Being aware of the implications of restrictive covenants
Jayna Patel, a commercial litigation solicitor with Wilsons Solicitors LLP, discusses why startups need to be alive to the implications of restrictive covenants.
Why use restrictive covenants?
In most commercial arrangements the parties will have access to each other's valuable business information e.g. trade secrets, confidential information, know how, client base, industry contacts, workforce and supply chain details.
Including restrictive covenants in a commercial agreement attempts to prevent one party from being able to use the information protected by the covenant to the detriment of the other party. By signing the agreement, one party agrees to refrain from doing something, which they would normally be free to undertake e.g. compete, disclose information, entice clients and employees away.
Restrictive covenants are commonly used in the following contracts: employment, consultancy, business purchase agreements, joint venture and shareholder agreements, franchise and commercial distribution and agency agreements.
The contracting parties can customise the covenants to suit their specific circumstances:
- In the sale of a business, a restrictive covenant might restrict the seller, for two years after the sale from setting up a competing business so as to protect the goodwill of the business sold to the purchaser.
- A business might protect its client base by restricting a consultant from dealing direct with its clients and attempting to divert business away.
How do restrictive covenants work?
Firstly, and most importantly, a restrictive covenant should only seek to protect a legitimate business interest.
Secondly, the covenant must be reasonable in nature having regard to the parties' intentions at the time the agreement was made and the sector in which they operate. In most cases, restrictive covenants apply for the duration of the agreement, as well as an additional fixed period after the agreement has come to an end.
What should I do if I think a restrictive covenant will be or has been breached?
Act quickly and seek legal advice. The longer the period of breach, the greater the potential harm.
As soon as you become aware of an actual or potential breach gather as much evidence as you can and ensure that relevant documents are not lost or destroyed.
The first step for you or your legal adviser is to send a letter of claim setting out:
- How the other party has breached the obligations under the agreement
- Remedies sought, including undertakings to abide by the restrictive covenants and damages for any losses suffered as a result of the breach
- The return, or supervised destructions, of information/devices held in breach of the restrictive covenants.
If your demands are not met you should consider whether to apply to court for an interim injunction restraining the offending activity, especially in situations where delay will cause serious harm to the business.
An injunction is a very persuasive tool as a deliberate breach of it can result in criminal sanction. You do, however, need to act quickly as the court will not grant an injunction if you have unreasonably delayed taking action.
Damages can also be sought in respect of the loss caused by the breach of the covenant. The general rule is that damages should place the claimant in the position that it would have been had the breach not occurred.
Will the court uphold restrictive covenants?
It depends on the individual facts of each case. For example, it is unlikely that a coffee shop franchisor will be able to rely on a covenant which prevents a franchisee from competing within a 30 mile radius on the basis that customers will probably not travel that far to buy a latte. A clause such as this goes further than is required to protect the franchisee's legitimate business interest.
In commercial contracts, the courts are slower to intervene and assume that the parties are competent business people negotiating on equal terms. This approach is longstanding and has more recently been confirmed in the Court of Appeal.
In this case the court decided that a restrictive covenant contained within a shareholders agreement was enforceable and reasonable and therefore bound employee shareholders for 12 months following the transfer of their shares, even though the transfer could (theoretically) occur many years after they ceased to be employed by the company.
Points to remember
When negotiating any form of commercial contract think about using restrictive covenants to protect your business interests. Also consider the following factors:
- What is the purpose of the covenant? What legitimate business interest is it designed to protect e.g. a specific product/ service?
- How long does it need to last? A non-compete covenant of a few years might be acceptable. However, in some sectors this period might be too long - especially if products/ services become redundant quickly.
- What is a reasonable geographical area in which it should apply?
- Is the restrictive covenant contrary to the public interest?
- Should the restrictive covenant be given by any other connected parties, such as a parent company of the seller subsidiary company, or people connected with the seller?
An unreasonable restraint of trade clause is void and unenforceable. It is therefore important to draft any restrictive covenant carefully so as to ensure that it is reasonable and not too restrictive. It is always advisable to obtain legal advice.