercial solicitor to advise you on potential restrictive covenant options so that a commercial agreement can be negotiated that meets and protects your business interests.
When can you use a restrictive covenant in a commercial contract?
Restrictive covenants should be used to protect business interests in a variety of settings such as commercial agreements dealing with:
- The sale of a company or business
- The creation of a partnership arrangement
- Joint venture agreements
- Agency agreements
- Sale and distribution agreements
- Exclusive supply and purchase agreements
- Franchise agreements
- Agreements relating to land
In addition to the above list there are other types of commercial agreement where one party can really gain protection from the use of a restrictive covenant that is relevant and tailored to the circumstances of the parties.
What restrictive covenants can be used in a commercial contract?
There are five main types of restrictive covenants used in business contracts, namely:
|Non-compete||A non-compete restrictive covenant stipulates that one party to the agreement is restricted from competing directly or indirectly with the other party to the agreement. The restrictive covenant should be limited to competing in a similar business for a specific period of time and within a defined geographical area. The restrictive covenant can cover the party setting up in a new business or taking up employment with a competitor business within the specified territory.|
|Non-solicitation||A non-solicitation restrictive covenant restricts the hiring and marketing activities by one party to the business agreement who agrees not to solicit employees or customers from the other party.|
|Non-dealing||A non-dealing restrictive covenant is designed to prevent one party to the agreement from dealing in with the suppliers and/or customers of the other party. The restrictive covenant can cover the situation where the supplier and/or customer freely approaches the party against whom the restrictive covenant applies.|
|Non-poaching||A non-poaching restrictive covenant is designed to protect customers and employees of the business and will state that one party to the business agreement will not canvass, solicit, or entice customers or employ certain individuals for a specified period of time. It is usual for this type of restrictive covenant to be limited to a geographical area and to include an exception if a contact approaches the party who is subject to the restrictive covenant of their own accord.|
|Non-disclosure||A non-disclosure restrictive covenant is designed to protect privacy and commercially sensitive information. The restrictive covenant can prevent a party to the business agreement from disclosing or stealing proprietary information, business or trade secrets, inventions or other information that has competitive advantage.|
What laws cover the use of restrictive covenants?
At one stage the use of restrictive covenants were determined by the courts using English common law principles but in recent years restrictive covenants have increasingly been considered and assessed by the court using both common law principles and anti-competitive agreements and practices, such as:
- Article 101 of the Treaty on the Functioning of the European Union
- Chapter 1 prohibition of the Competition Act 1998
Are restrictive covenants enforceable?
There is little point in including a restrictive covenant in a commercial contract if it isn’t enforceable. At common law a restrictive covenant is potentially void because it is a restraint of trade. However, a restrictive covenant is enforceable in a court of law if the restrictive covenant doesn’t extend beyond what is necessary to protect a legitimate interest. That is why it is best to take legal advice on what restrictive covenants to include in your agreements and to ensure that they are carefully drafted.
Some business owners question whether a restrictive covenant is relevant to their business or trade, but when it comes to restrictive covenants ‘trade’ isn’t defined narrowly. For example, a property developer, can include appropriately drafted restrictive covenants in their commercial agreements in accordance with the comments and ruling in Peninsula Securities Ltd v Dunnes Stores (Bangor) Ltd  UKSC 36.
When a court is deciding whether or not a restrictive covenant is enforceable in a commercial agreement, the court will apply the following criteria:
- What does the restrictive covenant mean?
- Does the beneficiary of the restrictive covenant have a legitimate business interest that requires protection?
- Does the restrictive covenant only go as far as it needs to go, and is it reasonably necessary to protect the legitimate business interest?
- Is the restrictive covenant contrary to the public interest?
The term ‘reasonable’ requires further explanation. In the context of restrictive covenants it means providing no more protection than is relevant and necessary to safeguard the relevant legitimate interest.
Many employers are warned about the limitations of restrictive covenants in employment contracts. However, restrictive covenants in commercial agreements are not subject to the same rigorous interpretation by the courts as those contained in contracts of employment. That is because two business persons are thought to have equal bargaining power unlike those in an employer and employee relationship where there may be inequality of power.
What is a reasonable restriction in a restrictive covenant?
A reasonable restriction in a restrictive covenant is one that goes no further than is necessary to protect the legitimate interests of one party to the business agreement. The restriction must be reasonable in terms of:
- The duration
- The scope
- The geographical area
How long can a restrictive covenant reasonably last for?
As a business owner wanting the protection of a restrictive covenant in your commercial agreement it isn’t unreasonable for you to want the restrictive covenant to be indefinite in length. However, a commercial solicitor will advise you that for the court to consider a restrictive covenant enforceable it has to be of ‘reasonable’ duration.
In commercial agreements a restrictive covenant length of two to three years for a non-compete obligation will generally be acceptable where goodwill and know-how have been acquired by the purchasing party. Longer periods may be justified depending on the circumstances of the acquisition, nature of the business, and after balancing the length of the restrictive covenant with the scope of the restriction and the geographical area that the restriction applies to. For example, a fast-paced technology or digital business where change is rapid may only justify a restrictive covenant that lasts for a year, whereas a professional services firm or a clothing store may justify a longer restrictive covenant.
How should you define the scope of a restrictive covenant?
Commercial lawyers will tell you that when drafting a restrictive covenant it is essential to carefully consider its scope so that, in the event of breach, the restrictive covenant is found to be enforceable or the clause severable.
Any restrictive covenant should be specific to the products or services of the business and take into account the legitimate business interest that needs protection by means of the restrictive covenant. If the scope of the restrictive covenant is wide then consideration needs to be given to limiting the geographic area it applies to or its duration.
The geography of restrictive covenants
When drafting a restrictive covenant the restriction should be confined to a specific identified area or territory. For example, in a business purchase agreement the restrictive covenant preventing the seller setting up a competitor business should be limited to the geographic area where the newly purchased business is operating (such as a county, city or town). If you were to try and impose a restriction on the seller setting up in business in an area where the buyer’s existing business is trading from but the recently purchased business doesn’t do so then the extent of the geographic area probably would not be deemed reasonable by a court, depending on both the size and nature of the business.
Can a restrictive covenant be partially approved by a court?
When you have to look at the duration, scope and geographic area of a restrictive covenant it isn’t unreasonable to ask what happens if the court thinks that parts of the restrictive covenant are reasonable but other elements are not. For example, the court may think that the scope and duration of the restrictive covenant is reasonable and necessary but that the geographic area is too widely defined.
When it comes to restrictive covenants, careful drafting is essential because if a clause comes under court scrutiny, a court may be able to strike out only what it considers to be the unreasonable part of the restrictive covenant rather than the whole clause.
Restrictive covenants when selling or purchasing a business
Particular care needs to be taken when drafting restrictive covenants in sale and purchase agreements. The purpose of restrictive covenants in the context of the sale of a business is to restrict the ability of the seller to sell an existing business and then immediately start or join a local competitor business as that would devalue the goodwill in the business sold to the purchasing party.
The extent of the concern about the drafting of the restrictive covenant may depend on the nature of the business. For example, in a professional services company the seller may be able to attract all their former clients to a new local business venture unless the sale of the goodwill element of the business is protected.
Suitable industry or sector related restrictive covenants on the seller should be included in the purchase agreement, preventing the seller of the business from:
- Soliciting existing customers or suppliers of the newly acquired business for a specified period.
- Soliciting and employing existing employees of the newly acquired business for a specified period.
- Competing generally with the newly acquired business within a specified geographical area for a defined period.
In some circumstances, it may be important to extend the restrictive covenants to the parent company of the seller subsidiary company or persons connected with the seller.
When selling a business, the seller may also be an employee of the business that is being sold and/or the seller may agree to become an employee of the business, often for a time limited period, so that they can pass on their expertise and knowledge of the business to the new owner.
Any separate employment contract between the business buyer and its former owner should also contain restrictive covenants to prevent the former owner setting up in direct competition to the purchaser after their employment has ended. The likelihood is that any restrictive covenants in the business sale agreement will be more onerous than those contained in the employment contract.
What steps can you take following the breach of a restrictive covenant?
If a restrictive covenant in a commercial contract is breached, there are four steps that you can take to try to resolve the situation:
- Letter Before Action: Normally a commercial solicitor will recommend as a first step in dealing with a threatened or actual breach of a restrictive covenant is to write a ‘before action’ letter as a cost-effective way to resolve the business dispute. This letter should include details of the threatened or actual breach, the consideration for entering into the contract, and the losses potentially incurred as a result of the breach. A letter before action will state that failure to remedy the breach of the restrictive covenant will result in legal proceedings.
- Injunction: There are some business situations where a delay in action will cause significant harm to the business and therefore applying to court for an interim injunction to prevent the breach of the restrictive covenant, or its continued breach, is more appropriate. If the interim injunction order is granted it will prevent the party from breaching or continuing to breach the restrictive covenant until the dispute over the restrictive covenant is fully resolved by the court. The court will hold a full hearing before making a final injunction order.
- Court Agreed Undertaking: This resolution is an option where the party who has allegedly breached the restrictive covenant doesn’t want findings made at a full injunction court hearing but will agree to give an undertaking to the court to refrain from breaching the restrictive covenant. An undertaking to the court can be enforced if it is breached by the party who gave it.
- Damages: For losses incurred as a result of the breach of restrictive covenant.
Can you claim damages for a breach of restrictive covenant?
If you have incurred loss as a result of the breach of restrictive covenant then you can sue the other party to the business agreement and claim damages. Commercial solicitors warn that it can be difficult to assess the exact financial loss incurred as a result of the breach of the restrictive covenant. The party seeking the damages will need to establish their loss resulting from the breach, for example, a loss of profits.
When deciding whether or not to award damages for a breach of a restrictive covenant the court will consider the following issues:
- Is the restrictive covenant enforceable?
- If so, is there a breach of the restrictive covenant?
- Has the breach of the restrictive covenant caused the loss sustained by the applicant?
- If so, how should that loss be quantified and assessed?
When interpreting the meaning of the restrictive covenant the court will try to construe the clause according to the intention of the parties at the time of the commercial agreement and award either an injunction order or an injunction order and damages, as appropriate.
If you are negotiating any form of commercial agreement it is important to consider the use of restrictive covenants to protect your business interests. If you are being asked to agree to the imposition of a restrictive covenant against you in a commercial agreement you should take legal advice on whether the covenant is reasonable or too restrictive in nature.