Restraint of trade clauses

A restraint of trade (ROT) clause (otherwise known as a non-compete clause) can be used in a variety of situations and is often found in share sale or business sale agreements, employment agreements and contractor agreements.

While similar principles apply to ROTs regardless of the context, we focus here on ROTs in a business sale or share sale scenario.

What is the purpose of a restraint of trade?

An ROT is often used in a business or share sale agreement to protect the goodwill of the business (or the business of the company) acquired by the buyer. The ROT will generally prevent the business or share seller from opening and operating or having an interest in (whether directly or indirectly), a similar or competing business, and preclude the seller from enticing customers, suppliers or employees away from the business or company, for a specified period of time and within a defined geographical area.

Therefore, from the business or share buyer’s perspective, it is important that the ROT clause is properly drafted and will be legally enforceable.

Is a restraint of trade enforceable?

Whether a restraint of trade clause is enforceable depends on the particular facts and circumstances of each case.  A restraint will be invalid if it goes beyond what is reasonably necessary to protect the buyer’s interests.  The onus of proving to a court that an ROT is reasonable and valid, is on the buyer trying to enforce the restraint.  To do so, the buyer must show that:

• the buyer has a legitimate interest to protect;
• the restraint imposed was no more than reasonably necessary to protect that legitimate interest; and
• it is not against public policy or harmful to the public interest.

Legitimate interest

Protecting legitimate business interests with a ROT clause does not extend to simply preventing future competition. A legitimate interest might include:

• a commercial interest, such as confidential information, trade secrets or intellectual property knowledge which if leaked, would harm the business or the company; or
• the goodwill of a business, including customer and supplier connections.  Many of the cases that consider restraints in the context of a business or share purchase indicate that the buyer would usually have a legitimate interest in protecting the goodwill in the business (or the business of the company) it has bought.

Reasonableness of the restraint

A court will consider several factors in deciding on whether a restraint clause is reasonable, including:

• the industry and nature of the business;
• the nature of the restricted activity;
• the length of the restraint (generally speaking, the longer the restraint period the less likely it will be considered reasonable);
• the geographical area to which the restraint applies (this should usually be limited to the location(s) in which the business or company operates); and
• whether the party that is the subject of the restraint (generally being the business or share seller) has received any consideration for agreeing to the restraint (typically, that would be the price the seller received for the business or shares).

Cascading clauses

Typically, a ‘cascading’ or ‘ladder’ approach is taken in drafting restraint clauses, providing for different levels of restraint so that the restricted activity, duration and geographical area is broken down from widest/longest to narrowest/shortest.

Whilst the courts will not rewrite a restraint for the parties, by using ladder clauses that provide alternate restrained activities, time periods and geographical areas on a sliding scale, if a court were to determine that the maximum restraint was invalid, the clause might still be held by the court to be partially valid for a narrower range of activity, period and/or geographical area.  The court would essentially “read down” typically by severing one or more limbs of the restraint, so the remaining parts of the restraint (i.e. those judged to be reasonable) can continue to operate and bind the seller.

Summary

Restraints of trade are complex, and restraint clauses need to be worded carefully and appropriately for the circumstances for which they are being used.  The general principles to keep in mind when considering a restraint of trade clause is whether there is a legitimate interest to protect and if so, the restraint must do no more that is reasonably necessary to protect that interest.  ‘Reasonable’ in this context means reasonable in relation to each party and in relation to public policy and having regard to the extent, duration and geographical restrictions imposed.

Need advice?

We are experienced in advising on and drafting ROT clauses in business and share sale agreements, as well as contractor and employment contracts.  Contact our team if you need advice on restraints of trade.

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