Restrictive covenants in business agreements

Last updated: 19 January 2016

Estimated reading time: 17 minutes

Restrictive covenants are not just found in employment agreements but are used on a regular basis in commercial contracts such as business or share purchase agreements, agency agreements and partnership deeds.

Here we look into:

  1. What is a restrictive covenant in a commercial/B2B context?
  2. What types of restrictive covenants are there, and what do they restrict?
  3. How does common law treat restrictive covenants?
  4. Some recent examples of precedents in court cases
  5. What is a reasonable restriction?
  6. Considerations surrounding restrictive covenants during and after the sale of a business
  7. What actions can reasonably be taken to prevent breach of agreement?
  8. What remedies are available/typically awarded for typical breaches?
  9. Examples of remedies awarded in breach of restrictive covenants

What is a restrictive covenant in a commercial/B2B context?

Restrictive covenants are anti-competition clauses that can be used, for example, in the sale of a business to protect the buyer against the seller setting up in competition immediately after completing the sale.

Restrictive covenants help buyers to protect the goodwill of the business they are buying particularly where the products/services are niche or where a certain individual is key to the business. They can also stop the seller from soliciting employees or customers away from the previous business or from disclosing confidential or proprietary information. Partnership agreements often include non-compete clauses, non-solicitation terms and non-disclosure provisions particularly for new owners or partners coming into an existing business.

What types of restrictive covenants are there, and what do they restrict?

The main types of restrictive covenant are:

Non-competeStipulates that one party is restricted from competing directly or indirectly with the other party in a similar business for a specific period of time and within a specific geographical area. This may also include being employed by a competitor within a specified geographical area.
Non-solicitationRestricts hiring and marketing activities by one party who agrees not to solicit employees or customers from the other party.
Non-dealingStipulates that a party must not deal in any way with the supplier and/or customer of the other party even if the supplier and/or customer goes freely to them.
Non-poachingStipulates that a party agrees for a certain period of time not to canvass, solicit, entice or employ certain individuals. These individuals are usually employees, clients or contacts of the party requesting the covenant to be adhered to. Such contacts are usually limited to being within a certain geographical area. Commonly these clauses contain exceptions where a contact has approached the exiting party of their own accord.
Non-disclosureRestricts communications and is designed to keep a party from disclosing or stealing proprietary information, business secrets, trade secrets, inventions or other information that has competitive advantage.

How does common law treat restrictive covenants?

Restrictive covenants are potentially void at common law on the basis of restraint of trade. They are only enforceable in a court of law if they do not extend beyond what is necessary to protect a legitimate interest.

To determine whether or not a restrictive covenant is enforceable in a commercial agreement, the courts will apply the following criteria:

  • What does the covenant mean?
  • Does the beneficiary of the covenant have a legitimate interest that requires protection?
  • Does the covenant only go as far as it needs to go, and is it reasonably necessary to protect the legitimate business interest?

Restrictive covenants in commercial agreements are not subject to the same rigorous interpretation by the courts as restrictive covenants in employment agreements. Due to the unequal bargaining position between an employer and an employee, the courts are more likely to question the reasonableness of a restrictive covenant in an employment context. As such, in business and share sale agreements it is not uncommon to see the duration of restrictive covenants as anything up to two or three years and sometimes even longer.

Some recent examples of precedents in court cases

Rush Hair Ltd v. Gibson-Forbes [2016] EWHC 2589 (QB)

SummaryIn Rush Hair Ltd v. Gibson-Forbes, the High Court had to consider two restrictive covenants in a share purchase agreement which prohibited the seller of a hair salon from (i) canvassing, soliciting, enticing or employing specified employees and from (ii) being involved directly or indirectly with another other similar business within defined territory over a two year period.
Having sold all her shares in a hair salon business to Rush Hair, Ms Gibson-Forbes through a new company opened a hairdressing salon in the restricted area and employed three of the individuals named in the non-poaching clause. The court found that these non-poaching and non-compete clauses were enforceable.
Court’s three-step approachTo assess the reasonableness of the restrictive covenants the High Court followed the approach taken in TFS Derivatives Ltd v Morgan [2005] IRLR 246, considering three questions:

 

1. What does the covenant mean?
Non-poaching covenant:
The court found that the meaning of the non-poaching covenant was ambiguous. It could be read as either prohibiting Ms Gibson-Forbes from poaching the individuals only on her own behalf or from doing so on her own behalf and as agent for another person.
The court construed the covenant in the only way that was commercially sensible – as prohibiting Ms Gibson-Forbes from canvassing, soliciting, enticing or employing any of the named individuals whether on her own behalf or as agent for another. The court made the following points:

  • Someone who covenants not to employ another must not do so either directly or through an agent
  • When a company acts through its director, the director is normally the agent of the company, not vice versa
  • Where someone who controls a company uses that company ‘as a cloak or sham’ to ‘conceal the identity of the real actors’ the court can conclude that the acts carried out by the company are in fact carried out by the person controlling it – using the company as a ‘cloak’ makes the company the agent of the controlling person (although in this case this was not applicable as there was no concealment of the identity of Ms Gibson-Forbes)
  • Where a person uses a company so that its separate legal entity will defeat a legal right or frustrate its enforcement, the ‘evasion principle’ allows the court to ‘pierce the corporate veil’ thereby treating the company’s acts as those of the controlling person (but again this was held not applicable in this case as no such attempt was made)

Non-compete covenant:
The court found that ‘Rush business’ meant the hairdressing business of Rush even though the share purchase agreement did not include a definition of this. It rejected the arguments made by Ms Gibson-Forbes suggesting it could be interpreted as meaning the use, sale and promotion of hair products alone and concluded that the covenant prevented Ms Gibson-Forbes from being involved in a business ‘similar to or which competes with’ Rush’s hairdressing business within a two mile radius of the Windsor and Maidenhead salons.

2. Does the beneficiary of the covenant have a legitimate business interest requiring protection?
The court made reference to the legitimate interest of protecting the goodwill of the business. This was the value of the personal relationship between the individual stylists and the regular customers of those stylists. This goodwill could be diminished if these stylists left the business, as the customers might follow if the stylists left to go and work in a new salon. The buyer had a legitimate interest in ensuring that the employees remained. While the seller could not guarantee that they would remain, she could and she agreed not to do certain things likely to cause them to leave.
Similarly Rush was entitled to take the view that Windsor was a small town and that loss of customers would occur if Ms Gibson-Forbes relocated to any part of Windsor. Given Ms Gibson-Forbes’ reputation, if she opened a competing salon even during the second year of the period the court held that there would be some real loss of business to Rush.

3. Does the covenant go no further than is reasonably necessary to protect that legitimate business interest?
The court held that the duration of two years was not unreasonable. It did not go beyond what was reasonably to be regarded as necessary for the protection of the buyer’s interests. Furthermore, the two-year period was not out of keeping with those upheld in other sale and purchase agreements.
The geographical reach was also held reasonably necessary to protect the buyer from from the detriment it wanted to avoid which was losing customers in Windsor. Although it prevented Ms Gibson-Forbes from operating in the area where she lived this fact had not previously prevented her from operating a salon elsewhere. The covenant also did not prevent her from continuing to operate that salon nor did it prevent her from opening a new salon elsewhere in the area.

Other notable pointsOther points considered by the court were bargaining power and the amount of consideration paid. A court will generally be less likely to find a covenant unreasonable where there is equality of bargaining power between the parties. Even though the court found that Ms Gibson-Forbes was in a weaker bargaining position because she only had the option of either selling her business to the buyer or walking away with nothing, this did not result in the court finding that the covenants were unenforceable. The amount of consideration can also be relevant and the greater the consideration the more likely it is that restrictive covenants are enforceable.
Another point to note is that both of the restrictive covenants in question failed to include some key wording. Had this wording been included, it would have made them more effective and less open to challenge.

Carewatch Care Services Ltd v Focus Caring Services Ltd [2014] EWHC 2313 (Ch)

SummaryThe claimant Carewatch Care Services (Carewatch) owned a number of directly owned care home businesses as well as running a number of outlets as franchises across the UK. The defendant Focus Caring Services Limited (Focus), run by Tony and Elaine Grace, ran two of these franchises from locations within East Anglia. After some time Carewatch decided to focus more on its directly owned branches and the number of franchises began to decline.
Focus claimed that because Carewatch had ceased to support and develop its franchise network and set up its own branches in direct competition, Carewatch had breached the implied duty of good faith in their franchise agreement causing the agreement to come to an end allowing them to walk away free from any post-termination restrictions. Focus opened a competing business called ‘Poppy Care’ (later ‘Purely Care’). Carewatch argued that Focus themselves were in breach and applied for an injunction to prevent them from acting in breach of their post-termination restrictions.
Restrictive CovenantsThe franchise agreements contained restrictive covenants operating for 12 months following termination of the franchise agreements and prevented Focus from engaging in or being employed by a business competing with Carewatch or any of its franchisees within a defined area and also from soliciting business from its customers or employing employees of Carewatch or its franchisees.
ArgumentsFocus claimed that the restrictive covenants were unenforceable because the agreements had been terminated as a result of Carewatch’s breach and because the agreements did not comply with competition law requirements. Carewatch asserted that Focus was in repudiatory breach of the contracts because it had set up and operated its own care business outside the franchise. It gave notice of its intention to enforce the restrictive covenants and to exercise its contractual right to ‘step in’ and operate the business in Focus’s place.
RulingThe court found that Focus had breached the agreement by opening a competing business, and awarded Carewatch injunctive relief to enforce both the restrictive covenants and the step-in provisions.
The court said there was no presumed intention that there is a general obligation of ‘good faith’ in a commercial contract. To imply such a term into a contract the court would have to decide if it was necessary to do so to fill a clear gap in the agreement and to make the contract work in practice. The franchise agreement contained very detailed express terms and addressed all aspects of the franchise business. Therefore in this case an implied duty of good faith was not necessary to make it work commercially.
Consequently the court had no issue with enforcing the post-termination restriction lasting for twelve months and preventing an ex-franchisee from being involved with a ‘competing or similar’ business. It also held enforceable a similar provision which extended to territories within which there were other franchisees.
The decision highlights that franchisees cannot rely on an implied term of good faith in an attempt to avoid the restrictive covenants contained in their franchise agreements.

BCM Group PLC v Visualmark Ltd & Anor [2006] EWHC 1831 (QB)
This case highlighted some important points regarding commercial agents and restrictive covenants.

SummaryIn the case, Visualmark were the agent for BCM Group promoting and selling office equipment further to a written agreement dated 2001 which contained post-termination restrictive covenants. On of these stated that for two years after the termination of the agreement, Visualmark would not canvass, approach or solicit the custom of anyone who had been a customer of BCM Group during the previous year. In 2002, the parties changed in the way in which Visualmark was remunerated through correspondence. The business relationship continued until 2006 when Visualmark wrote to terminate the agreement and BCM Group accepted.
Restrictive CovenantsThe issues that arose were (1) whether the agency agreement was extinguished or varied in 2002 and (2) whether the restrictive covenants were enforceable and to what extent.
ArgumentsThis decision on the enforceability of post-termination restrictive covenants contained in an agency agreement was the first made by the English courts in this regard.

 

1. Whether the agency agreement was extinguished or varied in 2002:
The court ruled that the letters represented a variation of the 2001 agreement as to remuneration only. As such, the other terms of the 2001 agreement, including the restrictive covenants, continued to apply.

2. Whether the restrictive covenants were enforceable and to what extent:
Visualmark argued the two-year restriction period was too long and the scope of the interests that it was trying to protect was too wide and as such this restrictive covenant was not enforceable.

RulingThe court considered each of these points in turn. To be enforceable the restriction had to be reasonable in terms of both duration and geographical scope.
Regarding two-year restrictive period, the court found that it was enforceable. Both parties had originally agreed to it and the Commercial Agents Regulations specifically state that a ‘restraint of trade clause shall be valid for not more than two years after termination of the agency contract’. However, although the judge held that BCM Group had a legitimate business interest requiring protection, the judge agreed with Visualmark that the covenant was wider than was reasonably necessary for the protection of those interests. The covenant applied to any customer of BCM Group, whether or not Visualmark had had dealings with them. Furthermore, Visualmark would have had no means of knowing who the other customers were. On that basis the covenant was held too broad.
The final question to be considered by the judge was whether the unenforceable restrictive covenant could be amended so that a reduced part of the clause would be enforceable. The judge recognised that the courts are extremely reluctant to re-write voluntarily undertaken contractual obligations. The judge took the view that only deletion was permissible and in very limited circumstances. However, the judge decided that there was no deletion which would give this covenant an acceptable and enforceable meaning.

What is a reasonable restriction?

A reasonable restriction is one that goes no further than is necessary to protect the legitimate interests of a business. It must be reasonable in terms of duration, scope and geography:

TimeA two to three year non-compete obligation will generally be acceptable where goodwill and know-how have been acquired. Longer periods may be justified depending on the circumstances. It is important to balance the length of time with the scope of the restriction and the geographical restriction as well as the nature of the business. For example, a fast-moving high technology business where change is rapid may only need a 12-month restriction compared to a clothing store.
ScopeThe restrictions should be specific to the products or services of a business bearing in mind the legitimate business interest that needs protection. This could be for example the client base of a business or the staff working for the business. The scope should be defined carefully as the courts are unlikely to hold a clause enforceable if one party is being restricted from working completely. For example, a business seller could be prevented from advising anyone on opening a similar business or from opening one up themselves. For this to be reasonable and protect a legitimate interest, a shorter duration may be required as it is much wider.
GeographyRestrictions should be confined to specific territories. For example, in a business purchase agreement the restricted territory should be limited to where the newly purchased business is operating (such as a county or specific urban area). However, imposing restrictions in areas where the buyer’s existing business trades but the recently purchased business does not would likely fall outside what is deemed reasonable. What is reasonable is likely also to depend on both the size and nature of the business.

Drafting is essential because if a clause has been drafted carefully but comes under scrutiny, a court may be able to strike out only the unreasonable part of the clause rather than the whole clause. For example, if a non-competition clause was too wide but a non-solicitation clause in the same contract was held reasonable, the court will strike out the non-competition clause but uphold the non-solicitation clause. Accordingly restrictive covenants should be drafted by an experienced lawyer in this area. Our commercial solicitors can assist you with this.

Considerations surrounding restrictive covenants during and after the sale of a business

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 a rival business that would compete with that business. It is essential for the purchaser to protect the business he is buying in this way and it is likewise an important consideration for the seller. If the seller does not enter into a valid covenant then he could not sell the goodwill of the company as the purchaser would not have the assurance he needs that the seller will not compete with him in the future.

Suitable restrictive covenants on the seller should be included in the purchase agreement, preventing the seller 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 specified period

In some circumstances, the restrictive covenants may be extended to the parent company of or persons connected with the seller.

The seller may also be under an employment agreement with the business that is being sold and this is likely to contain restrictive covenants that will need to be taken into account. Likewise, the seller may be employed by the purchasing company after the sale and may be provided with an employment agreement that is also likely to include restrictive covenants. Restrictive covenants in the business sale agreement are likely to be more onerous than those in any related employment agreement.

What actions can reasonably be taken to prevent breach of agreement?

Where there is a restrictive covenant in place, the most common actions to take to prevent a breach of agreement occurring are a letter before action, an interim injunction and a court agreed undertaking. 

Letter Before Action
Generally, one of the first steps in dealing with a threatened or actual breach is to write a ‘before action’ letter which is a cost-effective way to resolve a dispute. This letter will 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. The letter should highlight that a lack of action to remedy the breach will result in the start of legal proceedings.

Interim Injunction
However, with regards to breaches of restrictive covenants, where even a day’s delay could cause irreparable harm to a business, applying to court for an interim injunction to prevent it is more likely to be applicable. An injunction in this context will be a court order banning the party threatening breach or in breach from undertaking certain activities in order to preserve the position.

Court Agreed Undertaking
Another possible action is a court agreed undertaking.  Rather than face an injunction hearing, the offending party may agree to a court agreed undertaking to refrain from breaching the restrictive covenant. This kind of undertaking is taken more seriously than informal undertakings agreed between parties.

What remedies are available/typically awarded for typical breaches?

There are two main remedies awarded for typical breaches of restrictive covenants: injunctions and damages.

InjunctionThe most usual remedy for a breach of restrictive covenant is to seek a court injunction. Action should be taken as a matter of urgency as any delay is likely to be damaging to the business from the very start of the breach and make it less likely that an injunction will be granted. Before a final injunction is awarded, a full trial will take place involving a detailed consideration of the evidence. As it will take some time before a matter comes to trial, it is common first to apply for an interim injunction pending the outcome of the full trial.

 

An injunction is often followed by a financial claim for damages where financial loss has been incurred.

DamagesAlternatively, or if the court refuses to award an injunction, a party can also sue for damages for breach of the restrictive covenants. This is a less costly way of proceeding but there can be difficulties in assessing the exact financial loss incurred as a result of the breach of the restrictive covenants. The party seeking the remedy will need to show in detail the loss resulting from the breach. This will usually be loss of profits.

 

When deciding whether to award damages the court will consider the following issues:

  • is the covenant enforceable?
  • if so, is there a breach of covenant?
  • has the breach caused the loss?
  • if so, how should that loss be assessed?

The court will interpret the meaning of the covenant in the same way as it does in relation to any other contractual clause and will endeavour to construe the clause according to the intention of the parties at the time the agreement was entered into and award remedies sought accordingly.

Examples of remedies awarded in breach of restrictive covenants

In Rush Hair v. Gibson-Forbes, Rush applied to the High Court for an injunction to force Ms Gibson-Forbes to shut the Windsor salon because she was in breach of the restrictive covenants. The court ruled in their favour and forced Ms Gibson-Forbes to close her business for the remaining duration of the two-year restriction period imposed through the restrictive covenant.

In Carewatch Care Services Ltd v Focus Caring Services Ltd, Carewatch argued that Focus was in breach of the franchise agreement which contained a restrictive covenant prohibiting a former franchisee from being involved in ‘any business similar to the franchised business’. Carewatch applied for an injunction to prevent Focus from acting in breach of its post-termination restrictions and sought damages. The court found that Focus had breached the agreement by opening a competing business and ordered Focus to pay damages. The court also enforced the step-in provisions in the franchise agreement and allowed Carewatch to ‘step in’ to Focus’ new business and run it.

What next?

If you need advice on drafting a restrictive covenant, or you’re involved in a dispute about breaching one, our commercial solicitors can help. Call us on 0800 689 1700 or fill out the short form below and we’ll get back to you within 24 hours.

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