A restrictive covenant is a promise where one or more parties to an agreement undertake not to do something. Most commonly, restrictive covenants appear in:
- Employment contracts (e.g., a clause where an employee agrees not to compete, not to solicit clients or staff);
- Sale of business agreements (e.g., a clause where a seller agrees not to start a competing business); or
- Commercial property contracts (e.g., a clause containing land use restrictions),
and the most common types of restrictive covenants include:
- Non-compete clauses, where a party undertakes not to engage in a competing business;
- Non-solicitation clauses, where a party undertakes not to approach clients, customers, or staff;
- Non-dealing clauses, where a party undertakes not to deal with former clients (even if those clients approach that party); and
- Confidentiality restraints, where a party undertakes not to use trade secrets or sensitive information.
Restrictive covenants in commercial vs employment contracts.
The courts’ position in respect of restrictive covenants in employment contracts tends to be more restrictive, as an imbalance between the bargaining power of employer and employee is presumed.
However, in commercial contracts the courts assume that the parties had comparable bargaining power, negotiated commercially and that the restraint was part of a broader commercial allocation of risk – and will therefore be less likely to intervene.
This article will focus on the enforceability of restrictive covenants in commercial agreements.
General rule: Restrictive covenants are invalid.
Under Australian common law, restrictive covenants are prima facie void as restraints of trade, because they restrict a person’s freedom to work or conduct business.
When is a restrictive covenant enforceable?
A restrictive covenant can be enforceable if it meets all three of the following conditions:
- necessary to protect a legitimate business interest;
- reasonable in scope; and
- not contrary to public policy.
It must protect a legitimate business interest.
Courts have recognised the following as instances of legitimate business interests:
- Confidential information or trade secrets.
- Customer relationships and goodwill.
- Stability of workforce (preventing staff poaching).
- Goodwill in a business sale.
Conversely, a restrictive covenant:
preventing a party from carrying on business, or competing in the market; or
preventing a party from doing business with third parties introduced by the other (as opposed from protecting deep goodwill connections),
will likely be deemed an illegitimate restraint of trade and therefore unenforceable.
Additionally, and connected to these scenarios, clauses in which one of the parties demands that the other deals exclusively through it (e.g. where a distributor with a dominant position in the market demands that a manufacturer or supplier sell only through that distributor) would likely also be in breach of the Competition and Consumer Act 2010, sections 46 (misuse of market power), 47 (exclusive dealing), and 45AD (cartel conduct).
It must be reasonable in scope.
A restrictive covenant will likely be deemed reasonable in scope if is limited in time, geographic area and scope of activities as below:
Time: whereas more than 12 months would normally be unacceptable in an employment contract, a restriction during years may be reasonable for a sale of business, depending on the circumstances.
Geographic area: this must not extend beyond the actual area in which the business operates. If the business only operates in WA, NSW and Queensland, an Australia-wide restriction (or no mention of the geographic area where it applies) would likely be considered too broad and fail the reasonability test.
Scope of activities: whereas reasonable non-compete clauses that apply during the term of a commercial agreement tend to be enforceable, restrictive covenants that tend to eliminate or reduce competition, or prevent another party from trading freely after termination are likely to be more closely scrutinised, and deemed unenforceable if they are held to have the aim of stifling competition, rather than protecting a legitimate business interest.
Another common example is a clause preventing one party (say, a supplier) from soliciting customers of the other (say, a distributor). This is likely to be upheld if limited to the customers the distributor dealt with, and protects the distributor’s goodwill.
What is likely “reasonable in scope” and what is not?
Reasonable (examples):
- Distributor cannot sell directly competing products in the same territory during the agreement.
- 12-month restraint limited to customers introduced by the supplier.
- Restriction limited to the product category covered by the agreement.
Unreasonable (examples):
- Distributor barred from working in the entire industry.
- Restraint from dealing with “contacts” introduced by the supplier.
- Restraint applies worldwide when the agreement was limited to Australia.
- Broad prohibition on “any similar goods” without clear definition.
- Long post-termination restraint without justification.
It must not be contrary to public interest.
To be enforceable, a restraint must not harm competition or the public generally.
Use of cascading clauses.
In Australia, it is common to have cascading clauses in connection with restrictive covenants, including multiple alternative restraints (e.g., 12 months / 9 months / 6 months; Australia / NSW / Sydney).
Risk of having the entire clause struck off.
If you are the party inserting the restrictive covenant you will want to have a clearly drafted clause that passes all enforceability tests, as well as a cascading clause to ensure that the clause will be enforceable.
Whereas the courts in NSW under the may “read down” a poorly drafted clause (or one with unreasonable terms or no cascading) to enforce a “reasonable version” of it under the Restraints of Trade Act 1976 (NSW), the rest of Australia has no comparable legislation allowing the courts to read down a bad clause.
This means that, outside NSW, the courts will completely strike off a deficient restrictive covenant found to constitute a restraint of trade, effectively deleting that clause from the agreement.
Get in touch with Praetorium Law if your business is negotiating a commercial agreement with a restrictive covenant, or if your business has been impacted by an unfair restrictive covenant.
Email: info@praetoriumlaw.com
Tel : 0410 752 667