Restrictive covenants in shareholders' agreements and commercial contracts

The Court of Appeal has recently reaffirmed the approach to the enforceability of restrictive covenants in shareholders' agreements and other commercial contracts.

When employees leave an organisation, they are often subject to restrictions on competing with and soliciting customers, employees and suppliers from their former employers. Such restrictions are typically found in employment agreements, but are also often included in other commercial contracts such as shareholders' agreements or share purchase agreements. The enforceability of restrictive covenants has been the subject of much case law and decisions are often fact-specific, but it is generally accepted that such restrictions are enforceable where they are shown to be reasonable and that the English courts tend to assess reasonableness much more strictly in the context of employment contracts than in other commercial contracts. In a recent case, the Court of Appeal reaffirmed the approach of the English courts to the enforceability of restrictive covenants in shareholders' agreements and other commercial contracts.

In Guest Services Worldwide Ltd v Shelmerdine [2020] EWCA Civ 85, the Court of Appeal considered a shareholders' agreement which contained clauses prohibiting employee shareholders from competing with the company's business and from soliciting customers, employees and suppliers both during their employment and for a period of 12 months after they ceased to be shareholders. The High Court had found that:

• the proper construction of the specific clauses in the shareholders' agreement was that the restrictions would only bind an employee shareholder for so long as they were both an employee and shareholder of the company – if a person ceased to be an employee but continued to be a shareholder, then the restrictions would cease to apply to that person; and
• even if the above construction were wrong and the restrictions would apply to a former employee who continued to be a shareholder until 12 months following that person ceasing to be a shareholder, the restrictions would be unenforceable because the duration was longer than reasonably necessary for the protection of the company's legitimate business interests.

These two findings were appealed to the Court of Appeal. Overturning the first instance decision, the Court of Appeal decided that:

• taking into account the factual and commercial context of the shareholders' agreement, the correct construction of the specific clauses was that the restrictions would apply to a former employee who remained a shareholder, and that the 12-month period would begin from the date that the former employee ceased to be a shareholder in the company; and  
• those restrictions were not unenforceable as to duration (the enforceability of the restrictions as to scope and area was not considered by the Court of Appeal).

Duration

It was relevant to the Court of Appeal's decision on the issue of duration that the company's articles of association contained compulsory transfer provisions that would apply on an employee shareholder ceasing their employment and set out a tight timetable for a compulsory transfer of shares to be effected. Any employee shareholder who ceased to be an employee would likely cease to be a shareholder shortly thereafter, and this would have been understood by the parties at the time the shareholders' agreement had been negotiated. The 12-month period would therefore have been expected to begin a short period after an employee shareholder's employment had terminated. The Court stated that it would not declare the restrictions to be unenforceable as a result of the 'relatively unlikely possibility' of considerable delay to a transfer of shares or the 'very unlikely possibility' of permanent lock-in of an employee shareholder, notwithstanding that the shareholder in this case had been subject to a delay in selling his shares and remained a shareholder in the company.

The Court's decision on duration highlights an important point for companies and employee shareholders to be aware of, in that even with compulsory transfer provisions there is no guarantee that there will be a buyer for a former employee's shares, particularly in a small private company. Where a restrictive covenant continues to apply while a former employee remains a shareholder and for a period thereafter, that former employee could in some circumstances continue to be bound by the restrictive covenants for a considerable period of time. It is for this reason that shareholders' agreements are normally drafted such that the restrictions apply either from the date an employee shareholder's employment terminates or, if earlier, the date notice is given to terminate such employment.

Distinction between employment contracts and commercial contracts

While much of the judgment was concerned with the construction of the relevant restrictive covenants, the Court's decision also reaffirms the distinction that English law makes between restrictions in employment contracts and restrictions in shareholders' agreements and other commercial contracts such as share purchase agreements.

While the general position is that restrictive covenants, as restraints of trade, which apply to departing employees are only enforceable if the employer can show that the restrictions protect a legitimate proprietary interest of the employer and are no more than is reasonable having regard to the interests of the parties, the English courts are strict when applying these rules to employment contracts. This is because of the imbalance in the bargaining power of the employer and employee in negotiating the employment contract.

In the context of restrictive covenants in shareholders' agreements or other commercial contracts, the English courts are generally regarded as being more flexible on the grounds that, having been negotiated in a commercial context, there is likely to be more-balanced bargaining power between the parties. The English courts will still consider the restraint of trade doctrine and will assess the reasonableness of any such restrictions, but will apply a lower level of scrutiny in doing so.

The Court of Appeal in Guest Services Worldwide reviewed some of the authorities setting out the distinction between employment agreements and commercial contracts, and stated its agreement that the English Courts are less vigilant when assessing shareholders' agreements or similar agreements. In the context of that case, the Court of Appeal decided it was clear that:

• the company had a legitimate interest in seeking to prevent employee shareholders competing with the business and soliciting clients;
• the clause was contained in a shareholders' agreement made between experienced commercial parties; and
• a period of 12 months, even though running from the date the employee shareholder ceased to be a shareholder rather than the cessation of employment, was 'entirely reasonable' to protect that interest.