What are restrictive covenants?
Restrictive covenants are contractual clauses which protect one party’s (the beneficiary’s) key commercial interests. These covenants protect the beneficiary by preventing the other party from carrying out commercial activity that it would otherwise have been free to do.
How can restrictive covenants help my business?
In many business situations where parties are working together and the beneficiary needs to provide another party with confidential information or know-how or introductions to its clients/suppliers that the other party might use to its own benefit in the future, the beneficiary’s commercial interests may be threatened unless it can regulate the use that the other party makes of such information or introductions. Well-drafted restrictive covenants will protect the beneficiary, particularly after the agreement has ended.
Standard restrictive covenants in commercial contracts
- Non-compete covenant: restricting a party from competing directly or indirectly with the beneficiary, usually in a specified sector and for a specified period.
- Non-solicitation covenant: restricting a party from soliciting the customers or suppliers of the beneficiary.
- Non-dealing covenant: restricting a party from dealing with suppliers and/or customers of the beneficiary.
- Non-poaching covenant: restricting a party from canvassing, soliciting or employing the employees of the beneficiary.
All of the above usually last for a specified period of time (normally the term of the agreement and a fixed period afterwards), often in a specified geographical area and/or a specified commercial sector.
Are the restrictive covenants enforceable?
This is a key commercial and legal issue because at common law, a restrictive covenant is potentially void as a restraint of trade.
However, the courts are more likely to enforce the restrictions if it can be proved that they are proportionate and do not go further than reasonably necessary to protect the legitimate business interests of the beneficiary. This test will depend on all of the facts of a case, so there is no simple test to apply.
In deciding whether or not a restrictive covenant is enforceable, the courts will apply the following criteria:
- does the beneficiary of the covenant have a legitimate business interest to protect?
- what is the practical effect of the restrictive covenant?
- is the restrictive covenant proportionate and limited to protecting the legitimate business interest?
- is the covenant contrary to public interest?
In addition, the court will also consider the following factors:
- Bargaining power: The courts are more likely to enforce restrictive covenants when there is equality of bargaining power between the parties so, for example, a restrictive covenant that is enforceable in a supply agreement may be unenforceable in an employment contract. In general, the court will be reluctant to strike down a restrictive covenant freely negotiated between commercial parties as such parties are seen as the best judges of what is reasonable between themselves. However, in the recent case of Dwyer v Fredbar (involving a very large plumbing company and a single sole trader plumber), the Court of Appeal decided that there was unequal bargaining power making their relationship more like an employer and an employee; as a result, the covenant was held to be unenforceable.
- Is the restriction reasonable? Whilst this is ultimately a “global” test that examines all the circumstances at the time the contract was made, the beneficiary will initially have the burden of showing that the restriction is no more than is necessary to protect its legitimate interest – once that is shown, the party attacking the restriction will need to show that it is contrary to the public interest in order to invalidate it.
- No blue-pencilling: the court will not save a covenant by “blue-pencilling” (removing any unenforceable part to make the remainder enforceable) as the courts have clearly indicated that it is not their function to rescue a covenant by modifying it – so it is important for the beneficiary to ensure that it gets the drafting right first time by not imposing restrictions that are not necessary to protect its legitimate interests!
How are restrictive covenants enforced?
A claim for damages: breach of a restrictive covenant gives rise to a claim for damages in the same way that any other breach of contract would, and the beneficiary is entitled to seek damages for losses caused by the breach or, alternatively, the profits made by the party breaching the covenant.
Interim injunction: a beneficiary may also seek an emergency court order (interim injunction) restraining the activities which are alleged to be in breach of the restrictions in order to limit the damages that will be suffered. The courts have developed a body of case law which broadly requires the beneficiary to show that its interests will be irreparably damaged unless an order is granted preventing the other party from doing specified acts and that an award of damages will not be sufficient to protect its rights. If an interim injunction is ordered, the other party is required to cease the relevant activities until a final judgment can be made on the enforceability of the restrictive covenants. Although obtaining an interim injunction can be a powerful business remedy, it also comes with risks: the party requesting it will need to provide a financial bond that protects the party bound by the court order against any losses that it suffers if the court decides ultimately that the order should not have been granted.
Key takeaways and action points
- Restrictive covenants are important contract terms that protect the legitimate business interests of a party.
- A restrictive covenant is likely to be enforceable if it protects a legitimate business interest and is drafted in a proportionate way to do so – if not, it will be seen as being in “restraint of trade” and not enforceable.
- Restrictive covenants in commercial agreements are more likely to be enforceable than those in contracts of employment, as (i) equality of bargaining power is likely to apply and (ii) the courts are more likely to accept that business parties are best placed to decide their own commercial interests.
- The courts will usually not save a covenant by removing any unenforceable part as it is not the court’s function to rescue a covenant.
- Restrictive covenants should always be considered and drafted with regard to the specific circumstances and contract in which they operate.
- Speedy action is needed if a party is asking the courts to order an interim injunction to enforce a restrictive covenant– any delay is likely to mean no order will be awarded.
How Moore Barlow can help
We regularly advise on a wide range of commercial and technology agreements where some form of restrictions are necessary (including IT and software agreements, marketing, distribution, consultancy, franchising, agency and the supply of goods and services). We can help with drafting/reviewing/advising on restrictive covenants.
John Warchus is a Partner and Arnab Ray Chaudhuri a Solicitor in the Commercial & Technology team at Moore Barlow.
