Enforceability of restrictive covenants in sale agreements

When is a restriction too restrictive? A recent judgment found that non-compete covenants in a share sale agreement did not amount to a restraint of…

When is a restriction too restrictive? A recent High Court judgment found that non-compete covenants in a share sale agreement did not amount to a restraint of trade. This means that clauses which purported to extinguish rights to payments and share options, in the event of a breach, did not amount to penalty clauses.

The facts

In Cavendish Square Holdings BV & Team Y&R Holdings Hong Kong Ltd v Talal El Makdessi [2012] EWHC 3582 (Comm), the first claimant (the buyer) sought a declaration that the defendant (the seller) breached a share purchase agreement.

The seller was, amongst other capacities, a majority shareholder in the second claimant (the company) and the buyer, an existing minority shareholder in the company, agreed to purchase a further stake. Under that agreement, the seller retained put options over the balance of the shares and the buyer enjoyed the benefit of a variety of non-compete restrictive covenants from the seller, which had the potential to run for over eight years. The consideration for the deal was to be paid in stages but in the event the seller breached the non-compete provisions, the right to future instalments and the put options would be forfeited and he would instead be required to transfer the balance of the shares to the buyer at a reduced rate.

Following completion of the deal, in breach of it, the seller competed with the buyer. He accepted that he had no factual defence but raised several legal arguments, the most relevant, for the purposes of this article, being that 1) the non-compete clause represented an unreasonable restrain of trade and 2) the clauses relating to the extinguishment of future instalments and forfeiture of the put options represented unenforceable penalty clauses.  

The judgment

Restraint of trade

The Court found that the non-compete covenants did not amount to a restraint of trade. It was satisfied that, whilst the burden was on the buyer to demonstrate the covenants were reasonable, there was nothing to suggest they represented anything other than reasonable measures designed to protect the goodwill in the company, against any competitive actions of the seller, who remained influential and whose connections with the market had largely motivated the purchase of the shares. The agreement had been negotiated on a level playing field by experienced solicitors and the buyer had been entitled to conclude a competition breach was material. Additionally, the covenants were clear, certain and required. Furthermore, as the duration of the covenants had been calculated by reference to the potential duration of the seller’s ongoing interest, the duration was reasonable.

Penalty clauses

The Court recognised that the law on penalties did extend to transfer of property and to ‘forfeiture’ clauses and that it may prevent penalty clauses from being enforced. However, it also recognised that, in relation to commercial agreements, it should rarely interfere. In the present case, the Court considered that the forfeiture clauses were commercially driven and justified, were drafted as result of detailed negotiation and they were neither extravagant nor oppressive.

Considerations

Restrictive covenants are commonplace in share purchase agreements and, on the face of it, this judgment appears to affirm the enforceability of even quite lengthy non-compete clauses. However, the duration in this case was justified as it was connected to the relevant interest of the buyer. Similarly for penalty clauses, which are also common, whilst the Court will be reluctant to interfere in commercial contracts, it is unlikely to enforce that penalty if it is considered to be extravagant or oppressive. Businesses should seek to ensure, therefore, that restrictive covenants, and clauses which are designed to deter breach of the covenants, protect legitimate commercial interests and those covenants and clauses are no wider than is necessary to protect those interests.

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