RESTRAINTS OF TRADE.
Published on May 25, 2015
It’s business as usual……..until a former employee or shareholder sets up shop down the road and starts taking your clients! Nobody wants to be in this position - so what can you do to prevent it.
Restraint clauses are the most effective means of protecting the goodwill in your business. They can be used to restrain employees, directors, shareholders and business owners from competing with the business or interfering with your client relationships. They often feature in employment and consultancy agreements.
We also see them in:
- authorised representative agreements
- shareholder and partnership agreements
- business asset and share sale agreements
So… what are they?
Restraint clauses restrict a person’s ability to provide services which are similar to those offered by the business during and after their employment or engagement or sale of their interest in the business.
They take many forms but they usually prohibit:
- contact with clients of the business to provide similar services;
- using client records, business know-how, confidential information and other intellectual property belonging to the business;
- using a similar business name; or
- being interested or engaged in a competing business.
The length and geographical extent of the restraint usually varies depending on the nature of the relationship, the role of the person and the type of business.
Restraints are only enforceable to the extent that it is reasonable to protect your legitimate business interests. Whether it’s reasonable depends on the:
- geographical area;
- scope of restrained activities;
- necessity to protect goodwill and IP; and
- common industry practice.
Restraints preventing an employee from working in a competing business for long periods are generally unenforceable. You can't deny them the right to earn a living!
What’s reasonable will also depend on the industry, e.g. for insurance broking businesses, a reasonable period of restraint for a senior employee with strong and influential relationships with clients would be 12-13 months. This gives you a chance to provide services through the next renewal and retain the clients’ business.
But the goal posts shift when you’re buying a business. You pay the seller valuable consideration and need to protect your ability to service the clients you’ve paid for…… at least, until you’ve established your relationship with them. Also, you and the buyer are in a commercial relationship with equal bargaining power. Depending on what you can negotiate these restraints might be between 2 and 5 years.
Cascading location and duration provisions are a good way to increase the enforceability of restraints. These include a number of ‘options’ in your agreement allowing the court to read down the length and area of the restraint to whatever is reasonable. They are not as important if your business is located in NSW - where the courts can already modify restraints under the Restraint of Trade Act (NSW).
How are restraints enforced?
Usually, a business will need to enforce the restraint by seeking an injunction against the ex-employee, ex-director or ex-business owner to stop them carrying on the prohibited activity. The business can also seek damages if it suffers financial loss due to the person’s activities.
More imaginative ways of dealing with enforcement, so you don’t have to go to court, include:
- a clawback from future payments of the purchase price which is equal to the value of any clients lost; or
- an option under which the person is required to purchase the clients from you if the clients engage the person to provide services to them during the restraint period.
Restraint clauses need to be drafted carefully. In employment contracts, it’s essential to take into account the employee's or director’s role and seniority and their relationship with the clients and the business. For business or portfolio sales, make sure you restrain the seller and their associates including directors of the seller, family members, shareholders to prevent them from setting up a competitive business.
Taking legal advice on what is likely to be legally enforceable is critical before suing to enforce a restraint. If the clause is unreasonable or excessive, it will be void – not only will the business be unprotected, you might be liable for costs or worse still, damages.
Get in touch with us for advice on an appropriately drafted restraint clause that will protect your commercial interests.
Author: Jeremy Brown