Posted by Tom Llewellyn, Partner
Enforcing restrictive covenants following an M&A deal
Restrictive covenants are an essential tool for retaining goodwill and value in any business that you are looking to acquire. This is particularly so where the seller is intrinsically linked to the business or has the skillset to immediately compete with the target business, and could therefore quickly diminish its value.
Restrictive covenants in M&A deals typically prevent the seller from:
- setting up or having an involvement in a business in competition with the target business
- poaching key staff;
- poaching suppliers, and
- contacting, or dealing with, customers or prospective customers.
These are necessary because a Court will not typically imply such terms into a contact.
However, restrictive covenants are a restraint of trade and are therefore only enforceable if the scope and length is limited to what is necessary to protect the goodwill or value in the target business. Restrictive covenants are also common in employment contracts, but the typical length that can be enforced is quite short, perhaps 6 to 12 months for most. Far longer periods can be justified where the restriction forms part of an M&A deal on the basis that it is necessary to protect the value and goodwill that consideration has been paid for. Unfortunately, if the restriction is too long, covers wider business interests than the target company, or covers a geographical area wider than that which the target company operates in, there is a very real risk that the Courts will hold that the restrictive covenant is not enforceable. It is therefore essential to ensure that any restrictive covenants do not go wider than necessary.
Acceptable duration and scope
There are multiple examples of what an acceptable duration and scope will be, but it really depends on type of business and the circumstances of any given transaction. Whilst in 1894 the Courts did uphold a 25 year restriction, such historic examples should be approached with caution. It is unlikely that such a long restriction would be enforceable today. However, an 8 year restrictive covenant was upheld by the Supreme Court in 2015 and is indicative of what can be justified today. A note of caution is that if there is no time period for a restriction then will be taken to be indefinite – and therefore unenforceable.
It is important to ensure that only the business of the target business is protected. A restriction should be specific to services and products that an acquired business provides; if it is too wide then it will likely be unenforceable. For example, if only the employee benefits arm part of an advisory firm was acquired, then the restrictive covenant should be limited to employee benefit services. It should not cover other services such as wealth management, protection or mortgage advice.
Finally, the geographical scope of the restriction should be limited to the areas in which the target company’s business is operating. This could be limited to a region, a single country, or even multiple countries; either way, it has to be limited to areas in which the target business actually trades. A European or worldwide restriction would only be justifiable for a genuinely European wide or world-wide business, although in those circumstances it would not be necessary to prove that the target business traded in every country covered by the restriction. Of particular note for financial services firms is a decision from 2014 in which it was held that a UK wide restrictive covenant was enforceable despite the clients of a financial advice firm being predominantly based in London and the South-East. The Court held that financial services in the UK is increasingly a single geographical market.
Note of caution
It is not clear whether a restriction which covered a planned expansion would be considered necessary. If preparations are advanced, with significant market research and planning having been undertaken, and the future expansion plans are reflected in the consideration, then there might be a case. This is, perhaps, an area where further clarification from the Courts is required.
Should a restrictive covenant be held to be unenforceable, then Courts will apply a “blue pencil” test – i.e. can the offending words can be removed without the remaining words needing to be modified to make the remaining provisions work? If so, then assuming this has no major change to the overall effect of the restrictive covenants, the remaining terms will still be enforceable.
As long as the scope and geographical limit do not exceed what is necessary, then a long restrictive covenant should be enforceable. The Courts have indicated that they will uphold commercial terms agreed between the parties where there is equal bargaining power, where the seller is critical to the goodwill being acquired, and where substantial consideration was paid for the business. Indeed, if the value of a target business would be significantly reduced without a long restrictive covenant, then such a covenant is likely to be upheld.
In the unfortunate event that a restrictive covenant is breached, then remedies can include damages or an injunction. However, quantifying any loss suffered by a breach is difficult, so an injunction is often the best remedy. Notably, the Courts have even held that even a failed attempt to solicit clients justified injunctive relief because it showed that the seller was back in the market and competing.
Interestingly for commercial contracts such as JVs, franchise agreements, or agency/distribution agreements, the Courts have held than covenants lasting more than 12 months will be hard to justify. However, in a partnership where an outgoing partner sold their share upon leaving, a five year restrictive covenant has been upheld.
For more advice on restrictive covenants, please contact our corporate or dispute resolution teams:
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