PROTECTING BUSINESS WITH RESTRAINTS OF TRADE
One of the most significant threats to any business is a competitor who has the benefit of
"inside knowledge" in relation to that business. The focus of this paper is upon the extent
to which a business may protect itself from competitors (who may possess such knowledge
because they are either former employees or former owners of that business) by the use of
contractual restraints of trade.
General Principles
One of the difficulties with this area of law is that the starting point is that all contractual
restraints of trade are presumed to be void for reasons of public policy. The most
frequently cited decision for this proposition is Nordenfelt v Maxim Nordenfelt Guns and
Ammunition Co Ltd1 where Lord Macnaughton said:The public have an interest in every person's carrying on his trade freely: so
has the individual. All interference with individual liberty of action in trading,
and all restraints of trade of themselves, if there is nothing more, are contrary
to public policy, and therefore void. That is the general rule.2
The presumption may be rebutted if it can be demonstrated that the restraint is reasonable
in all the circumstances:[R]estraints of trade and interferences with individual liberty of action may be
justified by the special circumstances of a particular case. It is a sufficient
justification, and indeed it is the only justification, if the restriction is
reasonable – reasonable, that is, in reference to the interests of the parties
concerned and reasonable in reference to the interests of the public, so framed
and so guarded as to afford adequate protection to the party in whose favour
it is imposed, while at the same time it is in no way injurious to the public.3
It can be seen from the above quote that a court considering a covenant in restraint of trade
undertakes a two-step process. The first step is to consider whether or not the restraint
confers greater protection than can be justified as between parties. Where the restraint
does confer greater protection than can be justified the clause will fail and there is no need
to separately consider the public interest4. If, however, the clause confers no greater
protection than can be justified between the parties, the court must go on to consider
whether or not upholding the clause would be "injurious to the public".
In my experience, many practitioners carefully turn their mind to the issue of
reasonableness as between the parties but fail to consider reasonableness with respect to
the interests of the public. This may be because so much of our training as lawyers is about
weighing up competing interests as between individuals rather than considering broader
notions of public interest.
1
[1894] AC 535
Ibid. at 565 per Lord Macnaughton
3
Ditto
4
Amoco Australia Pty Ltd v Rocca Bros Motor Engineering Co Pty Ltd (1973) 133 CLR 288 at 306
2
2
In view of the fact that the presumption that all restraints are void is rebuttable, one may
think that the onus of proof lies exclusively upon the beneficiary of the restraint cause.
However, that is not the case. This was explained by Lord Atkinson in Herbert Morris Ltd v
Saxelby5:If the restraint affords to the person in whose favour it is imposed nothing
more than reasonable protection against something which he is entitled to be
protected against, then as between the parties concerned the restraint is to be
held to be reasonable in reference to their respective interests, but
notwithstanding this the restraint may still be held to be injurious to the public
and therefore void; the onus of establishing to the satisfaction of the judge
who tries the case facts and circumstances which show that the restraint is of
the reasonable character above-mentioned resting upon the person alleging
that it is of that character, and the onus of showing that, notwithstanding that
it is of that character, it is nevertheless injurious to the public and therefore
void, resting, in like manner, on the party alleging the latter.
The relevant time for making a determination as to the reasonableness of a restraint is at
the time of entry into the contract6.
A word of caution; whilst the principles of law in this area are pretty clear, there is a risk that
practitioners may rely too heavily upon previous decisions when assessing the
reasonableness of a proposed or existing covenant in restraint of trade. Most cases are
decided upon their particular facts as opposed to espousing some further refinement of
principal. As Justice McDougall noted in Stacks/Taree Pty Ltd v Marshall [No 2]7:There can of course be a problem with excessive reliance on decided cases.
The question of validity of a covenant in restraint of trade (including, in this, a
covenant against solicitation of the covenantee’s customers or clients) is not
really a question of law. Decided cases state the relevant principles, and may
prove useful, indeed valuable, guidance as to their application in particular
factual circumstances. But the validity of a covenant in restraint of trade is to
be assessed having regard to the terms of the particular covenant and the
facts of the particular case.
In the situations being considered here, namely employment and business sales, the
provisions of the Competition and Consumer Act 2010 prohibiting anti-competitive conduct
do not apply8.
5
[1916] 1 AC 688
Lindner v Murdock' s Garage (1950) 83 CLR 628
7
[2010] NSWSC 77 at [54]
8
See section 51 (2)
6
3
Employees
It is important that practitioners appreciate that there are a number of protections afforded
to employers in relation to the conduct of their employees that arise by virtue of the
significance that the general law has always placed upon the employment relationship. In
my experience some practitioners are unaware of these protections.
Firstly, the relationship between an employer and its more senior or trusted employees will
usually give rise to the imposition of fiduciary duties upon the employees. These duties
include the duty not to profit from the position of trust the employee has been put in and
the duty not to bring the employee's own interests into conflict with the employer's9. There
are significant advantages in being able to pursue a former employee for breach of fiduciary
duty in so far as the available remedies are concerned10 and the ability to obtain relief
against associated entities11
Secondly, where the employer is a company to which the provisions of the Corporations Act
2001 apply, all employees owe duties to the employer company similar to the fiduciary
duties12. Breach of these obligations results in the incurring of civil liability as well as the
possibility of prosecution by the Australian Securities and Investment Commission.
Thirdly, there are a number of implied contractual duties including the duty of fidelity and
good faith13 and a duty of mutual trust and confidence14.
Finally, equity has always afforded protection with respect to the misuse of confidential
information15.
Notwithstanding the existence of these duties, contractual covenants still offer an
advantage in more precisely defining the type of conduct which the parties consider to be
objectionable.
The approach of the courts to restraint of trade clauses contained in employment contracts
has generally been stricter than the approach to such clauses contained in sale of business
contracts16. The public policy reasoning behind this approach should be obvious.
The approach taken by the courts when considering a covenant in restraint of trade in the
employment area is, first, to identify what are the interests of the employer which it is
legitimate to protect with the restraint covenant. Next the circumstances of the employee
are examined to see how those circumstances relate to the legitimate interests. Thirdly, the
restraint is examined to ensure that it goes no further than is necessary to protect those
9
Hospital Products Ltd v United States Surgical Corp (1984) 156 CLR 41 and Warman International Ltd v Dwyer
(1995) 182 CLR 544
10
See, for example, Warman International Ltd v Dwyer supra
11
See, for example, Southern Cross Mine Management Pty Ltd v Ensham Resources Pty Ltd [2005] QSC 233
12
See sections 182 and 183 Corporations Act 2001
13
Robb v Green [1895] 2 QB 315 and Blyth Chemicals v Bushnell (1933) 49 CLR 66
14
Commonwealth Bank of Australia v Barker [2013] FCAFC 83
15
Australian Broadcasting Commission v Lenah Game Meats Pty Ltd (2001) 208 CLR 199
16
Geraghty v Minter (1979) 142 CLR 177
4
legitimate interests in the circumstances17. Of course the final step is to consider whether
or not the restraint is injurious to the public.
There are four types of restraint that an employer typically seeks to impose upon employees
in a contractual restraint of trade covenant. I will consider each of these in turn.
Restraint from Competing/Working for a Competitor
There are two temporal subcategories in relation to this type of restraint. The restraint can
be applied during the subsistence of the employment relationship and/or following its
termination. Restraints of the first kind are usually found to be reasonable 18 for employees
in full-time employment. It is the post-termination restraints that are subject to the
greatest scrutiny by the courts.
There are three aspects to a non-competition restraint, namely, the nature of the activity
that is prohibited, the duration of the restraint and the geographical area of operation. All
three may be interrelated. For example, in Pearson v HRX Holdings Pty Ltd19 a no
competition restraint on a senior executive employee was upheld notwithstanding that no
geographic limit was expressed in the restraint clause. This is because the nature of the
work that was restrained was a business or operation similar to or competitive with the
employer's business at the time of the employee's departure from the company. As the
employer was only doing business in Australia and New Zealand at the time of the
employee's departure, the court held that the clause was effectively self-limiting and went
no further than was reasonable in the circumstances.
The seniority of the employee and the nature of his or her duties has a significant bearing
upon the duration of a restraint which will be found to be reasonable. For example,
restraints of three years have been upheld in connection with medical practitioners20; a
restraint of two years has been upheld for a senior executive21; one year was considered
unreasonably long in the case of an IT consultant22.
Restraint against Poaching Employees
It is particularly important with restraints of this kind to carefully identify the legitimate
interest that is being sought to be protected. For example, in industries where there is
frequent employee turnover or limited security of employment, restraints of this sort may
be unreasonable23.
A general restraint on poaching any employee without discrimination may be very difficult
to establish as being a reasonable protection of the employer's interests24. On the other
17
Lindner v Murdock's Garage (1950) 83 CLR 628
Buckenara v Hawthorn Football Club Ltd [1988] VR 39
19
[2012] FCAFC 111
20
Whillans v Ashcoast Pty Ltd [1998] QCA 034
21
Pearson v HRX Holdings Pty Ltd supra
22
Wallis Nominees (Computing) Pty Ltd v Pickett [2013] VSCA 24
23
Aussie Home Loans v X Inc Services [2005] NSWSC 285
24
Allison v BDO (NSW-Vic) Pty Ltd [2010] VSC 35
18
5
hand, a restraint against the recruitment of employees critical to the continued success of
the business25 or who possess important confidential information26 can be upheld.
Restraint against Poaching Customers
For many businesses there is a significant interest in protecting their customer bases. Lord
Atkinson said in Herbert Morris Ltd v Saxelby27 that an employer is entitled "not to have his
old customers by solicitation or such other means enticed away from him". The Court of
Appeal of the Supreme Court of New South Wales has held that a restraint against
solicitation of customers can be breached even where the customer makes the initial
approach to the former employee28.
It should not be assumed, however, that every business has a legitimate interest in
preventing former employees from soliciting customers. In Philip M Levy Pty Ltd v
Christopoulos29, for example, a restraint against a real estate agent was found to be void
because the customers of the business were generally not of a recurring kind.
Even if the employer has a legitimate interest in protecting its relationship with its
customers, whilst it would be reasonable to restrain a former employee from dealing with
those customers with whom the employee was regularly dealing, it would not be reasonable
to restrain the employee from dealing with those customers with whom the former
employee had only limited contact30.
A case worth considering is the decision of Justice Ryan in Smith v Ryngiel31. There the
defendant was an accountant who managed a firm of accountants whose practice was
purchased by the plaintiffs. The plaintiffs entered into a written employment contract with
the defendant which included a restrictive covenant prohibiting the defendant from
practising as an accountant within 10 kilometres of the practice for a period of three years
following termination agreement. It also prohibited him for a period of three years after
termination from acting as an accountant for any person who was a client of the plaintiff's
firm at the time of making the agreement or during the three years following termination of
the agreement.
Justice Ryan found that the covenant not to act for clients of the firm who were clients
when the agreement was made was valid and enforceable but, insofar as it applied to
persons who became clients after the termination of the defendant's employment, it was
invalid. Interestingly His Honour also found that, because the covenant not to act for
current clients of the firm was reasonable, the covenant restraining the defendant from
practising within a 10, radius was unnecessary and, therefore, invalid.
25
Tullett Prebon PLC v BGC Brokers [2010) EWHC 484
Cactus Imaging Pty Ltd v Peters [2006] NSWSC 717
27
[1916] 1 AC 688 at 702
28
Barrett v Ecco Personnel Pty Ltd [1998] NSWSC 545
29
[1973] VR 673
30
Wallis Nominees (Computing) Pty Ltd v Pickett supra
31
[1988] 1 Qd. R. 179
26
6
Restraint Against Using Information
Restraints against using confidential information and trade secrets are usually upheld as
they largely reflect the implied duties to which an employee is subjected. As Farwell J
described the situation in TriPlex Safety Glass Co Ltd v Scorah32:… whether restrained by express contract or not, no employee is entitled to
filch his employer's property in whatsoever form that property may be,
whether it is in the form of a secret process or in some other form. On the
other hand, no employer is entitled to prevent his employee from making use,
in the service of any persons or on his own account, of any experience or skill
which the employee has gained during his term of service with the employer.
The difficulty that arises is in determining the difference between confidential information
and trade secrets on the one hand and know-how, experience or skill on the other. The
obvious advantage of using a written restraint of trade covenant in this area is the ability to
clearly define what information is confidential to the employer. As Lord Denning noted in
Littlewoods Organisation Ltd v Harris33:… experience has shown that it is not satisfactory to have simply a covenant
against disclosing confidential information. The reason is because it is so
difficult to draw the line between information which is confidential and
information which is not…
By defining what information is confidential, protection may be afforded to information that
would not be protected in equity34. However information that is freely available or can
easily be ascertained in some identifiable market or endeavour cannot be protected 35.
Examples of information which the courts have found may be legitimately protected in a
restraint of trade covenant include customer lists and contact details36, pricing
information37, projected profits38 and lists of reliable suppliers39.
32
[1938] Ch 211
[1977] 1 WLR 1472 at 1479
34
Wright v Gasweld Pty Ltd (1991) 22 NSWLR 317 and Cactus Imaging Pty Ltd v Peters [2006] NSWSC 717
35
GlaxoSmithKline Australia Pty Ltd v Ritchie [2008] VSC 164 and Tullet Prebon (Australia) v Purcell [2008]
NSWSC 852
36
Mid City Skin Cancer & Laser Centre v Zahedi-Anarak [2006] NSWSC 844
37
Brinks v Kane [2007] NSWSC 62
38
Transpacific Industries Pty Ltd v Whelan [2008] VSC 403
39
Wright v Gasweld Pty Ltd supra
33
7
Business Vendors
The identification of a legitimate interest entitled to protection in the case of the sale of the
business is much easier than in the employment situation. As Younger LJ put it in Attwood v
Lamont40:An employer is not entitled by a covenant taken from his employee to protect
himself after the employment has ceased against his former servant's
competition per se, although a purchaser of goodwill is entitled to protect
himself against such competition on the part of his vendor.
The legitimate protectable interest in connection with business sales has usually been
regarded as the goodwill of the business41. Lord Parker explained this in Herbert Morris Ltd
v Saxelby42:The goodwill of a business is immune from the danger of the owner exercising
his personal knowledge and skill to its detriment, and if the purchaser is to
take over such goodwill with all its advantages it must, in his hands, remain
similarly immune. Without, therefore, a covenant on the part of the vendor
against competition, a purchaser would not get what he is contracting to buy,
nor could the vendor give what he is intending to sell.
It is essential to identify what the goodwill of a business covers. For example, where a
brewing company was sold with a restrictive covenant prohibiting the manufacturing,
brewing, selling or disposing of beer or similar products, the restrictive covenant was held
not to be enforceable because at the time of sale the company was only brewing sake43. In
other words, there was no goodwill in relation to beer and nothing legitimate to protect.
Similarly where a vendor sold a business which supplied but did not manufacture steel
reinforcements for concrete roads, a covenant restraining the vendor from the manufacture
and sale of road reinforcements was held to be too wide44.
Most often restraints in sale of business situations simply prohibit competing with the
business within certain temporal and geographic limits.
Careful consideration needs to be given to the geographical constraints of a restraint. At
one end of the spectrum worldwide restraints have been upheld45 and at the other end
restraints as small as less than 2 kilometres have been struck down46. Whilst the enquiry
focuses upon the geographical area within which the business was legitimately being carried
40
[1920] 3 KB 571 at 589
Esso Petroleum Co Ltd v Harper's Garage (Stourport) Ltd [1968] AC 269
42
[1916] 1 AC 688 at 708
43
Vancouver Malt And Sake Brewing Co Ltd V Vancouver Breweries Limited [1934] AC 181
44
British Reinforced Concrete Engineering Co v Schelff [1921] 2 Ch 563
45
Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd supra
46
Mertel v Rigney (1939) 56 WN (NSW) 122 and Papastravou v Gavan (1968) 2 NSWR 286
41
8
on at the time of sale47, some allowance has been made for reasonable prospects for
expansion of the business contemplated by vendor and purchaser at the time of sale48.
The approach of the courts to the temporal restriction is much more generous than in
employment law cases with restraints unlimited as to time having been upheld 49. Justice
Mackenzie has said that "(c)ases where the duration of the restraint alone will render a
restraint unreasonable, where the terms of the restraint are otherwise reasonable, will be
rare"50.
A clause will generally be upheld where it provides the purchaser with a reasonable
opportunity to cement relationships with existing customers of the business as well as to
exploit the business' established reputation by attracting new customers without any
interference by the seller51. Recently Justice Philip McMurdo held that a restraint of more
than two years with respect to an accountancy practice was unreasonable in view of the fact
that most people require annual attention to their accountancy requirements52.
The purchaser of a business may also wish to restrain a vendor from poaching staff and
customers and/or from using confidential information. If it can be demonstrated that such
restraints are necessary to protect a legitimate interest that the purchaser had bought from
the vendor, such restraints will be enforceable. For example, if the main asset of a business
was a secret process or recipe, a restraint against the vendor using or disclosing it would be
upheld.
The assessment of whether or not a restrictive covenant is injurious to the public in respect
of the sale of a business involves very different considerations to the employment arena.
There is often no reduction in competition; one party simply exits from the market and
another enters. However where a restrictive covenant is "calculated to create a pernicious
monopoly" injury to the public will be found. Dealing with this topic Viscount Maughan in
the Privy Council has said:When the court is satisfied that the restraint is reasonable as between the
parties it must always be difficult to prove in a case connected with goodwill
that the public interest is affected. In the present case, it seems to their
Lordships that there are no grounds for holding that a restriction restraining
the respondent from carrying on a sardine business in Canada is likely to
produce a real monopoly, since every other person in Canada can set up such a
business, and the evidence is to the effect that some persons have done so. 53
47
Connors Bros Ltd v Connors [1940] 4 All E.R. 179 and Complete Business Strategies Pty Ltd v AFA Wealth Pty
Ltd [2013] QSC 43
48
McAllister v Cardinal (1964) 47 DLR (2d) 313
49
Leather Cloth Co v Lorsont (1869) 39 L.J.Ch. 86 and Eastwood Co-op Society Ltd v Williams (1932) 32 SR
(NSW) 403
50
CSR Ltd V Wagner Investments Pty Ltd [2002] QSC 143 citing Bridge v Deacons (a firm) (1984) 1 AC 705
51
Brown v Brown [1980] 1 NZLR 484 at 490
52
Complete Business Strategies Pty Ltd v AFA Wealth Pty Ltd supra at [22]
53
Connors Brothers Ltd v Connors [1940] 4 All ER 179 at 195
9
Drafting Issues
Identify the Legitimate Interests Which Require Protection
It should be clear from the principles discussed above that the first and most important step
in drafting a restraint of trade clause is to identify precisely what interests the promisee
wishes to protect. Until this is done you cannot sensibly attempt to commence drafting the
restraint covenant.
This means that you need to have a conversation with your client in order to understand the
elements of the business involved.
It may be worthwhile specifically addressing the interest that the restraint is designed to
protect. For example, if it is the goodwill of the business being sold that the promisee
wishes to protect, set this out in the clause and, if possible, identify that part of the
consideration attributable to the goodwill.
If trade secrets, customer lists or key staff are the legitimate interests, set this out in the
clause.
Consider What Activities Need to Be Restrained
This requirement will be informed largely by the previous exercise in identifying the
legitimate interest. So, for example, in the case of the sale of a business where the
legitimate interest is the goodwill that the purchaser has paid for, activities which would put
the vendor in competition with the purchaser should be restrained.
If the legitimate interest is some trade secret or commercial information, whether in the
employment or sale of business contexts, the use or disclosure of the trade secret or
commercial information is the activity that should be restrained.
If customer or supplier lists are the legitimate interest then the copying or use of the lists
and the poaching of the customers/suppliers should be restrained.
If the business relies heavily on key staff then the poaching of those staff is the activity that
should be restrained.
Should there be activities that your client for some reason does not wish to restrain then it
may well be worthwhile setting this out in the covenant to demonstrate the reasonableness
of the actual restraints.
Consider the Public Interest
This is particularly important in small regional communities. It is unlikely that a restrictive
covenant which had the practical effect of depriving a community of important services
would be upheld.
10
Identify Elements With Precision
The more general the concepts that are dealt with in a restraint covenant, the more likely
they are to be struck down. If you want to prohibit the poaching of important employees,
identify them by name, position or qualities.
If you want to restrain the use of confidential information, identify what information the
parties regard as being confidential.
If you want to restrain competition, you will need to carefully define what will be considered
to be competition.
Establish a Proper Basis for Geographic Limits
Adopting arbitrary geographic boundaries may result in the covenant being void. In
Idameneo (No. 123) Pty Ltd v Dr Teresa Angel-Honnibal 54 one of the reasons that a restraint
of trade was found to be unreasonable was that the promisee could produce no evidence to
justify the geographic restraint.
This may involve reviewing customer lists to ascertain where those customers live or carry
on business. If the business has multiple offices issues different issues will arise depending
upon whether it is an employment situation or a business sale. In the case of the former, if
the employee only worked at one office it would probably only be legitimate to restrain the
employee in relation to that office. In the case of the latter if may be legitimate to set out
distances from each office.
Severance
Because the starting point is that covenants in restraint of trade are void and because
different minds may reach different conclusions on what is reasonable and what is not,
drafting all restraints should be done in a way that facilitates severability. As Justice
Margaret Wilson reminded us in Dooley v Scotney55:Severance can apply only when the only changes are those made by running a
blue pencil through the offending parts: that is, only in cases where the two
parts of a covenant are expressed in such a way as to amount to a clear
severance by the parties themselves and as to be substantially equivalent to
two separate covenants.
In practice this means that the various types of restraint should be dealt with individually in
the contract.
A clause providing that the parties intend that any term or part of a term that is invalid or
void may be severed and that the balance of the terms of the contract should continue to
apply to the parties is essential.
54
55
[2002] NSWSC 1214
[2010] QSC 179 at p. 1-9
11
Cascading Clauses
The use of cascading clauses has time and again been upheld by the courts provided it
contains an internal mechanism for the excision of those sections that are unreasonable56.
Nevertheless, caution must be exercised so that there are not too many alternatives
provided for in the cascading clauses. In Austra Tanks Pty Ltd v Running57 there were
several alternatives provided for how a business might be carried on, what activities were
restricted, area and time. The judge calculated that the various alternatives lead to 82,152
different possible combinations of restriction. His Honour held the clause void for
uncertainty notwithstanding that it contained a provision allowing for severance.
Acknowledging Reasonableness
There have been diametrically opposed attitudes to the significance of the parties
acknowledging the reasonableness of a restraint at the time of entry into the agreement.
Such an acknowledgement was considered significant by the Full Court of the Federal Court
in Pearson v HRX Holdings Pty Ltd58 whereas, in stark contrast, Justice Philip McMurdo in
dealing with such an acknowledgement said59:But the Court must determine what was reasonable and the defendant's
agreement to the restraint is the reason for the question and not its answer.
What may be more significant is evidence that the parties arrived at the terms of the
restraint after a genuine negotiation involving concessions being made by both sides.
In Addition To Other Rights
In view of the various sources of rights similar to those which may be sought to be protected
in a restraint of trade covenant, it is important that the covenant be expressed to be in
addition to, rather than in substitution for, other common law, statutory and equitable
rights.
Ask Yourself Whether the Restraints Go Too Far
This may sound quaint but I suggest that the final step in the drafting process is to critically
evaluate what you have drafted from the perspective of a lawyer seeking to challenge it.
This may well help you to identify aspects of the covenant that require further attention.
56
See, for example, Run Corp Ltd v McGrath Ltd [2007] FCA 1669 , JQAT Pty Ltd v Storm (1987) 2 Qd R 162 and
Lloyds Ships Holdings Pty Ltd v Davros Pty Ltd (1987) 72 ALR 643
57
[1982] 2 NSWLR 840. See also Davies v Davies (1887) 36 Ch D 359
58
[2012] FCAFC 111
59
Complete Business Strategies Pty Ltd v AFA Wealth Pty Ltd [2013] QSC 43 at [23]