Restrictive Covenants in Shareholders’ Agreements

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What is a restrictive covenant?

A restrictive covenant is a promise not to do something. In an employment context, they are usually intended to prevent outgoing employees competing with their former employers by poaching customers, clients, suppliers or other employees for a defined period after they have left. To be effective, the covenants must continue after the employment relationship has ended. However, the court will not enforce a restrictive covenant unless the former employer can show that:

  • it has a legitimate proprietary interest (such as goodwill, trade secrets, confidential information or the stability of their workforce) that it is appropriate to protect, and
  • that the covenant in question is no more than is reasonable having regard to the interest of the parties and the public interest.

In practice, this means that restrictive covenants must be time limited and drafted carefully to be no wider than necessary.

Extent of restrictive covenants

While restrictive covenants are usually a feature of an employment contract, they can also appear in consultancy agreements, partnership agreements, directors’ service agreements and other similar contracts. They can also be introduced in a separate agreement all of their own (usually).

Restrictive Covenant in Shareholders’ Agreement

The  Court of Appeal decision in Guest Services Worldwide v Shelmerdine considered restrictive covenants contained in a shareholders’ agreement. This agreement recognised two distinct categories of shareholders, those who had worked for the company and those who had not, and placed the former under restrictions similar to those found in an employment context. These restrictive covenants would end 12 months after the relevant person ceased being a shareholder.

The Court was asked to consider whether such a restrictive covenant prevented a shareholder who had formerly been an employee of the company from working in the same industry using knowledge he had acquired on the job. The shareholder had been an employee and then a consultant to the company, but because negotiations for his new consultancy agreement had fallen through, the restrictive covenant in the shareholders’ agreement was the only thing preventing him from competing against his former employee in an already crowded industry.  On the facts, the Court of Appeal found that the restrictive covenants were effective.

This decision is interesting because it raises the possibility that restrictive covenants in a shareholders’ agreement could forever prevent a shareholder working for a competing business. As long as the relevant person was a shareholder (and for twelve months after they stopped being one) they would be restricted in the type of work they could do, even if they had long since stopped working for the company. It didn’t matter that they had stopped being an employee and no longer had access to sensitive information, as the relevant restriction was worded to include any shareholder who had ever worked for the company.

The Court of Appeal reached its decision on the basis of the particular wording of the shareholders’ agreement. They were assisted in making their judgement by the fact that the agreement was negotiated by experienced commercial parties, and that the interest protected by the restrictive covenant was of vital importance to the company.

The Court dismissed the shareholder’s argument that the restriction’s potently unlimited duration made it so onerous as to be unenforceable. In practice, compulsory transfer provisions in the company articles and shareholders’ agreement meant that it was unlikely that a former employee would remain forever ‘trapped’ as a shareholder.

Knowledge driven Industries

Restrictive covenants are particularly important in industries which depend on personal contacts (such as recruitment) or specialist knowledge (such as tech). Investors in such companies depend on restrictive covenants to prevent their businesses from being undermined. Often the person who is best placed to compete with a company is its founder, and investors in a new company will seek reassurances that the founder will not simply take their money and set up shop elsewhere. They may do this by including restrictive covenants in the founders’ employment contract, but this requires keeping the founder on the company payroll, which they may not be prepared to do. An alternative option is to include restrictive covenants in the investment agreement itself, or in a new shareholder agreement. Provided that the restrictive covenants protect a legitimate proprietary interest of the company and are not unreasonably wide or unreasonably long, the courts are very likely to consider that they are effective. However, considering how important these restrictions are in protecting the value of a company, it’s essential that they are done right. This is perhaps one of the best illustrations of the benefits of careful drafting.

Conclusions

The decision in Guest Services Worldwide v Shelmerdine makes it much more difficult for those seeking to escape restrictive covenants to run the so called ‘Hotel California’ argument. Even if a strict interpretation of a shareholders’ agreement raises the possibility of restrictive covenants which you can never leave (without losing your shareholding), the courts are unlikely set aside covenants which protect a company’s legitimate interest on this basis alone.   The court views restrictions under a shareholders’ agreement and other commercial agreements as entered into by business people who should know what they are doing and have the power to negotiate.  Restrictions in employment agreements can be viewed different depending upon the seniority of the employee or director.  Generally much shorter restrictions are regarded as acceptable in the employment context.

  • The employment agreement is a separate contract to the shareholders’ agreement. This means it is perfectly possible that restrictions under the employment agreement end but continue under the shareholders’ agreement.
  • The Courts are willing to uphold restrictive covenants in a shareholders’ agreement where the shareholder has played an active and important role in the business, even if the restrictions might survive indefinitely after the shareholder has ceased to have an active role in the company.

From an employee shareholder’s perspective, the search for restrictive covenants should encompass the shareholders’ agreement as well as the employment contract. This is something which Gannons would be happy to assist you with.

Please do call us on 0207 438 1060 for help.