Author: Sarah Jones, Legal Practitioner Director, JHK Legal
When you enter into a sale and purchase of business agreement, the seller will usually be asked to agree to a restraint of trade for certain acts done in a certain area and a certain period of time. Usually, this will apply to both the entity selling the business as well as any key personnel (for example, the director of a company seller). The purpose is to give comfort to purchasers that there will be value in the business after the sale, but there must be a limit so that there is no unreasonable restriction on free competition in the market. So: what are the recent updates, and how can a restraint clause affect you?[1]
What are the main factors in a restraint?
In Australia, restraint of trade is governed by common law (that is – by cases in court) other than in New South Wales where there is specific legislation. In order for restraint clauses to be upheld by a court, the general rule is that the limitations must be “reasonably necessary” in order to protect the goodwill of the business being purchased.
There are usually two types of restraint in business sale agreements:
- Non-compete: that is – the seller (and/or its director) will not open a business or work for a business which is substantially the same as the business it is selling within a particular timeframe and in a particular area;
- Non-solicitation: that is – the seller (and/or its director) will not approach employees, clients or suppliers of the business it is selling.
There are three main features which are usually considered in respect of non-compete and non-solicitation restraints:
- Area: that is – how close to the business being sold the seller may open or be employed by a competing business. This can be as limited as 1 kilometre from the business premises, or as wide as all of Australasia;
- Time: that is – how long the seller may not open or be employed by a competing a business or solicit customers of the business being sold. This can be as limited as a few months, or as long as a few years;
- Acts: that is – what the seller is specifically restrained from doing.
Ultimately, area, act and time limitations are agreed as necessary between the parties, and their legitimacy is determined by the courts on the circumstances on a case by case basis.
Breaking up a restraint clause
If there is a section of a restraint clause which is found to be unenforceable by a court, the remainder of the clause may continue in force if the offending parts may reasonably be severed without altering the nature of the agreement.
This was considered in the Victorian case of Freedom Finance Accounting Pty Ltd v Goldstein [2017] VSC 179 (Freedom) where it was held that the offending sections of the clause could not be severed without altering the nature of the agreement, and therefore the restraint clause in its entirety was found to be unenforceable.
Employee after sale
A lot of the cases determined in Australia in the last 10 years have dealt with businesses that were sold where the director of the seller was retained as an employee by the purchaser for a period of time after the sale. Those cases have, in the majority and where the restraint was only contained in the business sale agreement, determined that the relevant rules to apply are the consideration of goodwill of the business (and the reasonableness relevant to that determination) rather than consideration related to employment and employees.[2]
What is reasonable to protect the goodwill of a business?
In Freedom, the Court considered what limitations on acts, area and time were “reasonable” in order to protect the goodwill of the business that was the subject of the sale. The restraint was against the director of the seller for accounting and non-accounting services for a period of three (3) years in an area of a 100km radius of the business. Two factors of note (outside of that mentioned above) in the court ultimately finding the clause was not reasonable were:
- The injunction under the restraint clause was sought in respect of taking particular clients, but no client list had been annexed to the business sale agreement when it was signed; and
- The inclusion of “non-accounting” services when the director had only ever provided accounting services was beyond what was necessary to protect the goodwill.
On the other hand, a period of four (4) years was found to be reasonable in the case of the sale of shares in an IT business where that restraint was for specific IT procurement and management services in Southern Cross Computer Systems Pty Ltd v Palmer (No 2) [2017] VSC 460.
Further, an area of the whole of Western Australia with a period of ten (10) years (with some reservations) was found to be reasonable in Devil Dog Pty Ltd v Cook [2017] WASC 27 (Devil Dog).
Goodwill attribution
The value of the goodwill of the business being sold (as opposed to the plant and equipment or other assets) may affect what is considered reasonable in order to protect that goodwill by way of restraint clauses.
In Devil Dog, one of the reasons that such a lengthy period of time was considered reasonable for the purposes of an injunction restraining the former director of the seller from being employed by a competing business was that the sale price of the business attributed 90% of the value to goodwill. The court found this suggested there was customer loyalty to the business brand that would be affected by the former director operating in the same area as an employee of a competing business.
Cascading clauses
Finally, it has long been held that cascading restraint clauses may be valid and not contrary to public policy. Such a clause may look something like:
Restraint area:
- Australia;
- New South Wales;
- Sydney
This allows a court to consider the reasonableness of “Australia” as an area for restraint, but if that is not considered reasonable, to move to consider New South Wales and so on. Because of the nature of such clauses, they may overcome the issue in Freedom and allow for an offending clause to be severed with another in its place. Such a cascading clause existed in the case of Richmond v Moore Stephens Adelaide Pty Ltd [2015] SASCFC 147 for example.
Ultimately, restraints in business sale agreements are acceptable where they are found to be reasonably necessary to protect the goodwill of the business being sold. If you have any questions about restraints that you think you require or are bound by, or any other questions about restraints, please contact JHK Legal.
[1] This article does not discuss employee restraints in any detail. If you have questions about employee or employment agreement restraints, please contact JHK Legal for legal advice.
[2] Freedom Finance Accounting Pty Ltd v Goldstein [2017] VSC 179.
