Enforcing Restrictive Covenants and Non-Competition Clauses (employment and contractors)

Restrictive covenants and non-competition clauses prevent ex-employees and contractors from doing things they are otherwise entitled to do.

Depending on how they're written into a contract, they apply:

• during the contract to employees and contractors, and
• for a limited time only after the contractual relationship ends: after termination.

Restrictive covenants can be difficult to enforce.

 

Enforceability of Restrictive Covenants

Two different people could have exactly the same contract – word for word. The restrictive covenants could be enforceable against one person, but not the other. The restrictions may be justifiable against one of them, but not against the other.

If a business has the right type of restrictive covenant clauses and does it the right way,  the business is better placed to:

• guard against types of competition which can be encountered when consultants and employees leave the business, and
• enforce them more easily and effectively.

 

What are Restrictive Covenants?

You might see restrictive covenants referred to as “non-competes”.

Non-compete clauses are only one type of restrictive covenant. There are others.

They’re used in contracts to protect a business – usually after the legal relationship has ended: post termination.

They can be made to apply in:

1. employment contracts
2. contracts for the sale of businesses
3. contractor / consultancy arrangements
4. franchise agreements
5. shareholders agreements
6. partnership agreements, and
7. any other sort of business agreement.

The fundamental rules of restrictive covenants have universal application to contracts that prevent people doing what they’re otherwise entitled to do: work with whoever will have them.

In the different situations they’re encountered, they apply with different emphasis with the same considerations.

 

When Restrictive Covenants aren’t Enforceable

When restrictive covenants aren't enforceable they’re as good as not being in the agreement at all.

Sellers of businesses, former employees, exiting business partners and consultants can:

1. work with competitors
2. pilfer customers from the business they just left
3. engage the supply chain of the previous business 
4. take employees and contractors to the new business 
5. use the confidential information of the former business to the extent that it forms part of their skill judgment and labour subject to a few exceptions
6. compete and “set up for business next-door”
7. compete with the franchise they just left.

There are no limits on what the leaver can do, other than the restraints on confidential information referred to above and diverting business opportunities.

Restrictive covenants serve to plug those gaps.

 

When Restrictive Covenants are Enforceable

The starting point is always: restrictive covenants are void. 

It's on the business relying on them to show that clauses which hinder or prevent competition are fair in all of the circumstances of the case. 

The businesses has to show that they're justified.

That can be quite difficult.

The longstanding policy of the law that restrictive covenants are enforceable to the extent that they protect:

• the legitimate business interests
• of the business relying on the restrictive covenant, and
• which are also the interest of the public, and
• extend no further than is reasonably necessary to achieve that purpose.

The person subject to the restrictive covenant can’t be unduly restricted in their post-contractual behaviour. Nor can larger public (which is usually a reference to the market of buyers of relevant goods and services).

It's been said time and again by courts:

The public have an interest in every person's carrying on his trade freely: so has the individual

And they're not shy when it comes to enforcing the policy.

 

Common Restrictive Covenants

Restrictive covenants come in a series of types.

They're restrictions that aimed at preventing different specific acts.

Here’s a list of common restrictive covenants used to restrict competition: 

• Non-solicitation clauses
• Non-dealing clauses
• Non-poaching clauses
• Non-competition or non-compete clauses
• Confidentiality and Trade Secrets clauses
• Goodwill Protection clauses 

Due to the way the law operates, the words “non-solicit”, “non-dealing” and other labels above don’t even have to be used in the non-compete covenant.

It’s is the overall effect of the covenant in the agreement that counts in the end. Not the exact words used.

Using those labels usually means they’re more likely to be enforced. They're well-recognised and defined categories of restrictions.

Also, the effect of some of the clauses can overlap. For instance:

• a non-dealing clause will usually cover restricted persons defined for a non-solicitation clause
• a non-competition clause will most often cover persons covered by a non-solicitation clause and a non-dealing clause

It depends on how they're written into the contract.

 

Severance of Restrictive Covenants

Where the clause (as it’s written in the contract) is void, courts can in some cases delete words from the contract – that is, sever – parts of the restrictive covenant to make it enforceable.

When words used can be severed to make the clause enforceable, the words which remain in the contract are interpreted for their legal effect.

That’s because remaining words are the restrictions agreed by the parties in the contract.

That’s the effect of severance. But the rules of severance only apply to some types of clauses.

We cover the rules of severance here.

 

Enforceability: Guide to Outcomes 

So when a restrictive covenant appears in a agreement to restrict competition, there are 4 possible outcomes: 

1. The clause is valid and enforceable as drafted, or
2. The clause is invalid as drafted, but the unreasonable parts can be severed to save it from being void (ie a restraint of trade). The parts left after the severance are enforceable, or
3. The clause is invalid as drafted, and the unreasonable parts of the clause can’t be severed and:
   1. the clause is void and of no legal effect, or
   2. the entire contract is of no legal effect.

 

Legitimate Interests: Protectable Interests

In law, not any old restrictive covenant will do. It must meet the criterion above to be enforceable.

The restrictive covenant must protect a recognised “legitimate interest” of the business from the leaver. Also, it must extend no further than is required on the facts of the case to protect that interest.

The form of the business protected is not relevant. It might be a private company, plc, limited liability partnership, sole proprietorship, or any other form that a business might take.

There are 4 broad classes of legitimate interests which may be protected against competition with restrictive covenants:

 

1. Trade Connections & Business Connections

“Trade connections” of a business are those where it can be shown that the leaver had recurrent contact with customers or suppliers such that the person is likely to acquire knowledge of and influence over the customers or suppliers

A trade connection might be client or customer connections, a supplier or other information about customers fall which are in the nature of a proprietary interest. 

They’re primarily about prevention of taking away customers.

 

2. Workforce Stability & Integrity of the Workforce

Every business is entitled to have a workforce.

It takes time and money to build up a workforce and investment to train them to the requirements of the business.

Then as agents of the business, employees (typically) engage with the customers of the business and build personal relationships.

It’s a legitimate interest of a business to protect against poaching staff and guard against recruitment of other employees to other companies by leavers: it destabilises workforce of the business.

 

3. Protection of Trade Secrets

This includes highly confidential information of the status of a trade secret. Sometimes it’s referred to “quasi-proprietary” information.

The legitimate interest of the company takes account of the shelf-life of the information and the extent to this it is portable or memorable.

 

4. Protection of Goodwill

Goodwill is the attractive force of a business that brings in enquiries and leads to sales and purchases from a business. It’s usually one of the most valuable assets of the business (whether or not it’s also protected by a registered trade mark or the law of passing off).

The legitimate interest is about protecting the loyalty of customers against unfair competition.

 

Which Legitimate Interest?

An agreement which contains the negative covenants should make clear what the interest it seeks to protect.

Courts can identify the legitimate interest that the business is entitled to protect from:

• the wording of the contract surrounding circumstances and identify the interest intended to be protected
• the focus and substance of the contract
• a series of contracts entered over a period of time. The validity of restrictive covenants are assessed in the context of the overall transaction.

This means that courts are able to approach contracts flexibly. Especially in hybrid situations where:

1. an employee is also a shareholder for the purposes of a sale of shares in the business
2. a consultant is also a shareholder
3. franchisee is also an employee
4. seller of the business continues to play a role in the protected business after it is sold

There is more freedom of contractual terms to enforce a restrictive covenant against a leaver who was the owner of a business, in contrast to one between an employer and employee.

That’s because in a sale of a business, one of the many factors taken into account is the price paid for the business. To take an extreme example:

A purchase price of a business is £1,000,000.

That price will justify more extensive protection of the legitimate interests of the purchasers of the business, than with an apprentice or new starter taken on at £23,000 per year.

It’s in the public interest that the seller should be able to achieve a high price for what he has to sell, and protect against pilfering of the business by the leaving owner after the sale.

 

What are the Types of Restrictive Covenants?

What are the types of clauses which can be in play in a non competition agreement?

Any of them might be used in any of the sorts of contracts listed above.

Courts will allow use of some of the clauses most of the time, provided the use is “reasonable” on the facts of the case. When they’re not, they’re void.

There are 4 types of person involved in the assessment of enforceability of restrictive covenants. 

We get into that below.

First some terminology to keep things easy...

Terminology in Restrictive Covenants

In the cast of players in restrictive covenants, there are at least 4 different types or classes of people (which includes separate legal entities).

Below, we adopt this language to distinguish between:

1. the "Leaver": this is the person who has left a business and subject to the restrictive covenant.
   The Leaver could be a former employer, former business owner, former franchisee.
2. the "Protected Business": this is the business relying on the restrictive covenant. It has a contract with the leaver. That contract might be one of:
   • Employment contract
   • Share purchase agreement
   • Franchise Agreement
   • Shareholders agreement.

Really, it can be any contract with a restrictive covenant in it.

3. the "Targeted Person": this is the person or class of persons that are made off-limits by the restrictive covenant.
   The Targeted Person could be, say:
   1. customers of the Protected Business
   2. suppliers of the Protected Business
4. the "New Business": means the business that the leaver has joined, after leaving the Protected Business.
   It competes to some extent with the Protected Business, whether that’s a part of the trade channels, types of services or customer base profile.
   It could be a completely new business or an existing business.

A “person” in law can mean a company with separate legal existence. A "business" could take the legal form of a private company, Plc, partnership, LLP or an individual. 

 

What is a non-competition clause?

Non-competition clauses provide another direction to come into protecting the legitimate interests of the business.

Non-solicitation clauses, non-dealing clauses and non-poaching clauses each protect a business from competition in their own particular way.

They drill into and prohibit specific acts. The methods tend to be (or should be) refined.

Competition clauses are wider in application. Much wider.

It’s one thing to say that a Leaver won’t attempt to entice away a Prohibited person from Protected Business.

It’s quite another to say they the Leaver will not compete with the Protected Business at all.

It’s pretty difficult to appreciate the approach of courts to non-competition covenants without knowing at least two things:

1. The public policy basis of why courts are generally so unwilling to enforce non-competition clauses.
   That public policy is “the greater good” of fostering competition amongst all businesses and recognition that it is free movement of employees between businesses that allows that to happen, and

2. The limits to protection of confidential information law.
   Not all confidential information is able to be protected by restrictive covenants

Let me explain that comment about confidential information.

 

1. Public Policy: against Non-Competition Clauses

As a matter of public policy, courts favour competition amongst businesses: they’re pro-competition.

Non-compete clauses clash with that public policy objective. 

Head-on.

There’s a collision between public policy and private contractual interests.

Non-solicitation clauses and non-dealing clauses are seen to be:

• a reasonable and adequate step protect the legitimate interests of the business, and
• a more moderate way to address the competing interests between the public and private businesses.

Non-solicit and non-dealing clauses focus on the Leaver's personal contacts and their influence with trade connections.

 

2. How confidential information is protected

For the purposes of restrictive covenants, there are 3 types of information. Two can be protected, and the other can’t.

• Trade secrets and highly confidential information similar to a trade secret.
• Information which is confidential, but which does not fall into the class above, because it forms part of the professional expertise of the Leaver gained as part of an employment relationship.
  That is, confidential information which forms part of the employee's:
  • stock of skill, knowledge and experience, or
  • dexterity, manual or mental ability

The skills and knowledge of the employee are seen to be the employee’s. Not the employer’s. Where there’s an overlap, the employer usually loses.

• Information which is not confidential at all.

Where there are no restrictive covenants which apply post-employment, only trade secrets are protected.

Courts recognise that preventing disclosure of trade secrets can be “practically worthless” unless it is backed by accompanied by a restriction upon the employee possessed of secrets against entering into competition with the Protected Business.

With enforceable restrictive covenants, the Leaver can be prevented from using information in the information which is described above in the second category above as well .

 

Enter Non-Competition Clauses

Competition clauses are more likely to be justified to protect a legitimate interest and reasonable when:

• There is doubt whether the information to be protected qualifies as a trade secret or highly confidential or not
• Genuine disputes exist as to what information is confidential
• in the circumstances of the case, confidentiality clauses and prohibitions on solicitation or dealing are inadequate or will be difficult to prove or police
  That is, non-solicitation, non-dealing clauses and measures to protect confidential information will not achieve the ends for each they are designed.

• Confidential information is easily transportable or memorable and not easily shown to have been taken, such as:
  • searches for businesses in the industry to refresh memory,
  • relevant information is a customer list or price list

When those situations arise, it is increasingly difficult to show that there has – or will – be a breach of the other flavours of restrictive covenant. Usually, it’s not impossible to show. Just very difficult.

That’s when non-competition clauses are more likely to be justified.

To rely on a non-competition covenant the employer must show which part of the business is entitled to protection, and set out in the no compete clause:

• the areas in which the employee can work
• competitive activity permitted after the end of the contract
• the time and geographical constraints of the restrictions

And after that, non-compete covenants are analysed for their broad anti-competitive effect, such as whether:

• a less restrictive form of restriction (for example, a non-solicitation clause) might not have given the employer sufficient protection
• another non-compete clause have been a more proportionate form restriction (for instance, a smaller geographical restraint)
• the extent to which the restraint agreed would diminish the Leaver’s prospects of employment

By working through this process, the court is finding a balance between:

• the extent of protection required to protect the legitimate interests of the business, and
• the extent that the employee’s knowledge and skill restricted, which deprives the greater public of legitimate competition

Example non-competition clause:

You agree not to directly or indirectly compete with the business of the Protected Business during the period of employment and for the leaving period and notwithstanding the cause or reason for termination.

The term "not compete" shall mean that you shall not own, manage, operate, consult or be employed in a business substantially similar to or competitive with, the present business of the Protected Business.

 

Protection of Trade Secrets with Restrictive Covenants

Introduction

There's no general restriction on an ex-employee canvassing or doing business with customers of their former employer. Special circumstances are required.

 

Types of information

• Class 1: trade secrets and highly confidential information
• Class 2: confidential information which does not form part of the leavers skill and knowledge
• Class 3: information which is not confidential at all.

 

Class 2: Confidential information: Part of Skill and Knowledge

Class 2 of this categorisation regime causes real problems to businesses trying to protect confidential information. Once confidential information forms part of a Leaver’s skill and knowledge, it becomes harder to prevent use in a post-employment relationship.

That’s because to do so would prevent the Leaver from working.

 

Class 1: Trade Secrets

Trade Secrets information may not be protected by an express blanket post-termination confidentiality clause wide enough to cover Class 2 information.

It would prevent the ex-employee using what has become part of their general expertise.

Nevertheless, a person who learns of a trade secret when they did not appreciate it was confidential but was then told, would from that moment owe an equitable duty of confidence.

The legal principle is that a post-termination non-competition clause – reasonable in time and scope – may properly have the practical effect of preventing a former employee from using or disclosing information which is wider that in class 1 above. A clause with that effect is at least capable of being reasonable in time and scope.

 

Protection of Goodwill

There's a marked difference between the way the law treats negative covenants in employment contracts on the one hand, and business sale agreements and business dealings similar to sales of businesses on the other.

The amount paid for the business is likely to be a material factor in the assessment of the reasonableness of the covenant.

It's in the public interest that:

• buyers of businesses have access to more stringent restrictive covenants than what would be enforceable against an employee
• the seller should be able to achieve a high price for what they have to sell.

Buyers of businesses therefore have greater freedom of contract to protect the value of what they've purchased. 

In one case it was said:

It is obvious that in many types of business the goodwill would be well-nigh unsaleable if it was unlawful for the vendor to enter into an adequate covenant against competition.

There's another factor that justifies stronger restrictive covenants to protect goodwill.

Parties in a sale of a business are seen have equal bargaining power.

There is no legal compulsion on the seller to sell. The parties to the transaction are more often than not the best judges of what is reasonable as between themselves.

However, where a restraint grossly exceeds what is adequate, it like any other restraint is likely to be struck out of the contract.

The main points about goodwill include:

• An employee is not in the same position as a business owner looking to sell a business. Employees are more in a take it or leave it proposition at the time they are offered their contract of employment
• Courts assume that the buyer and seller have “equal bargaining power”.
  They can take care of themselves in negotiations. There is no compulsion to sell. Or Buy.
• The amount paid for the business is a relevant consideration for assessing the strength of permissible restrictive covenants
• Franchisees are closer to the position of a seller of business: they’re assumed to be of equal negotiating power and capable of take care of their own interests.
  No one is forcing a franchisee into accepting a franchise

For these reasons, courts treat sellers of businesses and franchisees similarly to one another on one end of a spectrum, and junior employees (as in young new starters) on the other end of the spectrum.

Example Clause to protect Goodwill:

For the purpose of providing to the Purchaser the full benefit of the goodwill, the Vendor undertakes to the Purchaser that it will not during the Restricted Period in any part of the UK be engaged, concerned or interested in, or provide financial support or management services or technical, commercial or professional advice to any other business which supplies goods or services which are competitive with or of the type supplied by the Purchaser.

Really though these clauses aren't that special. The usual sorts of clauses are used to guard against post-sale competition to prevent abuse or devaluation of the goodwill purchased as part of the sale. A greater range is available to the purchaser to prevent specific acts which would degrade the value of the business purchased.

 

Severance of Restrictive Covenants

A brief recap on restrictive covenants:

• all covenants and restraint of trade are prima facie unenforceable at law
• covenants are enforceable only if they are reasonable with reference to the legitimate interests of the parties concerned and of the public. .

When a covenant is has too broad and application, in limited circumstances, it can be severed to narrow its legal effect on restricted activities.

Unless the unreasonable part can be severed by removal of either part or the whole of the covenant , its inclusion renders the covenant unenforceable altogether, and sometimes the entire contract.

Sometimes however, if only a discrete phrase within a particular covenant is held to be unreasonable, individual words or phrases may be blue-pencilled or severed, provided that what is left makes independent sense without the need to modify the wording and that the sense of the contract is not changed.

 

Saving an excessive restrictive covenant

Severance only applies to a restrictive covenant that contains a number of different covenants, rather than a single covenant.

What is left after severance is enforceable where:

• the unenforceable provision is capable of being removed without the necessity of adding to or modifying the wording of what remains
• The removal of the unenforceable provision does not alter the character of the contract that it becomes "not the sort of contract that the parties entered into at all."
• that the severance must be consistent with the public policy underlying the avoidance of the offending part.
• The remaining terms continue to be supported by adequate consideration

Here’s an example.

Suppose the circumstances of the case at hand mean that the first clause is too broad: it goes to too far in an attempt to protect the legitimate interests of the Protected Business. If it can’t be severed, it would be a restraint of trade and void.

The Leaver shall not for 6 months following termination undertake, carry on or be engaged or interested in any capacity in either any business which is competitive with or similar to a Prohibited Business, or any business an objective or anticipated result of which is to compete with a Prohibited Business,

The clause might be severed to render it reasonable to protect the legitimate interests of the Protected Business, like this:

The Leaver shall not for 6 months following termination undertake, carry on or be engaged or interested in any capacity in either any business which is competitive with or similar to a Prohibited Business, or any business an objective or anticipated result of which is to compete with a Prohibited Business;

Comments:

• The words after the comma begin the second covenant.
• If the words after the comma in the first covenant weren’t in the original at all, it would be a single covenant.
  That would mean that the words “or similar to” might not be able to be severed, because it would be a single covenant.

In the employment context, if a restrictive covenant:

• which applies after termination of a contract and the employer repudiates the contract, the employer won’t be entitled to rely on it
• is held to be unreasonable, then it is void and unenforceable.
  Courts cannot take a narrow reading of the clause to render it reasonable and enforceable. Parts of it may be severed to narrow its application, which may render it enforceable

A word of warning.

These are basic principles of law. There are others.

Restrictive covenant cases are decided on its own facts, which includes what happened before the contract was signed, precisely what the contract says, and the circumstances in existence at the time the clause is relied upon. Sometimes, it's difficult to predict how the law will be applied. 

Moving on from that….

Also, contractual clauses which say that courts will "read down" an otherwise void restraint of trade clause to turn it into a restraint which would have been enforceable, have no legal effect.

 

Enforceability of Restrictive Covenants

A careful and staged process is adopted by courts to assess validity of restrictive covenants. 

Emphasis in the process differs for the different types of case. 

The usual rules of contractual interpretation apply:

• At the top of the list, restrictive covenants will be interpreted in the context of the entire agreement to give effect to the intention of the parties.
• The reasonableness of a restrictive covenant will be assessed as at the time the contract is made.

 

The Process

1. The restrictive covenant is interpreted to decide what it means.

If the covenant can be interpreted two or more ways, and one of them would render the clause unenforceable, the lawful interpretation is selected.

2. Identify the legitimate interests of the Protected Business, if they exist.
   If none exist, the clause and perhaps the entire contract is void.

3. After that, is the clause on its proper interpretation no wider than reasonably necessary to protect that legitimate interests(s) identified.
   The assessment takes place as at the date of the contract:
   • by reference to events within the contemplation of the parties as at the date of the contract, and not improbable events
   • “looking forwards, as a matter of the covenant's meaning, and not in the light of matters that have subsequently taken place”
   • the class of Targeted Person whose future custom is uncertain is the class of Prohibited Person for which the legitimate interest and clause was designed to protect
   • a contrast is drawn to assess whether a narrower covenant would have achieved the same purpose to protect the relevant legitimate interest
   • courts won’t give the restriction a meaning it cannot reasonably bear

4. The burden is on the Protected Business to show that the restraint is no greater than reasonably necessary for the proper protection of protectable interests.
5. “Reasonable necessity” is assessed from the perspective of reasonable persons in the position of the parties at the time that the contract was entered into or varied and having regard to the contractual provisions as a whole and to the factual matrix to which the contract would then realistically have been expected to apply
6. If the covenant is reasonable:
   1. it is enforceable
   2. The Leaver is liable to pay damages for breach of contract to the Protected Business;
   3. The New Business may be liable for damages to the Protected Business, on a variety of grounds, such as procuring a breach of contract, misuse of confidential information and potentially other grounds
   4. the court retains a discretion to order injunctive relief (or not) having regard, amongst other things, to its reasonableness at the time of trial.

 

Rules of Thumb in assessments of Restrictive Covenants

Factors at work in enforceability of restrictive covenants include:

• A restrictive covenant which goes too far for a senior employee will probably go too far for a junior employee
• If a restrictive covenant goes too far for a junior employee and is unenforceable at the stage, it does not come good, and become enforceable when the person moves up to a senior position or greater salary.
  Once a restrictive covenant is void, it is void for all purposes. It does not become “valid”, because of changes of events over time. 
• This means that when Leavers are promoted through the organisation, their restrictive covenants should be changed to match that increase seniority, expansion in role, increase in customer contacts, or integration within the business.
• What works against a senior employee is more likely to work for a purchaser of a business

 

Conclusion

Businesses rely on their work-forces to go out to the market, find potential customers, and convert them to customers. Then sales. Then repeat sales. Then up-sells on sales.

The workforce prioritises contacts to make them customers. It takes investment to do that. And lots of time and training. 

The nature of some industries mean that contact is infrequent, others require frequent contact to maintain the customer base, whether or not sales are made constantly.

When those that deal directly with customers leave the company and set up on their own behalf or join a competitor. The customer base can be expected to follow them. And perhaps part of the workforce.

That's the nature of personal relationships. The trust and confidence is built up with the person, not the company.

There are different interests to balance:

• The interests of the Protected Business which invested time and money to build and solidify customer relationships for the Leaver to do the business of the company on its behalf and have a job in the first place
• The interests of the Leaver to find and get work after leaving
• The interests of the larger public in having access to competitive businesses competing against one another to drive prices down, provide better service levels, superior products or financial returns
• Businesses should be entitled to hire whoever they like to provide the best price, service or quality of product that they want to put out on the market. 

People are free to go on and develop their careers. Elsewhere. In many industries, that’s how Leavers get ahead in their careers: lateral hires.

The law relating to restrictive covenants and restraints of trade is the way courts find the balance to regulate between Leavers taking unfair advantage of the investment made by businesses in them.

Restrictive covenants should be tailor-made for the level of employee, consultant or business.

The terms of restrictive covenants should be decided by reference to:

• the seniority of the employee
• the access to confidential information within the business, and the ability to remember it
• the personal contact that the employee has with customers and/or suppliers of the protected business
• where customer base is located
• the modes of doing business to build trade connections, and convert sales

Let’s say you’re an SAP consultant or employee for a business which does not have a global presence. Is it really reasonable to restrict post-employment activities worldwide, or even for the entire UK for all SAP related services?

Is that really reasonable to protect the legitimate interests of the business? Those cases will be rare.

What you have in each case is a situation where you have different factors pulling in different directions. It all adds up to a question with a binary answer:

Is the restraint reasonable to protect the legitimate interests of the business?

Or not?

That’s where the law of restrictive covenants and preventing competition come in to decide where the line is drawn in any particular case.