Restrictive covenants in commercial contracts
- AuthorChristopher Buck
Restrictive covenants are clauses contained in agreements. Their intention is to restrict the party agreeing to them, from carrying out certain activities. Whether it’s a commercial or employment contract, there are a number of factors to consider…
In employment contracts, restrictive covenants usually come into play when an employee’s contract with the company ends. They are for a set period of time after their employment has been terminated.
In commercial contracts, such as Share Purchase Agreements, restrictive covenants may also be included to prevent the party selling their shares from undertaking certain activities post-sale.
When including restrictive covenants in commercial contracts, you should consider the following:
- Keeping each covenant short and succinct. That way, if one is found to be unenforceable, it’s more likely that one can be treated as severed from the contract.
- Ensure the drafting is clear and unambiguous, so the correct meaning is given to the covenant, and the risks the business is considering are appropriately protected.
- Ensure care is taken when considering the legitimate business interest of the parties and how this can be protected. A covenant should be narrow enough to protect the interest, but not so narrow that they no longer protect the business.
- Where contracts are between a buyer and a seller, wider covenants regarding length and geographical area are more likely to be found to be enforceable than those contained in agreements between employees and employers.
- Courts will not rewrite a covenant so it may be enforced, even if wording is included stating ‘subject to such restraints as the court deems appropriate’.
When determining the enforceability of a restrictive covenant, the court will consider the following:
- The meaning of the covenant
- Whether the beneficiary of the covenant has a legitimate business interest that requires protection
- Whether the covenant only goes as far as it need go, and is reasonably necessary to protect the legitimate business interest.
Rush Hair: A Case Study
The most frequently used restrictive covenants include non-poaching and non-compete clauses, both of which were reviewed in Rush Hour Ltd v Gibson-Forbes & Anor .
A non-poaching clause is when 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 be adhered to. Such contacts are usually limited to being within a certain geographical area. It’s common for such clauses to contain exceptions where a contact has approached the exiting party of their own accord.
A non-compete clause prevents the agreeing party from setting up a business within a certain geographical area, and directly or indirectly competing with the company they are entering into the agreement with. This may also include being employed by a competitor within a specified geographical area.
In this case, Ms Gibson-Forbes (the party bound by the restrictive covenants) argued against being found to be in breach of the covenants for a number of reasons. Both covenants were intended to be enforceable for a period of two years after the sale of the business.
Ms Gibson-Forbes argued that it was not her, but rather the new company, which had employed the three individuals named in the non-poaching clause. She argued both clauses were unenforceable as they were unreasonable, excessive, not specifying a geographical limit (the non-poaching clause) and because the bargaining power between the parties was unequal.
The court found there to be no evidence that Ms Gibson-Forbes had attempted to conceal her identity and poach the individuals through the new company. There were, however, questions surrounding the ambiguity of the clause. The court construed the clause to mean Ms Gibson-Forbes was not only restricted from poaching in her capacity as an individual, but also as an agent for another.
The court went on to look at whether the covenants were necessary in the way they were drafted. It was for the buyer to prove that the covenant was reasonable, as is the case in commercial contracts, but it’s not a heavy burden. The buyer managed to prove this.
The duration of two years for the covenants was not found to be unreasonable and was upheld. The geographical limit on the non-compete clause was also found to be reasonable. As such, Ms Gibson-Forbes was found to be in breach of the covenants.
Companies don’t have complete freedom when drafting and entering restrictive covenants into agreements. However, one of the most important things to consider when drafting restrictive covenants is ambiguity, and that the covenant succinctly works in the way it’s intended to. The Rush Hair  case outlines how and when covenants can be found to be reasonable and explores longer time limits on restrictive covenants being upheld.
Image courtesy of 123rf.com.