Will the Courts enforce a restraint of trade provision to protect the goodwill you acquire in an acquisition?
Background
Restraint of trade clauses are often used by employers to prevent departing employees from taking clients or competing with the business for a period of time after they have terminated their employment. It is also common for vendors and key employees in a sale of business or shares to give a restraint of trade in order to protect the goodwill acquired by a purchaser.
Restraints of trade are contractual terms which restrict the free exercise of trade or business. Such clauses generally refer to specific geographic areas, a specified time period and the defined restricted activity.
Recent cases
The recent cases of TSV Holdings Limited v Evans & Summit Innovations Pty Limited (1) and Extraman (NT) Pty Ltd v Blenkinship and Anor (2) provide guidance as to matters a court may consider in determining whether a restraint of trade clause in a sale of shares is enforceable.
TSV Holdings Limited v Evans & Summit Innovations Pty Limited
Facts
Hilary Evans was the sole director and secretary and majority shareholder of Tecsound (Vic) Pty Limited (Tecsound) which conducted an electronic communications business. There were two other shareholders of Tecsound.
Pursuant to a share sale agreement (Agreement) the plaintiff company now known as TSV Holdings Limited (TSV) acquired the entire issued capital of Tecsound.
The Agreement contained a restraint of trade clause which restricted the vendors from contacting customers of, or operating a competing business to that operated by Tecsound. The restraint of trade clause provided a maximum restraint period for Mr Evans of 5 years and a maximum restraint area of Australia, whereas the maximum restraint period and area for the other vendors was significantly smaller.
The Agreement also contained an express acknowledgement by each vendor that the restraint clause was reasonable in its extent.
After completion of the Agreement (Completion), Mr Evans developed a number of software products which were similar to those sold by Tecsound (Summit Products), and sold these products through Summit Innovations Pty Limited (Summit) which was incorporated after Completion. TSV became the main exclusive distributor of the Summit Products, however, subsequently, Mr Evans independently contacted and received enquiries from customers of Tecsound in relation to the Summit Products TSV sought an injunction to restrain Mr Evans from having unauthorised contact with the customers of Tecsound.
Issues
Is the restraint clause in the Agreement reasonable?
Judgment
Justice Hollingworth granted the injunction on the basis that the extent of the restraint clause as it applied to Mr Evans was reasonable to protect TSV’s legitimate interests.
Justice Hollingworth stated that relevant considerations in determining the reasonableness of a restraint clause include:
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the scope of the restraint in terms of the geographic area and duration;
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the activities covered by the restraint;
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the relative bargaining power of the parties;
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the consideration paid in exchange for the restraint; and
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the context of the contract.
In this case Mr Evans was an experienced business person, and there was “no evidence that the restraint clause or the agreement were negotiated in circumstances of unequal bargaining power”. Further the provisions of the Agreement suggested that goodwill represented a very substantial part of the purchase price. Accordingly, the restriction imposed by the restraint clause was necessary and valid.
The differing restraint periods and areas which were applicable to Mr Evans and the other vendors merely reflected that Mr Evans had made the greatest contribution to growing the Tecsound business and creating the goodwill which was sold.
Lastly, it was held that “although not determinative, some weight may nevertheless be given to the express contractual acknowledgements by Mr Evans and the other sellers that the restraint clause is reasonable”.
Extraman (NT) Pty Limited v Blenkinship
Facts
A group of companies including Extra Group Pty Limited, Extraman (NT) Pty Limited (Extraman (NT)) and Extraman (HR) Pty Limited (Extra Group) conducted a business providing labour hire services to clients in the mining, engineering and construction industries in Western Australia, the Northern Territory and Queensland.
The first defendant, Mr Blenkinship, was considered a “driving force” of the business conducted by the Extra Group including that conducted by Extraman (NT). As at 4 July 2005 he was a director and shareholder of Extra Group Pty Limited and Extraman (NT).
On 4 July 2005 Skilled Group Limited (Skilled) entered into a share sale agreement whereby it acquired the entire issued capital of the Extra Group (Agreement). The purchase price under the Agreement was $21,982,766.00 (Purchase Price), of which $19,650,000.00 was allocated as goodwill.
The Agreement contained a restraint clause whereby the “Vendors and Covenantors” including Mr Blenkinship were prohibited from competing with or carrying on the same or a substantially similar business as that of the Extra Group in specific areas including the Northern Territory for up to 5 years. The restraint clause was drafted as a ‘cascading clause’ with alternative combinations of temporal and geographical restraints and provided that any of the restrictions in the restraint would be read and construed as separate, severable and independent prohibitions.
Shortly after Mr Blenkinship received his last instalment of the Purchase Price, he resigned from his employment with Skilled and formed a company, the second defendant, through which he intended to conduct business providing labour hire services in the Northern Territory and compete with the business conducted by Extraman (NT).
Another employee of Extraman (NT), Mr Pedersen, also resigned from Extraman (NT) shortly after Mr Blenkinship’s resignation, and joined Mr Blenkinship in working for the second defendant. Both Mr Pedersen and Mr Blenkinship pursued clients and former clients of the Extra Group.
Skilled and Extraman (NT) sought an injunction against Mr Blenkinship to restrict him from carrying on a competing business.
Issues
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Is the restraint of trade clause void because it is too uncertain?
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Is the restraint of trade clause unenforceable due to a public policy objection that the parties have left the court to fix the measure of the restraint?
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Is the restraint of trade clause unenforceable because it is an unreasonable restraint of Mr Blenkinship’s trade?
Judgment
The injunction against Mr Blenkinship was granted on the basis that the restraint of trade did not go beyond what was adequate or necessary for the protection of the plaintiffs’ interests.
The first argument advanced by the defendants was that the restraint clause in the Agreement was too uncertain as the ‘cascading’ clause allowed for an infinite number of combinations of restraint areas and time periods. However, as the cascading restraint clause in this case provided for the severance of any of the prohibitions in the clause that were invalid or unenforceable for any reason, it was held that the clause was not uncertain in terms of construction.
On the issue of whether the restraint clause was unenforceable as the parties had left the court to fix the measure of the restraint, it was held that the parties to the Agreement did not contemplate an infinite number of variables and that the parties did not intend to leave it to the court to make a contract for them. Accordingly, the restraint clause was a genuine attempt to confine the restraint to that necessary for the covenantees’ real need for protection.
Lastly, Angel J held that the restraint was a reasonable restraint on Mr Blenkinship’s trade after considering several matters. Firstly, the plaintiffs sought only to restrain Mr Blenkinship in the Northern Territory which is an area in which the defendants’ competition with the plaintiffs would enure to the injury of the plaintiffs. Thus it was held that the restraint area was reasonable.
As Mr Blenkinship was a “driving force” of several companies of the Extra Group including Extraman (NT) and he had an interest in the goodwill of the Extra Group, the duration of the restraint was reasonable.
Further, Mr Blenkinship was an experienced businessman, was represented by a solicitor and participated in negotiations leading up to the execution of the Agreement. Therefore there was no evidence of inequality of bargaining power.
Given that the Agreement included the purchase of substantial goodwill by Skilled, it was determined that the restraint enabled the substantial purchase price to be agreed and realised.
Lastly, whilst not conclusive, it was relevant that the Agreement contained an express warranty from Mr Blenkinship that the restraint was reasonable.
Conclusion
The common law rule in Australia is that a restraint of trade is prima facie contrary to public policy and is unenforceable, unless the restraint is reasonable in the parties’ interests and is not an infringement of public policy.
The well established criteria which a court will have regard to when determining the reasonableness of a restraint of trade are whether there is a genuine and legitimate interest that must be protected and whether the duration, area and breadth of the restraint is only to the extent necessary to protect that interest.
The courts generally take a stricter and less favourable view of restraint clauses in employment agreements than those in cases concerning a sale of business or a sale of shares by the owner of a business, as the sale of goodwill provides a justification for and measure of the enforceability of a restraint.
It must be noted that in New South Wales, the Restraints of Trade Act 1976 (NSW) allows a court to sever unreasonable parts of a restraint of trade clause i.e. the court is entitled to modify a restraint of trade clause in terms of the time period or geographic area until it is deemed to be reasonable. In all other states and territories of Australia, however, the common law rule applies.
For more information, please contact:
John Reen, Partner
T: 61 2 8233 9572, E: john.reen@dibbbarker.com
Crystal Png, Lawyer
T: 61 2 8233 9569, crystal.png@dibbsbarker.com
1 [2008] VSC 157
2 [2008] NTSC 31
