Andy McNish Discusses Restrictive Covenants

What is a restrictive covenant?

Restrictive Covenants (sometimes known as ‘restraint of trade’ clauses or ‘bar-outs’) are used by businesses to protect their interests in two common circumstances:

~ By an employer restricting an employee’s activities after the end of his or her employment;

and

~ By the buyer of a business restricting the seller’s activities after the sale.

For long-held public policy reasons, English Law dislikes clauses which restrain free trade and individual’s freedom to contract and so such clauses are only enforceable if they are (and provided they do not go beyond) what is required to protect legitimate business interests.

The only recognised business interests are:

~ ‘trade connections’ (including customer contacts, general business goodwill and reputation, and relations with staff); and

~ trade secrets and confidential information.

A covenant protecting trade connections must be limited in terms of the restrictive activities themselves, and apply for a limited time and within a limited geographical area (if appropriate).

However trade secrets and confidential information also often give rise to their own proprietary rights and so the owner may well be entitled to protect them more widely (without necessarily any geographic or time limits).

Types of restrictive covenant

  • Non-solicitation restrictive covenants (this means the covenantor agrees not to approach people such as customers, potential customers or other employees with a view to enticing them away from or altering their relationship with the business). Generally, the covenants should be restricted to people that that the covenantor has had recent contact with.
  • Non-dealing restrictive covenants. This is similar but covers any commercial dealings with the person. This type of covenant has a clear advantage as it avoids the need to prove that the former employee made an approach, which is usually difficult to show. However, it is wider and therefore can be more difficult to enforce.
  • Non-competition restrictive covenant. These are much easier to enforce against business sellers than employees (as competition would damage the goodwill the seller has just been paid for). It is sometimes possible to enforce these against key employees but not if they would make it impossible for the employee to find suitable replacement employment.

Ensure restrictive covenants are drafted carefully

It is dangerous to simply re-use old covenants in new contracts as case law and judicial practice changes rapidly in this area.

It is critical that restrictive covenants are drafted carefully by a professional so that they properly reflect the covenantor’s role and the circumstances of the business and do not go beyond what is legitimately required.

Also all covenants should be carefully layered and a severance clause inserted into the contract, so that one or more of them can fail without bringing down the others.

In the case of employees, the business should regularly review contracts that include restrictive covenants and check whether they need to be updated (for example, if the employee’s role has changed).

In general it is easier to enforce longer and wider covenants in the case of the seller of a business (or of shares in a business unless the shareholding was tiny) as often most of the purchase price is a payment for the goodwill which the covenant is seeking to protect. For similar reasons, allowing employee covenants to last longer than 12 months (including any period of ‘garden leave’) is extremely rare, whereas two years is standard in business sales and periods of up to five years have been found to be acceptable in certain circumstances.

Please visit Andy’s profile should you wish to talk to him about this or any other business law related matter.

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