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Restrictive covenants in shareholders' agreements

Court of Appeal judgment upholds the decision that restrictive covenants in shareholder agreements are enforceable.

Guest Services Worldwide Limited v Shelmerdine [2020] EWCA Civ 85

On the 4 February 2020, the Court of Appeal handed down an important decision relating to the enforceability of restrictive covenants in shareholders’ agreements. The Court held that a covenant contained within a shareholder’s agreement was enforceable and reasonable, despite the fact that an individual would be subject to the covenant for 12 months following the transfer of their shares, an event which could (theoretically) occur many years after their departure from the company.

Background

Mr Shelmerdine was a shareholder of and provided consultancy services to Guest Services Worldwide Ltd (the “Company”).

Within the shareholders’ agreement relating to the Company, Mr Shelmerdine was considered an ‘Employee Shareholder’, being defined as a person who is an agent, employee or director of the Company. The shareholders’ agreement contained restrictive covenants which applied to employee shareholders, stipulating that they were unable to compete with the Company’s business whilst they were, and for 12 months after they ceased to be, a shareholder. In addition to this, Mr Shelmerdine was subject to the Company’s Articles of Association which contained compulsory transfer provisions which, it was argued, may have caused a possible delay in the transfer of his shares upon his departure from the Company (whilst discussions regarding price for example were ongoing).

Following his decision to stop providing consultancy services (and in turn ceasing to be an employee shareholder), the Company brought High Court proceedings against Mr Shelmerdine alleging that he was in breach of the restrictive covenants contained within the shareholders’ agreement.

In the first instance, the High Court held that the restrictive covenants would be unenforceable due to the fact that their duration was longer than necessary to protect the legitimate interests of the Company. The judge stated that, having considered the definition of employee shareholder, "if an employee, agent or director ceases to be an employee shareholder he must also cease to be subject to the covenants at that time".

Court of Appeal decision

The Court of Appeal overturned the High Court’s decision and found that the restrictive covenants were both reasonable and enforceable. The decision, led by Lady Justice Asplin, focused on two main issues (i) the 'construction issue'; and (ii) the 'duration issue'.

In respect of the construction issue, it was held that the objective meaning of the language used in the restrictive covenants were to be considered in light of the commercial context of the shareholders’ agreement as a whole. It was stated that the purpose of the rights and obligations were to protect the Company’s goodwill and the value of its shares. Lady Asplin stated that "neither the possibility of delay in the process of a compulsory transfer nor the fact that the dispute between the parties… can affect the factual and commercial context as it would have been understood by the reasonable person in the shoes of the parties at the date of the shareholders’ agreement…" It was decided therefore that the covenants served a legitimate purpose and that Mr Shelmerdine was to be bound by these.

On the duration issue the Court held in favour of the 12 month period, stating that (i) the Company had a legitimate interest it needed to protect (i.e. preventing employee shareholders from competing with the business and soliciting clients); (ii) the clause was contained within the shareholders’ agreement made between two experienced commercial parties; and (iii) the period of 12 months was entirely reasonable to protect the Company’s interests.

Points to note

This decision (as well as being a relief for many companies) demonstrates the courts’ willingness to uphold the enforceability of restrictive covenants contained within shareholders’ agreements. When drafting restrictive covenants, it should be kept in mind that such provisions must be reasonable in terms of duration, geographical location and purpose in order to protect a valid and legitimate interest of the company.

However, the longstanding legal principal that restrictive covenants are unenforceable until proved to be reasonable and for a legitimate purpose remains in force.

For any assistance in relation to shareholders’ agreements or restrictive covenants, please contact a member our corporate team.

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