Restrictive covenants in sale agreements: Enforceable or restraint of trade?

Restrictive covenants in sale agreements: Enforceable or restraint of trade?

Published:

Author: Adam Dowdney

A recent High Court case has considered whether restrictive covenants placed on a seller amounted to an unlawful restraint of trade.

It also considered whether certain further provisions surrounding, amongst other things, the cancellation of obligations to pay future instalments in the event of breach of the restrictive covenant amounted to a penalty clause.

This important case may have an impact when considering the value and length of restrictive covenant clauses.

Background

It is very common to include restrictive covenants in SPAs, aiming to limit the activities of the seller to act in competition with the business sold post-completion.

However, restrictive covenants are potentially void at common law as an unlawful restraint of trade. They are enforceable only if they are in the public interest and go no further than necessary to protect the legitimate business interests of the buyer.

This seller was the founder and principal shareholder of a company (TYR) in which a company within the WPP advertising group (WPP) held a 12.6% stake. Pursuant to a heavily negotiated sale and purchase agreement, WPP agreed to acquire a further 47.4% of the shares from the seller. There were put options enforceable by the seller over the remaining 40% of the shares at a price based on a profit multiple.

The consideration payable was significant - around $34m on completion, a second payment of $31.5m and two further payments referable to operating profits. The total amount of consideration payable was capped at around $150m, against a net asset value of approximately $70m.

There was clearly substantial goodwill in the business. A great deal of this was attributable to the seller and his contacts. Understandably, the SPA contained extensive non-competition covenants given by the seller.

The non-compete restrictive covenants ran until 24 months after the date the seller no longer held any shares in TYR (ie the options had been fully exercised) or the earlier termination of the seller's employment or directorships. This meant they could run potentially for eight-and-a-half years after completion.

 

The SPA also stated that if the seller was in breach of the non-compete covenants:

  • the seller's entitlement to any future instalments in relation to the outstanding consideration fell away
  • the seller lost its put options. Instead, WPP could acquire the remaining 40% of the shares at a much reduced price based on a net asset value calculation

The case

After completion, and despite the large amounts at stake, the seller competed with the business. At the time, he was either a director or employee of TYR meaning he was in breach of his fiduciary duties.

TYR sued for breach, a matter which was settled with a payment of $500k from the seller to TYR. However, WPP also pursued the seller separately for breach of non-compete restrictive covenants in the SPA.

The seller challenged that the covenants and price adjustment clauses were unlawful and unenforceable as:

  • they were too long and a restraint of trade
  • the price adjustment clause was an unlawful penalty

The court held that, generally, the provisions were reasonable. It is interesting that the court took into account these factors:

  • although the onus is on the buyer to prove that the restraints were reasonable, the overall terms of the deal were subject to substantial negotiation between parties acting without oppression, represented by experienced solicitors on a "level playing field"
  • the buyer had agreed to pay a substantial premium for the business and the restrictions were an effective protection of the goodwill it was acquiring
  • the value of TYR's business depended heavily on the seller's personal connections, a fact acknowledged in the SPA

The duration of the covenants was also acceptable. The judge decided that the eight-and-a-half year duration was tied to a relevant interest of the buyer and was therefore not unreasonable. It is worth noting that this case relates to business interests outside the UK and is certainly to be differentiated from employment contract restrictive covenants.

Finally, although loss of rights to future payments could in principle amount to a penalty, on these facts the loss of future instalments and variation of options were justified and did not amount a penalty. In fact, they were a reflection of the loss that might accrue to WPP from a breach, assessed at the time the SPA was signed (though an exception was made in relation to the $500k settlement to avoid any double counting).

So what does this mean?

This was an international acquisition, so the guidance published by the OFT that non-compete covenants in SPAs should not exceed three years was largely dismissed by the judge. However, this does not mean that eight year restrictive covenants will be valid in every case.

Buyers must bear in mind that a restrictive covenant must not be contrary to the public interest and must protect the buyer's legitimate interests but should go no further. In addition, where UK and EC competition rules apply, guidance states that a non-compete restriction can be justified for a period of up to three years where both goodwill and know how are transferred, but only two years where it is solely goodwill. Each case, and the protections sought, must be considered on a case by case basis.

Other considerations apply when considering the legitimacy and enforceability of restrictive covenants, such as the geographic scope and the nature of the business being protected. Long restrictions can be enforceable, particularly where they are part of sensibly negotiated SPAs.

However, overly onerous restrictions cannot be justified purely by the amount paid for them (though the level of consideration paid is a relevant factor).

Drafting non-compete restrictive covenants in an SPA is a complex area. What value is attributed to the restrictions as well as geographical location and bargaining strengths must all be considered, and local jurisdictional competition issues must also be reviewed.

It is also important to draw the distinction with restrictive covenants in employment contracts. The courts take into consideration the employer versus employee dynamic, and so are very unlikely to accept longer restrictive periods in such agreements.

Case: Cavendish Square Holdings BV and another v El Makdessi [2012] EWHC 3582