Restrictive covenants – watch out for restrictions of employee shareholders and those contained in commercial agreements

Written by Barri Mendelsohn

Executive summary

This year has shown us that when it comes to commercial parties having a dispute regarding restrictive covenants, the Courts have shown a willingness to uphold the validity of the restriction on the basis that they are competent business people who should have known better or taken advice.

When restrictive covenants are challenged in the Courts, they are construed against the surrounding context of the rest of the agreement.  But that is not the only hurdle – to strike out the covenants a party must show that not only do the restrictive covenants amount to a restraint of trade, the restraint must also be found unreasonable.

The Courts appear to be less vigilant in striking out restrictive covenants applicable to employee shareholders and those contained in commercial agreements.  The Courts are finding that where a  restrictive covenant to restrict an employee shareholders’ actions for a certain defined period is agreed between the parties, if the covenant only commences following an employee shareholder ceasing to be a shareholder – an event which theoretically could occur many years after an employee shareholder departed from the company – it should still be enforceable.

The period and the wider arrangement should still be assessed for reasonableness in light of the overall context of the shareholders’ agreement or otherwise to remain enforceable.

Equally for commercial agreements between experienced parties,  the Courts have shown willingness to uphold the enforceability of restrictive covenants so long as a party can prove the covenants are for a legitimate business interest and are reasonable in the wider context of the arrangements.

These cases serve as a reminder to those attempting to strike out restrictive covenants that if such covenants are given in a commercial context and deemed reasonable, the UK Courts may very well hold the covenants enforceable and therefore it is critical to ensure that  parties negotiating restrictive covenants take care when considering terms of duration and purpose.

February 2020

Guest Services Worldwide Limited v David Shelmerdine [2020] EWCA Civ 85

Facts

Mr. Shelmerdine was a shareholder of and provided consultancy services to Guest Services Worldwide Limited (the “Company”) under a shareholders’ agreement, which classified him as an ‘Employee Shareholder’, being both a shareholder and agent, director or employee of the Company (the “Agreement”).

The Agreement contained restrictive covenants including a non-compete covenant that prevented Employee Shareholders from engaging in a competitor’s business whilst they were, and for 12 months after, they ceased to be an Employee Shareholder.  Following Mr. Shelmerdine’s decision to cease providing consultancy services to the Company, and subsequently ceasing to be an Employee Shareholder, the Company sought an injunction from the High Court to prevent Mr. Shelmerdine from using its products and alleged that Mr. Shelmerdine had been in breach of the restrictive covenants contained in the Agreement.

The High Court dismissed the claim and ruled that the restrictive covenants were unenforceable on the basis that (a) the duration of the restriction was unenforceable because 12 months was longer than reasonably necessary for the protection of the Company’s business interests, and (b) the restrictions applied to Employee Shareholders for so long as they remained an employee and a shareholder, therefore, if a person ceased to be an employee but continued to be a shareholder, the restrictions would cease to apply.  The Company appealed.

Judgment

The Court of Appeal overturned the High Court’s decision and focused on the two main issues of (i) duration; and (ii) construction.

In respect of duration, although the restrictive covenant amounted to a restraint of trade, the Court was of the opinion that a 12-month period was not unreasonable stating that “the Company had a legitimate interest in seeking to prevent Employee Shareholders from competing with its business”.  The Court also noted that the Company and Mr. Shelmerdine were both experienced commercial parties, so there was no imbalance of negotiating power and that it would have been understood at the time that any Employee Shareholder who ceased to be an employee would likely cease to be shareholder at the same time or shortly afterwards.

In respect of construction, the Court held that the objective meaning of the language used in the Agreement should be taken in context to the factual and commercial context of the entire Agreement.  The Agreement contained, amongst other things, restrictions imposed upon Employee Shareholders (who had a knowledge of the business) to protect the Company, its goodwill and the value of its shares. Therefore, the restrictive covenant should have been interpreted by the High Court to mean that an Employee Shareholder would remain subject to those restrictions even after ceasing to be a shareholder, and the 12 month period would begin from the date of cessation as a shareholder and not the date they ceased to be an employee.

May 2020

Quantum Advisory Ltd v Quantum Actuarial LLP [2020] EWHC 1072 (Comm)

Facts

In 2004, a company and a group of individuals formed a joint venture pensions advisory business (the “Legacy Business”).  Three years later, as the parties’ interests diverged, they agreed to restructure the Legacy Business.  This resulted in the creation of a new entity, Quantum Actuarial LLP, being the defendant in this case (“Quantum LLP”).  The restructure involved the Legacy Business transferring its business to Quantum LLP to carry on a similar business whilst maintaining its name and keeping its existing clients.  These clients were envisaged to engage directly with the Legacy Business, rather than Quantum LLP.

The above arrangement was formalised by an agreement entered into between Quantum Advisory Ltd (the “Claimant”) and Quantum LLP (the “Services Agreement”).  The Services Agreement contained typical restrictive covenants for the benefit of the Claimant which bound Quantum LLP for the duration of the Services Agreement and for a period of 12 months after its expiration or its termination. By way of example,  Quantum LLP was prevented from soliciting or enticing away or performing services for the Legacy Business’ existing clients.

The initial term of  the Services Agreement was a fixed term of 99 years, meaning that the restrictive covenants would last for 100 years (the initial term and 12 months thereafter).  It was noted that the Services Agreement could be terminated by either party upon three months’ written notice.  For commercial reasons, Quantum LLP decided to remove itself from these arrangements on the basis that the restrictive covenants amounted to an unreasonable restraint of trade and consequently were unenforceable.

Judgment

The High Court held that the restraint of trade doctrine did not apply to the restrictive covenants in the Service Agreement for the reasons set out below.

Although at first look, Quantum LLP’s trade was restrained by the Services Agreement, this did not accord with other restraint of trade cases.  In this instance, the Court held that the Services Agreement was “a bespoke agreement which was fashioned to address the competing needs and interests of a group of professional people”.  Quantum LLP was incorporated for the purpose of the restructuring and it had no prior business, i.e.  it had no other raison d’etre and would not have been incorporated but for the Services Agreement – its sole purpose was to carry on the Legacy Business.  The Court held that the Services Agreement was “a means of providing the opportunity to trade” rather than a restraint of trade.

The Court held that a restraint of trade could exist if a party contractually agreed to restrict its liberty in the future to carry on trade with non-parties.  Restraint can be justified as being reasonable by reference to the parties and the public interest.  Inequality of bargaining power was a relevant factor but does not inherently prove a restraint or make it unreasonable.  Lastly, consideration could be relevant to justification for a restraint of trade but it had to be distinct from the benefit of the contract’s performance.

Quantum LLP did not negotiate for any profits nor ask for a shorter contract term when negotiating the Services Agreement with the Claimant.  It also did not obtain any independent legal advice.  The Court held that the parties were  “experienced, intelligent, articulate and highly competent business people, who were able to look after their own interests” and consequently the Services Agreement had to be considered on its own terms and in its own circumstances.  At that time, the parties had considered the terms of the Services Agreement to be fair, and in particular, the restraints to be reasonable. As a result, the Court held them to be enforceable.

Key Takeaways

Typically, most UK Court decisions in respect of restrictive covenants and restraints of trade relate to employment contracts, where the restraints of trade doctrine is more likely to apply as there tends to be more of an imbalance of bargaining power in an employer and employee context.  However, the Courts appear to be less vigilant in striking out restrictive covenants applicable to employee shareholders and in commercial agreements.

The UK Courts are finding that where a restrictive covenant is agreed to restrict an employee shareholder’s actions for a certain defined period, if the covenant only commences following an employee shareholder ceasing to be a shareholder – an event which theoretically could occur many years after an employee shareholder departed from the company – it should still be enforceable.

The period and the wider arrangement should still be assessed for reasonableness in light of the overall context of the shareholders’ agreement or otherwise to remain enforceable.

Equally for commercial agreements between experienced parties,  the UK Courts have shown willingness to uphold the enforceability of restrictive covenants so long as a party can prove the covenants are for a legitimate business interest and are reasonable in the wider context of the arrangements.

Given that the UK Courts appear to be taking a holistic approach, parties drafting restrictive covenants need to take care when considering terms of duration, purpose and geographical location in order to protect a legitimate and valid interest of the company.