A Guide to Restrictive Covenants in Commercial Contracts

What are restrictive covenants?

Broadly, a restrictive covenant is a clause in a contract that is designed to prevent the contracting party from undertaking certain commercial activities which s/he would otherwise be free to undertake. Typically, they include (1) restrictions on participating in a competing company; (2) restrictions on soliciting or dealing with customers / clients; (3) restrictions on poaching staff; and (4) restrictions on interfering in relationships with suppliers.

When are restrictive covenants likely to be imposed?

The use of such restrictions are designed to prevent one party taking advantage of or exploiting an opportunity it  would otherwise have due to its relationship with the other party. They are common in franchise agreements, consultancy agreements, distribution & agency agreements and agreements for the sale of a business. Ordinarily they will operate for the term of the agreement plus an additional fixed period after the agreement has come to an end.

In all of the above examples, the party which is subject to the restrictions would, if the restrictions were not in place, have a commercial advantage from receiving enhanced exposure to one or more of the other party's (1) confidential information / know how; (2) client base & and industry contacts; (3)  workforce;  and (4) supply chain.  Such matters are often cited as the legitimate business interests that require protection.

Are restrictive covenants enforceable?

The short answer is, "it depends". Understandably the Courts are opposed to clauses in contracts which operate as a 'restraint of trade' and will not readily enforce them. However, the Courts will depart from that approach if it can be established that the restrictions go no further than is reasonable to protect a legitimate business interest. In commercial contracts, the burden of proving that a restriction is reasonable is less heavy than a restriction contained in an employment contract.

What is a reasonable restriction?

Again, unhelpfully, the answer is: "it depends". Perhaps more than any other clause of a contract, the enforceability of a restrictive covenant will depend on external factors. The Courts have made clear that enforceability is "highly sensitive to the individual facts of each case". Whilst that was made clear in relation to restrictions in an employment contract, the principle applies equally to restrictions on commercial contracts.

A good example may be that a franchisor, operating in the hair and beauty industry, may find it difficult to impose a restriction on a franchisee from competing in a 30 mile radius of any other franchisee when the franchise agreement comes to an end. This is because the individual facts - i.e. the characteristics of a hair-dressing business, do not support such a restriction being reasonable. Here, the buying habits are relevant. It is very unlikely that anyone will travel such a distance to have their haircut so it is more than is reasonably necessary to protect a legitimate business interest.

Parties to commercial contracts should also be aware that the Courts will be slower to intervene (and find a restriction unenforceable on the grounds of unreasonableness) when there is greater equality of bargaining power between the parties. For example, a restriction that would be unenforceable in an employment contract, may be readily enforceable in a Share Purchase Agreement.

How are restrictive covenants enforced?

If a restrictive covenant is breached, it gives rise to a claim for damages in the same way any breach of contract would. Essentially, the other party would be entitled to seek damages to reflect the losses it has suffered as a result of the breach of contract. There are various ways of assessing those losses depending on the nature of and circumstances surrounding the breach.

Such damages, if they cannot be agreed, would be pursued by issuing Court proceedings against the breaching party.

However, by its very nature, a breach of a restrictive covenant, is likely to give rise to greater damage, the longer the breach continues. As such, it is possible for a party to seek an urgent interim injunction from the Court's restraining activities which may be in breach of the restrictions and so stem the consequent damages. If the Court is satisfied that there are grounds to grant an interim injunction, the party will be Ordered by the Court to stop the activities complained of pending a trial when a final judgment will be made on the enforceability of the restrictions, and if appropriate, any damages to be awarded.   

An interim injunction is a powerful tool and carries with it the threat of criminal sanctions if breached. The losing party will also ordinarily be Ordered to pay a significant contribution to the winning party's costs. As such, the outcome of an interim injunction application will often result in resolution of the dispute.

What should I  do if  a dispute arises about a restriction being breached?

The granting of an interim injunction is at the discretion of the Court. If a party delays unreasonably, an interim injunction may be refused. Equally, if a party goes straight to Court without trying to engage with the other party first, the Court may refuse to grant an interim injunction (although in certain circumstances that may be appropriate). Evidence of the breaches is crucial and a party pursuing a claim must carefully analyse the extent to which the evidence supports a claim. The enforcement of restrictive covenants can turn on the application of the relevant circumstances and to some extent the technicalities of how the restrictions are drafted. As such, it is essential to obtain legal advice as soon as the issue of a breach arises (or, in some cases, before, if a breach is anticipated).

How can Ashfords help?

Ashfords has extensive experience in advising on, pursuing and defending, claims where a breach of a restrictive covenant in a commercial contract is alleged. We understand both the legal and commercial issues relevant to alleged breaches of restrictive covenants and can advise you on how best to maximise your position tactically and, if possible, avoid Court proceedings in reaching a commercially acceptable resolution.

Watch this video below: