Restrictive covenants case – form over substance

July 2017

Form over substance: a case about what I think is quite a silly way for the law to treat restrictive covenants
(Rating system:
Reading time (1-10 minutes): 3
Sophistication level (1 (idiot) – 10 (expert)): 6
Entertainment value (1 (turgid) – 10 (side-splitting)): 4)

[editor’s note August 2019: this case subsequently was appealed to the Supreme Court, reported on here]

Background

If you are entering into a business deal with someone, whether they are selling their business to you as part of which you are expecting to take over their customers, or providing services to you as part of which they could get to know your customers, you might well want to add a ‘restraint of trade’ or ‘restrictive covenant’ clause to your contract saying that after your business deal has ended they must not try to steal your customers or compete with your business. There is a whole lot of law about whether such clauses will be enforceable or not. In very brief, the law says that a clause that goes beyond what is reasonably necessary to protect a party’s legitimate business interests is illegal and unenforceable.

The law is, in principle, the same for all contracts, whether business sales or employment contracts. However, courts are naturally much tougher on restrictive covenants in employment contracts. After all, an employee generally needs to keep working, whereas in a business sale the seller will have been paid for selling the ‘goodwill’ in the business to the customer.

As a rule, you have to judge whether a restraint of trade clause is fair by the circumstances that exist at the time a contract is entered into. This makes things difficult for ongoing contracts such as employment or other services contracts which might not come to an end for years after they were signed. The law has also developed in such a way that courts look closely at the wording of the restraint of trade clause as it was written, and if it in any way offends then then the whole clause will usually be held to be unenforceable unless the court is prepared to allow certain rules of interpretation to be applied which occasionally let you strike out some unacceptable words whilst letting the overall clause remain.

Over the years, it has become industry practice for most non-compete clauses to come with a standard carve-out proviso saying that the restrictions won’t apply to prevent the person owning a small number of shares in a quoted company which might just happen to include a competing business.

Recent case

In this case, a large executive search company (‘EZ’) took on a very senior lady (Ms Tillman’) to work in its financial services group. She eventually became head of the whole group, which represented about a quarter of the whole company business.

Her contract had industry standard restraint of trade wording saying that ‘you shall not…either alone or jointly with or on behalf of any third party and whether as principal, manager, employee, contractor, consultant, agent or otherwise howsoever at any time within the period of six months from the Termination Date…directly or indirectly engage or be concerned or interested in any business carried on in competition with any of the business of the Company…which were carried on at the Termination Date or during the period of twelve months prior to that date and with which you were materially concerned during such period.’ But the clause didn’t have an industry standard carve-out allowing her to hold a small shareholding in a quoted company for investment purposes.

After 3 years’ employment she resigned and said she was going to work for a direct competitor. On the face of it, a blatant breach of what the restraint of trade clause was designed to protect against.

Ms Tillman argued that the whole clause should be ruled to be void because (even though it was irrelevant to what she was actually planning to do) the restriction on being ‘interested’ in a competing business could have prevented her having a tiny shareholding purely for investment purposes in a quoted company which just happened to be a competitor, which would have been unreasonable.

What did the court say?

The High Court judge upheld the clause and granted an injunction stopping her from going to the competitor. But Ms Tillman appealed and the Court of Appeal upheld her appeal and said that the whole clause was void.

Comments and advice

Generally UK law has been moving in the last few decades in the direction that courts will not look to overturn provisions in contracts (such as exclusion clauses) which have been agreed and set out between businesses, and will try to interpret what parties were trying to set out in their commercial contracts by using commercial common sense rather than pedantically focussing on the language used. But the world of restraint of trade clauses seems to be a bit of an exception. Unless you are a specialist lawyer how can you be expected to know that you have to follow these rules about how you must draft such clauses?!

This case involved an employment contract, albeit an unusual one with a high-powered employee. But presumably the rule would apply just as much in a business sale context. So, don’t forget to include these kinds of ‘industry practice’ carve-outs if you are buying a business or company and want to tie in the sellers.

For any contracts (business sale or services), be very cautious about the restrictions you ask for. If in doubt, water them down.

Whenever you promote an employee, think about agreeing to strengthen their restrictive covenants, as their new seniority may justify tougher restrictions. EZ didn’t do that in this case.

Bonus comment: think about who’s entering into restrictive covenants. If you’re buying a business from a company, don’t just ask for the seller company to give restrictive covenants! This wouldn’t stop the individual owners of the seller company from going off and setting up competing businesses, soliciting customers etc! Consider insisting that the individual owners also enter into the agreement so they can give restrictive covenants personally!

Case: Tillman v Egon Zehnder Ltd (2017 Court of Appeal)