May 5, 2020

Restraints of trade the ultimate guide

Introduction

What is a restraint of trade?

Restraint of trade clauses can be categorised into:

1. Non-compete clauses.
2. Non-solicitation clauses.
3. Trade secret / confidential information clauses.

Restraints of trade are relevant at all stages of the business lifecycle, including when

1. Employing people or engaging contractors.
2. Buying or selling a business or shares in a private company.
3. Starting a business with others.
4. Entering or exiting a franchise system.

To be enforceable, a restraint must protect legitimate interests such as goodwill, trade secrets or confidential information. Restraints against mere competition are not enforceable 

Types of restraints

Employees may be employed on:

1. Non-compete clauses

2. Non-solicitation clauses

3. Trade secret / confidential information clauses

1/Non-compete clauses

Non-compete clauses usually seek to prohibit a person from being involved in a competing business. In employment agreements, non-compete restraints are usually only enforceable against senior employees in possession of confidential information or trade secrets. 

2/Non-solicitation clauses

Non-solicitation clauses do not seek to prohibit a person from working for a competitor or starting their own business, but rather they seek to prohibit a person from encouraging clients or employees to follow them. There are three types of “non-solicitation” clauses. They are:

1. Restraints on soliciting clients;
2. Restraints on being employed by clients; and
3. Restraints on soliciting employees, contractors or suppliers.

To be enforceable, the restrained person must be in a position to gain trust and confidence so as to be relied on in a client’s affairs and there must be a possibility that the person  may take the client’s business with them. The likelihood of successfully enforcing a non-solicitation restraint against an employee increases with seniority and pay. 

3/Trade secret / confidential information clauses

Trade secret / confidential information clauses seek to prohibit the restrained party from exploiting trade secrets or confidential information acquired in their former position.

Section 183 of the Corporations Act 2001 (Cth)
Employees (as well as directors and other officers) of corporations are also prohibited from using information to gain an advantage for a person or cause detriment to the corporation under section 183 of the Corporations Act 2001 (Cth).

Determining enforceability

General principles

The overriding principle to keep in mind is that the restraint must be reasonably necessary to protect the other party’s legitimate interests.
 
There are three questions of reasonableness:

1. Is the prohibited activity reasonable?
2. Is the restraint period reasonable?
3. Is the restraint area reasonable?
The validity of a restraint is to be determined at the time the contract was entered.

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Severability and the Restraints of Trade Act 1976 (NSW)

Except in New South Wales, the starting point is that restraints of trade are presumed to be void. It is on the enforcing party to satisfy a court that a restraint goes no further than reasonably necessary.

Restraints are most commonly drafted in severable (or cascading) terms, which list a number of possible combinations of restraint areas, restraint periods and restrained activities. This allows a court to invoke the “blue pencil” rule, which allows the court to strike out the unenforceable parts of the restraint, and leave the enforceable parts standing. In New South Wales, restraints of trade are not presumed to be void. The Restraints of Trade Act 1976 (NSW) allows the Supreme Court of New South Wales to uphold a restraint to the extent it is reasonable, even if the clause is not drafted in severable (or cascading) terms.

Employee restraints vs. goodwill restraints

Employee restraints, as the name suggests, are restraints in employment agreements. Employee restraints are less readily enforceable because there is usually an inequality of bargaining power between employers and employees, and most of the time the employee does not receive additional compensation for giving the restraint.

A goodwill restraint is a restraint included in a commercial agreement (such as a business sale agreement, share sale agreement, shareholders’ agreement or franchise agreement). Courts are more willing to enforce goodwill restraints because usually the person giving the restraint has received some form of payment or other consideration for giving the restraint and there usually is not an inequality of bargaining power.

Franchise restraints

Section 23 of the Franchising Code of Conduct prevents restraints in franchise agreements having effect after the agreement expires if:

1. The franchisee has sought to extend the agreement;
2. The franchisor does not extend the agreement;
3. The franchisor does not compensate the franchisee for goodwill; and
4. The other conditions set out in section 23 of the Franchising Code of Conduct are met. 

Recent cases

Employment contracts

Wales granted an interim injunction restraining a senior property manager from starting employment with a competitor pending a final hearing

Background

1. The employee had become employed by the employer where the employer bought a rent roll from the employee’s former employer for $1.3 million.
2. The employee commenced employment on 31 October 2016, but had not signed an
employment agreement with restraints until 23 April 2019.
3. The employee was made redundant on 12 November 2019.
4. The employee did not receive any additional financial benefit for agreeing to the
restraints

 
Restraints in dispute

1. A three year, 15-kilometre non-compete restraint
2. A three year non-solicitation and no dealing restraint.

 
Held
 
1. The judge granted an interim injunction restraining the employee from starting employment with a competitor pending a final hearing because the protection afforded by non-solicitation and confidentiality provisions is unlikely to be perfect because it is often difficult to prove a breach. Although the employee had given back copies of customer lists and databases, such information would be retained in her memory and there was a risk she may inadvertently use that information for the benefit of her new employer and to the detriment of her former employer.

2. The judge observed that the non-compete may be enforceable, but the non-compete restraint may be read down to less than three years, and possibly less than 12 months. The judge further observed that while there may be questions about the reasonableness of a three-year restraint for the non-solicitation and no dealing restraint, 12 months may be reasonable

Business sale agreements

Shareholders’ agreements

The Federal Court of Australia held that restraints in a shareholders’ agreement were binding on an individual even though that individual did not sign the shareholders’ agreement in his personal capacity, but the restraints were unenforceable due to being too broad

Background

1. Mr McKay’s entity, Vandaman Pty Ltd (Vandaman) was a shareholder of Civic Financial Planning Pty Ltd (Civic)
2. Findex Group Ltd had become a shareholder of Civic where it bought 60% of the share capital from the existing shareholders (including Vandaman) for a total of $11 million. Vandaman received $2.153 million
3. The shareholders’ agreement took effect from completion of the above share transaction.
4. Although the principals of each shareholder were specified as a party to the shareholders’ agreement, the final draft of the shareholders’ agreement only had signature blocks for them to sign for their shareholding entities. There were no signature blocks for the principals to sign in their personal capacity. These signature blocks were, however, included in previous drafts

 
Restraints in dispute

1. A non-solicitation restraint.
2. A non-acceptance restraint.
3. A non-interference restraint.
The maximum restraint area was the ACT.
The maximum restraint period was five years.

Held

1. Mr McKay was personally bound by the restraints in the shareholders’ agreement

2. The restraints failed because the restrained conduct and persons caught by the restraints were too complicated (for example, a great-grandchild of a spouse of a beneficiary of a trust of which Vandaman is or has been at any time a trustee would have been caught by the restraints). Further, the restraints could not be saved by severing parts of the restraints

3. The judge observed that, if the restraints were enforceable, then a maximum restraint area covering the ACT would be reasonable, as the business was conducted in that area. The judge further observed that a restraint period of five years would be reasonable.

4. The court also considered section 183 of the Corporations Act 2001 (Cth), but had found Mr McKay had not contravened that section.

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