In a sale of a business (whether by a sale of shares or the underlying business or assets), a primary concern of a buyer often includes how to protect the goodwill and client base of the business it is purchasing following completion of the transaction.
It’s important to remember that aspects of the business may be compromised by the actions of a seller if, for example, a director, shareholder or key employee of the seller is able to use information, know-how and expertise derived from the business to the advantage of a competitor, or to establish a competing business.
Restraint of trade
A common method of protecting the newly acquired business is to include a restraint of trade clause in the sale agreement, which prohibits specific individuals from engaging with competitors or actively competing with the business.
However, restraint of trade clauses need to be created carefully drafted for the buyer to ensure that, if challenged, it is enforceable by a court.
This article provides a refresher on the key principles arising from case law which should be taken into account in preparing an enforceable restraint of trade clause.
Courts are generally more willing to enforce restraints of trade in a sale of business context, as the sale of goodwill of the business provides a justification – and measure – for enforceability.
This is because the buyer has paid to purchase the goodwill of a business and that goodwill can often only be adequately protected by a restraint clause. Courts are generally stricter in the case of employment restraints.
Guidance for restraint clauses
As a general rule, a restraint of trade is contrary to public policy and is unenforceable. However, it will be considered enforceable if, upon considering the overall circumstances (assessed at the time that it is imposed i.e. the date of the sale agreement, not at the time it is being challenged), the clause is deemed to be reasonable and, importantly, in the interest of both parties.
Courts will generally assess the following factors in the context of the involved parties and the transaction (including its terms and surrounding circumstances) when determining whether the restraint is reasonable:
- the scope of the prohibited activity;
- the duration of the restraint; and
- the geographic area within which the restraint operates.
Courts may also assess whether there is evidence of inequality of bargaining power or if the restrained party was in a vulnerable economic position when negotiating the restraint. For employment-based restraints, a court will also generally consider the seniority of the individual and the relationship with clients, as well as relationships with customers or suppliers of the business.
The restraint will be considered reasonable if it includes only what is necessary to legitimately protect the goodwill of the business at the time of the agreement. Restricted activities, restraint periods and areas may apply differently to certain parties, depending on the impact that party may have on the goodwill of the business if unrestrained.
With that in mind, it is vital for a buyer to properly assess the risks and vulnerabilities of the business, and understand how the business is exposed to the activities of each relevant party. Navigating the enforceability of restraints requires balancing a restraint that is broad enough so that it protects the business, without going too far – something that could run the risk of rendering the clause invalid.
Restraint clauses should always be drafted as a ‘cascading’ clause.
A cascading restraint begins with the broadest and most burdensome option, followed by options in decreasing levels of scope for activity, duration or geographic area (or a combination of all factors).
In the event that the broadest option is deemed to be unenforceable by a court, the court can then sever that section and read the provision down to the next option, and so on, until it reaches the option that is deemed most appropriate to the circumstances.
Accordingly, a cascading restraint reduces the burden of determining a single satisfactory scope because, if one aspect of the restraint is deemed to be invalid, it will not render the entire clause unenforceable.
Key points for sale agreements
While the general principles applicable to restraints of trade in a sale of business are well established, their application in particular situations can be less certain. Before finalising the form of a restraint of trade clause in a sale of business contract, it is a good idea to keep these tips in mind:
- Avoid using standard clauses – restraint of trade clauses should be tailored to the individual circumstances.
- It is important to assess whether the restraint adequately protects legitimate business interests, and goes no further. Consider the interests to be protected and the scope of the protection required.
- In most cases, it is advisable to use cascading clauses (see above).
- For employee restraints, periodically review the restraint in light of any relevant employee’s progression. For example, if the employee is promoted to a more senior position, this may impact the scope of the restraint required.
It may also be prudent to advise a restrained individual to obtain independent legal advice before accepting the terms of a restraint in a sale agreement.
Note: This insight contains commentary for general reference purposes only. It does not constitute legal advice and should not be relied on for any purpose. You should always seek specific legal advice based on your own individual circumstances.