Restrictive covenants and restraint of trade

In this feature, we put the spotlight on some of the issues raised in recent decisions on the construction and enforceability of restrictive covenants in employment contracts

Any term in a contract (or related agreement) which operates in restraint of trade is, on the face of it, contrary to public policy, and consequently unenforceable at common law. In employment contracts, such terms (restrictive covenants) normally take the form of confidentiality clauses, non-competition clauses, and non-dealing or non-solicitation clauses, and seek to place restraints on an employee's freedom to trade or work after his or her employment ends. Restraints which are otherwise unlawful may, however, be justified if they are no greater than is necessary to protect a legitimate business interest of the employer, and are reasonable: (1) in relation to the interests of the parties concerned; and (2) in relation to the interests of the public.

This feature looks at some of the key points which have been raised in recently decided cases in this area.

Effect of clause is crucial

Whether a contractual term amounts to a restraint of trade depends not on its form, but its effect.

For example, in Stenhouse Australia Ltd v Phillips, certain interrelated terms meant that an employee could act as an insurance broker for his former employer's clients only if he paid the former employer 50% of the commission (or other financial benefit) received on any such transaction. This clause amounted to an unlawful restraint, which would have been likely to cause the employee to refuse business which he would otherwise have taken. And, in Sadler v Imperial Life Assurance Co of Canada Ltd, an employee's right to receive post-termination commission payments on insurance policies from his former employer was subject to the proviso that such payments would cease immediately if the employee took up further employment in the insurance industry. The High Court concluded that the clause had the effect of requiring the employee to give up "some freedom which he would otherwise have had, namely the freedom to take employment in whatever field he chose". It thus constituted a direct financial incentive to limit the employee's activities, and amounted to an unenforceable restraint of trade.

A similar situation was addressed in the recent case of Marshall v NM Financial Management Ltd. Mr Marshall was engaged by the company as a self-employed agent selling financial services. He was entitled to what was termed "initial" and "renewal" (that is, recurrent) commission on investments, agreements or policies which he sold. His contract with the company provided that, subject to one exception, he would not be paid any commission arising on an agreement or policy after the date on which his agency was terminated. The exception was that if, at the date of termination, Mr Marshall had been an agent with the company for at least five years and either (i) he had not, within one year of the date of termination, become an independent intermediary or become employed by, represent or become an appointed representative of any company or organisation which was directly or indirectly in competition with the company, or (ii) at the date of termination he was at least 65 years of age, the company would pay "renewal" commission in respect of any investment agreement or policy resulting from applications submitted by him prior to termination.

The High Court was in no doubt that proviso (i) was an effective restraint of trade. It was, said the Court, well established that "there is no relevant difference between a contract that a person will not carry on a particular trade and a contract that if he does not do so he will receive some benefit to which he would not otherwise be entitled. Proviso (i) is a financial incentive to the agent not to carry on business in the specified fields. It is therefore unlawful unless it can be justified as being reasonable in the interests of the parties and in that of the public."

Legitimate employer interests

The courts have developed fairly clear principles about the interests which an employer can legitimately seek to protect by way of a restrictive covenant. These have traditionally been limited to the protection of trade secrets and confidential or sensitive business information; trade, customer or business connections; and "goodwill". An employer's claim for protection must, therefore, "be based on the identification of some advantage or asset inherent in the business which can properly be regarded as, in a general sense, [its] property, and which it would be unjust to allow the employee to appropriate for his own purposes, even though he, the employee, may have contributed to its creation" (Stenhouse Australia Ltd v Phillips).

A covenant will not be upheld merely on the basis that an employee has, by reason of his or her employment or training, obtained the skill and knowledge necessary to equip him or her as a possible competitor in trade. The courts will not enforce a bare covenant against competition. An employer must consequently demonstrate that an employee might obtain such personal knowledge of and influence over its customers, or such acquaintance with its trade secrets, as would enable the employee, if competition were allowed, to take advantage of the employer's trade connections or utilise information confidentially obtained (Herbert Morris Ltd v Saxelby).

On the other hand, the fact that an employee has helped to develop the employer's business or customer connections due to his or her own "natural gifts" or personal qualities will not in itself preclude the operation of a carefully drafted non-competition or solicitation clause. But such a clause may need to be particularly carefully drafted if it is to be valid in the case of a self-employed worker. In the Marshall case (above), the High Court held that proviso (i) was an unlawful restraint of trade and was not reasonably necessary for the protection of any of the company's legitimate interests. Mr Marshall's business as a self-employed agent, including the goodwill arising from his reputation and connections, was his own property and not the company's, the Court said. The only interest which the company could have to protect was its interest in the goodwill attaching to its business as a seller of investment agreements. This was largely if not entirely an interest in the protection of its existing clients with whom it already had contracts. Against that background, the Court continued, proviso (i) was remarkably broad. It was not limited to the company's existing or even potential clients. Indeed, it was not even limited to solicitation of clients or customers, but sought to restrain competition completely. In addition, there was no clear territorial limitation on the operation of the proviso.

Interest in stable workforce

It is generally thought that an employer also has a legitimate interest in protecting the stability of its employed workforce, particularly where it has invested considerable time and resources in training. This means that the employer may be able to enforce suitably drafted clauses which prohibit employees, and in particular senior employees, from soliciting the services of, or enticing away (that is, "poaching"), other members of its staff.

There has, however, been some judicial uncertainty about the extent of the employer's interest in this respect. In Hanover Insurance Brokers Ltd and another v Schapiro and others, for example, contractual clauses prohibited, for a period of 12 months after the termination of their employment, four of Hanover's senior employees (including its chairperson and managing director) from "poaching" "any employees of the company to the intent and effect that such employee terminates that employment". The Court of Appeal pointed out that an employee has the right to work for the employer he or she wants to work for if that employer is willing to employ him or her. In the present case, the poaching clause, as drafted, would have applied to all Hanover staff, irrespective of their expertise or seniority, and would have applied to staff who had joined the company after the defendants had left. As such, it amounted to "a mere covenant against competition", which the Court would not enforce. Lord Justice Dillon conceded that the goodwill of Hanover's brokerage business in a sense depended on its employees. The same was true of any other company. But, he said, that did not make the staff an asset of the company "like apples and pears or other stock in trade".

By contrast, in Ingham v ABC Contract Services Ltd, which was decided only some three months after Hanover, a differently constituted Court of Appeal concluded that a firm of recruitment consultants had "a legitimate interest in maintaining a stable, trained workforce in what is acknowledged to be a highly competitive business". It therefore agreed with the High Court that a clause which prohibited one of the firm's branch managers, for 12 months from the termination of his employment, from poaching any of its directors, managers or servants was valid and enforceable (subject only to the caveat that a reference to directors and servants of "associated companies", which the Court thought wider than necessary, was "severed" or excised - on the principles of severance, see p.6 below).

Most recently, in Alliance Paper Group plc v Prestwitch, the High Court came down decisively in favour of the approach adopted in Ingham. His Honour Judge Levy said that the Court of Appeal in Ingham had "recognised that an executive in Mr Ingham's position could properly be restrained from poaching". He consequently upheld a covenant which restrained Mr Prestwitch, who was employed by Alliance Paper as its managing director, from endeavouring to entice away or employ any person who had, at any time during the six months immediately preceding the termination of his employment, to his knowledge been employed or engaged by the company or any associated companies in a "senior capacity". It should also be noted that Mr Prestwitch had been both the managing director and major shareholder of Alliance Paper Group prior to its sale some years earlier, and the judge concluded that he had to consider the covenants in Mr Prestwitch's service contract in the context of the share sale agreement which had transferred ownership. The judge nevertheless concluded that the covenants were valid and enforceable whether they were given by a vendor (of a business) or, on the narrower basis, by an employee.

Must be a business to protect

Any discussion of an employer's legitimate interests obviously presupposes that the employer has a business which is capable of protection! In Scotcoast Ltd v Halliday and others, for example, Scotcoast Ltd carried on business as producers and suppliers of potatoes and potato products to the catering trade. It did this under an exclusive use and licensing agreement with a third party, Coastal Fruits Financial Partnership Wisconsin. Under that agreement, Scotcoast leased from Coastal the equipment which it used for processing potatoes; had the exclusive use of that equipment in the United Kingdom; and had exclusive rights to sell in the UK products produced by that equipment or under licence from Coastal.

Scotcoast obtained interim interdicts (that is, interlocutory injunctions) in the Court of Session against a former senior sales executive and a company of which he was a director. These sought to enforce restrictive covenants preventing the employee from disclosing or using Scotcoast's confidential information and, for a period of two years following the termination of his employment, soliciting orders, custom or instructions from anyone who had been a customer of Scotcoast within the three years prior to termination, or working in any capacity for any person, firm or company in direct or indirect competition with Scotcoast.

On the employee's appeal against the interdicts, however, evidence was produced that Coastal had already given Scotcoast notice of the termination of the exclusive use and licence agreement. Lord Cameron of Lochbroom said that this meant that the equipment which formed the manufacturing base for Scotcoast's products would be lost, and Scotcoast would no longer be entitled to lay claim to the exclusive rights which it sought to protect in the present proceedings. Equally important, upon termination of the agreement, Scotcoast would itself be under an obligation not to compete with the relevant products. In Lord Cameron's opinion, this tilted the balance of convenience in the employee's favour, since the whole business interest which Scotcoast sought to protect rested upon the agreement with Coastal. He consequently allowed the appeal and recalled (that is, discharged) the interdicts.

Construction and reasonableness

The proper construction and interpretation of restrictive covenants, and the question of their reasonableness, are essentially matters of law for the courts. As with any contract or other written document, the courts' primary duty is to give effect to covenants as they are expressed and not to correct their errors or supply their omissions. To this extent they should not rewrite a vague and imprecise clause. A clause will, however, be construed in the light of its context (including the other terms of the contract or agreement) and by reference to the intention of the parties at the time the agreement was entered into. It is thus permissible for the court to look at the surrounding circumstances in which the agreement was made in order to arrive at its meaning.

For example, in PR Consultants Scotland Ltd v Mann, Mr Mann was employed as an accounts director by PR Consultants Scotland Ltd, which carries on business as public relations consultants. His contract of employment contained a clause which, amongst other things, precluded him, for 12 months after the termination of his employment, from being employed or engaged by, or seeking employment or engagement with, any person, firm or company who was at the time of termination, or who had been within the 12 months prior to that date, a customer or client of (or in the habit of dealing with) PR Consultants or its associated companies (although this latter part of the restraint only applied if he had personal dealings with, or had worked on the accounts of, clients or customers of those companies).

When PR Consultants sought to enforce the clause by way of interim interdict, the Court of Session underlined the fact that it could not be looked at or construed in a vacuum. Regard must be had to the fact that Mr Mann was an experienced public relations executive, and that customers of PR Consultants would essentially be interested in public relations services from him. Given the context in which the covenant was devised it seemed unlikely that the parties had any intention that Mr Mann should, for example, be prevented from seeking a relationship with a former customer in the capacity of "office boy" or "doorman".

The clause was, said the Court, moderate and reasonable when it was entered into. It observed that the relationship between a public relations firm and its customers is of a confidential and intimate character. If, therefore, an employer allowed an employee access to its customers at a high level, and to cultivate them, it was not unreasonable that it should seek to protect itself against the privilege thus accorded to the employee. The contractual protection sought against abuse by an employee of the employer's trade connection could not, the Court said, be calculated on too narrow a basis. In many cases, the only practical protection for an employer in such circumstances was that for a period there should be no commercial contact between the ex-employee and the employer's customers.

Danger of imprecise clauses

As this last case indicates, the reasonableness or otherwise of a restrictive covenant will depend on an amalgam of factors. These include the nature and scope of the business or customer connection for which the employer seeks protection, the status or position of the employee, the geographical area of the restriction imposed and the duration of the restraint. In Mann, the employee held a senior and responsible position within the employing organisation, the clients and customers to whom the restraint applied were fairly well defined, and, in those circumstances, the duration of the restraint was not excessive.

The dangers of an imprecisely drafted clause are demonstrated in Aramark plc v Sommerville. Ms Sommerville was employed by the company, which supplies coffee machines and associated products throughout the UK, as a tele-sales and field-sales representative. Her contract of employment incorporated express clauses which prohibited her, following the termination of her employment, from divulging or using any information of a confidential nature concerning customers or suppliers of the company or the company's current/future business interests; and, for a period of 12 months following termination, whether directly or indirectly in any capacity, dealing with or making any form of approach to any actual or prospective customers of the company with whom the company had established business contact. Aramark obtained interim interdicts in the Court of Session in almost identical terms to the contractual provisions just outlined. Ms Sommerville returned to the Court in an attempt to have the interdicts recalled.

Upholding the confidential information clause, the Court said that the terms of the prohibition on use or disclosure were not so wide as to be unreasonable. The material to be derived from the documents to which Ms Sommerville had access during her employment was of a character which had arguably enabled her to acquire extensive knowledge of Aramark's products, methods and techniques, marketing strategy, pricing and customers. And it was reasonably clear from an express definition of "confidential information" in the contract that the reference to the company's "current/ future business interests" was limited to the kind of information which could be derived from existing documents to which Ms Sommerville had been privy. Those documents included sales and market research plans and records upon which future marketing strategy and pricing plans were being based when her employment terminated. This amounted, said the Court, to a legitimate business interest which the company was entitled to protect.

In contrast, the Court concluded that the non-solicitation clause was "wholly unjustifiable" as protection for the company's customer connections, and wholly unreasonable in extent. Ms Sommerville had argued that the clause was too wide, in that it contained no geographical restriction, attempted to protect Aramark in respect of future business connections and sought to prevent her from contacting persons with whom she personally had never dealt in respect of business with which she had never dealt. The Court agreed. It said that the reference in the clause to "actual or prospective customers" was far from clear. How was it to be determined whether a person was a prospective customer? At what point in time was it to be determined whether a person was an actual or prospective customer? Did this mean the date of Ms Sommerville's first approach to that person after her employment ended, or the actual date when that employment ended? The customer base to be protected had not been clearly identified by the company. It could not be argued that Ms Sommerville knew or was likely to know all of Aramark's customers, let alone its prospective customers, with whom it had established contact at the date of her dismissal, throughout the UK. And the clause did not in any case merely restrict dealings, approaches or solicitation to those made in the context of a business that was in competition with Aramark: it would cover any solicitation in connection with the sale of goods and products wholly unrelated to those supplied by the company.

Enforcing confidentiality

An express (or, indeed, an implied) term prohibiting the disclosure of trade secrets or confidential information after the termination of employment will not in itself always be sufficient to protect an employer's business interests. According to Lord Denning, this is because "it is so difficult to draw the line between information which is confidential and information which is not; and it is very difficult to prove a breach when the information is of such a character that a servant can carry it away in his [or her] head. The difficulties are such that the only practicable solution is to take a covenant from the servant by which he [or she] is not to go to work for a rival in trade" (Littlewoods Organisation Ltd v Harris). Similar sentiments were expressed by Mr Justice Cross in Printers and Finishers Ltd v Holloway, where he observed that if an employer believed that there were features of a process which could fairly be regarded as trade secrets and which employees would inevitably carry away with them in their heads, then the proper way for the employer to protect itself would be by exacting covenants from its employees restricting their fields of activity after they had left their employment, "not by asking the court to extend the equitable doctrine to prevent breaking confidence beyond all reasonable bounds".

This problem was considered in Poly Lina Ltd v Finch and another. Poly Lina manufacture bin liners and other plastic products sold to retailers. Dr Finch was employed as its market controller, until his employment was terminated in November 1993. In December of that year, he began working for one of Poly Fina's major competitors. The company immediately obtained relief in the High Court, enforcing clauses in Dr Finch's contract of employment prohibiting the use or disclosure of confidential information relating to its business affairs or trade secrets, and prohibiting him from trading or working (whether on his own behalf or otherwise) in any trade or business carried on by the company for a period of one year after his employment ended.

The Court found that a wide range of information to which Dr Finch had access while employed by Poly Lina was confidential and in the nature of a trade secret. This included the technical and scientific specifications of products, and detailed information on costings, customer accounts, profit margins, actual and hoped-for sales, and development plans. The company was, said the Court, "justified in seeking to protect both technical and commercial information from dissemination to competitors operating outside the United Kingdom as well as within it." Rejecting Dr Finch's offer to give an undertaking or submit to an injunction not to pass relevant confidential information on to his new employer, the Court felt that it would be extremely difficult, if not impossible, for him not to pass on such information, whether knowingly or otherwise. Given the large number of categories of information set out in this case and the variety of that information, the only effective way to protect Poly Lina's interests was by enforcing both the confidentiality and the non-competition clauses.

Principles of severance

The courts retain the residual power to "sever" or excise the unreasonable parts of a restrictive covenant in order to leave related promises under the contract intact. This process was usefully illustrated in the Marshall case (pp.2-3, above).

As we saw, the clause which made Mr Marshall's right to receive "renewal" commission after the termination of his agency dependent (as a result of proviso (i)) on his not working for competitors for a year was an unlawful and unreasonable restraint of trade. However, it was not suggested that the entire contract was void as a result. The question was, the High Court said, how much of it was to be removed? If the whole of the offending clause were removed, Mr Marshall would not be entitled to renewal commission, since that clause provided the sole contractual basis for his claim. And if proviso (i) alone was severed, he would still not be entitled to the commission in question because his right would continue to be dependent on proviso (ii) - that is, that he should have reached the age of 65. Thus, the only modification which would enable him to receive his commission post-termination was the excision of both provisos (i) and (ii). This would leave the remainder of the relevant clause in force, providing a right to renewal commission conditional only on the agent having achieved five years' service.

The Court said that the principles under which unlawful provisions of an agreement could be severed from the rest are clear. This may be done where: