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Restrictive covenants in directors' service contracts

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Directors' service contracts . The directors, as the most senior employees of a company, ar...

This guide is based on UK law as at 1st February 2010, unless otherwise stated. It is part of a series on Directors' service contracts.

Purpose

The directors, as the most senior employees of a company, are likely to have strong relationships with the company’s key customers, intimate knowledge of the company’s most confidential information and, quite possibly, significant sway over the company’s employees, many of whom they will probably have recruited. Given this, it is prudent for a company to protect itself against the risk of future competitive activity from a departing director. The mechanism for doing so is restrictive covenants.

There is an anecdotal view in some sectors that covenants are ‘not worth the paper they are written on’. While it is true that justifying the need for and scope of covenants can be difficult, costing the company significant amounts in management time and legal fees, the UK courts do have a track record of enforcing appropriate and properly drafted restrictions.

Starting position of UK courts (restraint of trade doctrine)

A UK court will only enforce a particular covenant if:

  • it is satisfied, on reviewing the evidence, that the covenant is necessary to protect the company’s legitimate business interests (historically, client connections, confidential information and workforce stability);
  • the particular covenant is drafted so as to provide the minimum necessary protection to those interests.

This reflects the need to protect and uphold the principle of free trade.

Ensuring enforceability

The key to enforceability is making sure that any covenant can be seen to have been tailored to the particular business of the company and the role that the employee will be carrying out. A long non-solicitation of customers covenant may be appropriate where a company has a limited number of important clients with whom it has developed a close relationship over time and from whom it receives instructions on a fairly infrequent basis – for example, once a year; it will be less easy to justify where a company has a significant number of more ‘arm’s length’ customers who buy its products/services very frequently. Similarly, a
12-month non-solicitation restriction may be right for a sales director who has very close relationships with key customers and in-depth knowledge of their requirements but ‘wrong’ for a junior employee or a finance director who has no direct dealings with customers.

As a rule of thumb, courts will be reluctant to enforce employment covenants for more than a 12-month period. Six-month covenants will be easier to enforce, particularly in the case of non-compete restrictions. (See: Types of covenant, an OUT-LAW guide below.)

In cases where the departure of a director could be a real competitive threat to the business, detailed instructions should be given to a specialist employment lawyer so that covenants can be properly tailored and drafted.

Types of covenant

Non-compete covenants

These have often been viewed as unreasonable, extreme and, therefore, as difficult to enforce. A court will ask why sufficient protection to the business could not be provided by less stringent clauses (eg non-solicitation, non-dealing and non-poaching covenants or an express confidentiality provision) and will question the company’s right to preclude an individual from joining a competitor.

It may, however, be possible to justify a non-compete provision where:

  • the company has a very local clientele that may be expected to follow a departing employee; thus, a hairdresser or estate agent may be justified in preventing someone from leaving and setting up in opposition in the same street;
  • the company can prove that significant technical or other business- critical information that is not necessarily client-specific and, therefore, not necessarily safeguarded by non-solicitation/dealing covenants, could not be adequately protected through an express confidentiality provision.

A 2007 decision by the Court of Appeal has confirmed that non-competen restrictions will be enforceable if drafted appropriately (see the case of Thomas v Farr plc, below.)

As stated above, the length of the restriction will be key. So, too, will its geographical scope: if a director has been primarily responsible for and had knowledge of a company’s business in the south-east, a clause preventing them from competing anywhere in the United Kingdom is likely to be held to be too wide, and the court will not enforce it.

Thomas v Farr plc

In 2007, the Court of Appeal upheld a 12-month non-compete restriction for the former managing director of insurance broker Farr plc.

The managing director, Huw Thomas, had claimed the noncompete clause was an unreasonable restraint of trade and therefore unenforceable. But the court ruled that his position meant he was privy to commercially sensitive and strategic information that non-solicitation covenants and pure confidentiality provisions could not adequately protect.

The fact that it would be difficult for both employee and employer to draw the line between information that remained confidential post-termination and information that did not, only strengthened the argument, in the court’s view, for a non-competition clause.

One of the keys to the ruling was the restriction’s scope: Thomas was only prevented from competing in the sector that Farr specialised in – insurance for providers of social housing. He remained free to work in other areas of insurance, or to work in social housing insurance so long as he did not compete with Farr.

Finally, the court ruled that, since information about Farr’s business could often remain confidential for more than 12 months, the duration of the restriction was also reasonable.

Non-solicitation covenants

The easiest type of covenant to enforce is usually that precluding an exdirector from soliciting his former employer’s clients for a period following termination. Provided the length of the period is reasonable, and the covenant only covers the previous employer’s line of business and those clients with whom the director has had individual dealings or of whom he has individual knowledge, a well-drafted non-solicitation of clients clause should be enforceable.

Non-dealing covenants

A non-dealing covenant not only precludes active solicitation of the former employer’s clients but also acceptance of work from the former employer’s clients – even when it is they who make the initial contact. Nonetheless, non-dealing restrictions can be enforceable. This is particularly true if the policing of a non-solicitation clause is likely to prove difficult.

Where non-solicitation and non-dealing restrictions are part of the same contract, they should be contained in ‘severable’ (ie separate) subclauses. This way, the employer will still be able to call on the non-solicitation clause if the non-dealing restriction is found to be too wide and, therefore, unenforceable.

In sectors where an employer may need to go through a lengthy tendering process for a contract or where the company invests heavily in building up contacts with potential clients, the company may wish to protect those potential leads as well as existing ones. The scope of nonsolicitation and non-dealing covenants may thus extend beyond established customers.

Non-poaching covenants

The position on clauses to prevent a departing director recruiting former colleagues was in doubt for some years. Several cases have now made clear that, in the right circumstances, a UK court will enforce a nonpoaching restriction.

The keys to enforceability are to ensure that the covenant:

  • is drafted only to cover those who may be expected to have particular knowledge of/influence with clients or knowledge of a company’s confidential information;
  • is of reasonable duration.

Where a company is particularly concerned about the risk of poaching by a departing director it should consider further provisions. It could, for example:

  • expressly specify that information about employees’ salaries and remuneration is confidential;
  • place directors and other senior employees under a contractual obligation to notify the company if a colleague or former colleague seeks to solicit them.

Non-interference with suppliers covenants

These covenants can be useful where a company is very reliant on relationships with certain key suppliers. They should be drafted to preclude interference with those relationships (and to make clear that they do not apply to the suppliers of general utilities).

Covenants and garden leave

Most companies will wish to protect themselves from competitive activity by a departing director not just through restrictive covenants but also through a ‘garden leave’ clause. On ‘garden leave’, an individual remains employed but is not given any duties. They serve out all or some of their notice at home, tending, the popular fiction is, to their garden.

Provided the clause is properly drafted, the individual will remain under a contractual and fiduciary obligation not to compete in any way with the company for the duration of the garden leave. Further restrictions
will prohibit contact with customers or clients and deny access to offices, etc. The company therefore gets a breathing space – time to shore up customer contacts before the individual’s departure.

The relationship between garden leave clauses and restrictive covenants has been a topic of debate. Should a company that wishes to rely on a restrictive covenant give credit for any period of garden leave? The leading case on the issue makes clear that this will not always be necessary. In practice, however, covenants are generally now drafted to apply for a particular period less any period of garden leave served.

Other related clauses

Well-drafted service agreements will contain various other provisions to make restrictive covenants more effective. They should, for example:

  • Allow the company to enforce restrictions on behalf of other group companies.
  • Oblige a director to make any prospective new employer aware of the terms of the restrictive covenants that apply to them (new employers who ignore the terms can be sued for inducing a breach of contract).
  • Make clear that the director should not have any other business interests during the period of employment.
  • Include an express confidentiality clause. Where particular categories of sensitive information exist, these should ideally be specified within the clause and be treated as confidential within the company.

Enforcement

The detail of how restrictive covenants may be enforced through an injunction or action for damages is beyond the scope of this text. The key point for a company that believes that an employee may have acted in breach of a covenant is to act quickly. Injunctions can prevent exemployees and their new employers from taking certain steps but they are emergency measures; courts will be reluctant to grant them if they feel the company has been late in seeking relief.