Restrictive covenants: key reminders recently highlighted by the Court of Appeal
06 April 2020
In the recent case of Guest Services Worldwide Limited v David Shelmerdine the Court of Appeal found that a non-compete clause, restricting Mr Shelmerdine for a period of 12 months after he ceased to hold shares, was binding. The clause prohibited Mr Shelmerdine, a shareholder who was also a consultant of Guest Services Worldwide Limited (GSW), from being interested in competing businesses.
There are no legal game changers in this case. However, it does emphasise some important reminders in relation to restrictive covenants for employees, consultants and directors who are also shareholders (employee shareholders):
- Restrictive covenants should be well drafted
It sounds obvious, but restrictive covenants can have a profound impact on people’s lives, and it is not uncommon for them to be breached (both deliberately and accidently). Those bound by them often seek to capitalise on any poor or unclear drafting. They are often found to be unenforceable or, at best, require a company to incur substantial legal costs to enforce them.
The High Court in this case accepted a (rather spurious) argument regarding the scope of the restriction stemming from a poorly drafted shareholders’ agreement. The Court of Appeal reversed the decision, but considerable money and time would have been spent before reaching this stage.
- Restrictive covenants need to be properly justified
Covenants in restraint of trade are prima facie unlawful and accordingly are “to be treated with suspicion”.
To merit an exception, a restriction must be “reasonable”, which means:
- The company must identify a “legitimate interest” (which falls within one of the categories set out in case law) that is capable of protection.
- The company must show that the covenant extends no further than necessary to protect that interest.
There is no single easy rule that can be applied to determine how long a restrictive covenant is permitted to apply for, or what it is able to cover, to make it “reasonable”. Each business is different, and even within a business each employee/shareholder should be considered separately. Legal advice should always be sought. Re-purposing existing agreements without new advice is high risk.
- Comprehensive restrictive covenants for longer periods of time are more likely to be binding in shareholders’ agreements than employment agreements
The court is “less vigilant where [restrictive covenants] are contained in a shareholders’ agreement or an agreement akin to it, rather than in an employment contract”.
In this case, the Court of Appeal recognised that the shareholders’ agreement had been made between “experienced commercial parties”, which is often not the case in an employment context, and found the restriction to be binding.
We would typically advise companies to include restrictions in both an employee shareholder’s employment contract (where the restrictions are connected to that individual’s employment) and in any shareholders’ or similar agreement (where the restrictions are connected with that individual’s shares).
- Be careful where a restrictive covenant could be construed as lasting indefinitely
Mr Shelmerdine was required under the articles of association of GSW to offer his shares for sale upon his ceasing to be a consultant. “Compulsory transfer provisions” such as these are typical where there are employee shareholders.
As is often the case, Mr Shelmerdine’s restrictive covenants applied while he was a shareholder and for a fixed period thereafter (in his case, 12 months).
The Court of Appeal recognised that the termination of Mr Shelmerdine’s appointment as a consultant was likely to end at the same or a similar time as him ceasing to be a shareholder. They concluded that “the clause should [not] be declared to be unreasonable on the basis of the relatively unlikely possibility that there may be considerable delay or the extreme and very unlikely possibility that a Shareholder may be locked in indefinitely”.
Where an employee shareholder is less able to sell their shares (and therefore remain bound by the restrictions for an indeterminate length), the restrictive covenants are less likely to be enforceable.
From an employee shareholder’s perspective, having a non-compete that lasts indefinitely and relies on a third party to acquire their shares is a difficult position to be in, and importantly, it may be enforceable.
Determining an appropriate length and scope of restrictive covenants is a delicate balancing act between the interests of the company and the rights of the employee shareholder.
- Always obtain legal advice applicable to the individual(s) in question. One rule doesn’t fit all.
- Review existing arrangements to ensure that restrictions are likely to be enforceable and suitably protect the business.
- Consider having restrictive covenants both in their employment agreement and in a separate shareholders’ or similar agreement (where this is not already the case).
- Consider amending restrictions on employee shareholders where they are less easily able to sell their shares, as the restrictions may be considered to have indeterminate length and be unenforceable as a result.
What we think
Our advice in relation to restrictive covenants from employee shareholders is: