Employee shareholders & the enforceability of restrictive covenants

The enforceability of restrictive covenants is critical to protecting organisations’ legitimate business interests. A recent summary judgment application sheds light on the approach to be taken where covenants are contained in a shareholders’ agreement.

Background

The claim relates to the alleged breach by the defendant (the former Joint Managing Director) of numerous restrictive covenants set out in a shareholders’ agreement (by competing with the claimants’ business, soliciting their clients and poaching their staff) and misuse of confidential information.

The court’s decision

When ascertaining enforceability, the courts have to consider if restrictive covenants are reasonable. Specifically, the covenants must protect a legitimate interest(s) and must not go further than is necessary to protect the legitimate interest(s).

Generally, restrictive covenants set out in shareholders’ agreements will be enforceable (due to the commercial context in which those agreements are negotiated), while those set out in employment contracts will be the subject of greater scrutiny.

In this case, the defendant argued that the reasonableness of the restrictive covenants should be analysed with the scrutiny usually applied to an employment contract, given:

1. the defendant was an employee and a minor (5%) shareholder
2. the defendant had the same unequal bargaining position as many employees; and
3. the shareholders’ agreement was not negotiated.

With regard to the claimants’ application for summary judgment in particular, the defendant’s position was that the reasonableness of the covenants could only properly be determined at trial as a judge needed to be fully informed of all the relevant facts and circumstances.

The court held that the defendant had no real prospect of successfully defending the issue as to the reasonableness of the covenants and no further investigation of the issue at trial was required. Particular reasons for the enforceability of the covenants were:

1. as managing director, the defendant was in a position where he knew all confidential matters relating to the claimants’ business;

2. the defendant was a ‘sophisticated commercial operator’; and

3. (regarding the duration of the restrictions) many of the relevant client contracts lasted for several years, making it reasonable to prevent competition for 18 months.

Note that the judge declined to give summary judgment in respect of the alleged breaches of the restrictive covenants, such that the issue remains to be decided at trial.

Conclusion/comment

Commercial entities can be reassured by the court’s decision in this case; while the enforceability of restrictive covenants has to be considered on a case by case basis, restrictive covenants set out in shareholders’ agreements entered into with ‘sophisticated commercial operators’ will generally be enforceable.

Employers should remember that where restrictive covenants are contained in an employment contract they will be void for being in restraint of trade and contrary to public policy unless the employer can show there is a legitimate interest to protect and the protection sought is no more than is reasonable. Careful drafting and regular review and updating of covenants in employment contracts is essential if an employer wants to be able to rely on those covenants.

For further information about the summary judgment application, please visit Bailii.org.