Restraint of Trade
What is the purpose of a restraint of trade?
Thank you to The Project & Procurement Professional Community of Practice for asking for more information on this topic.
A restraint of trade is usually requested to protect business revenue and reputation. Some areas where restraints are commonly requested are:
- where an employee is leaving a business
- where a contractor is engaged to work with a business temporarily
- where a shareholder or investor is exiting a company and they were more than a silent partner
- on the sale of a business to new owners
Restrictions on trade must be reasonably necessary and proportionate to the legitimate interests being protected. In general, for a restraint of trade provision to be enforceable, it must protect a legitimate interest, such as protecting trade secrets, confidential information, or customer relationships, and it must be reasonable in scope, duration, and geographic area.
A confidentiality agreement regarding the use of confidential information may have some of the same effects as a restraint of trade, but they are not the same thing.
What is reasonably necessary and proportionate for a restraint of trade?
Different types of restraint will be considered differently by the courts if a decision needs to be made about the reasonableness of the restraint.
The parameters of a restraint need to be considered for each different type of agreement and circumstance. Restrictions on stealing clients or customers are the most likely to be enforceable. Having regard to the difficulty in attracting and retaining those clients, and the value they bring to the restraining business is what will impact the reasonableness or otherwise of a timeframe for restraint.
For some businesses, a restraint framed in time and area is more easily applied and makes more sense. In cases where business can be conducted online with international partners, a limit by location will have no benefit. Note also that a court may be limited by its territorial jurisdiction in enforcing a restraint, so an employee leaving a job in Australia and taking up with a direct competitor in the US might only be able to be sued if they steal clients and that is what they are restrained from doing.
Where a restraint of trade is stated to apply to an employee, then it will NOT be reasonable if it has the practical effect of stopping someone from earning a living or requires them to move away from their usual home to be able to get a job.
How an employee restraint takes effect may be different if the person had ownership in the business. A more restrictive restraint of trade is likely to be reasonable when applied to a former owner, rather than an unrelated employee. See ‘sale of business’ below.
Restraints on employees also must take into consideration the nature of the work completed by the employee.
It is unlikely to be considered reasonable to attempt to restrain someone who is a barista from working in another local café. This is because the barista is unlikely to hold any unique or confidential information that could be detrimental to the original business. The barista is unlikely to control where the coffee is sourced, how it is priced, who the customers are or what the business serves in addition to coffee.
Compare a barista with a chef. The chef may have a following of people who really appreciate their style of food and will follow them. In that case, a form of restraint might be reasonable.
At the other end of the scale, a C-suite executive is likely to have a restraint in their contract of employment because of the nature of the work they do and the amount of knowledge they have.
Examples of what could make a restraint reasonable (restraints don’t usually contain all) are:
Limits on time
A 6-month restraint will be more reasonable than a 5 year restraint, however, you must think about the impact on the business. Think about the cycle of change applying to customers or clients of the business. If they come back every week, then a shorter restraint is likely to be reasonable. If they purchase products or services only once every few months, then a 12-month restraint might be reasonable. The more knowledge a person has about the management and operations of the business, and they risk that knowledge has to their competitive advantage, will also impact the length of time that is considered reasonable.
The impact on the business to be minimised is the loss of customers. If customers purchase again getting used to working with a new member of staff, then the restraint has had the desired effect.
Limits on geography
I’ve seen people request restraints from as little as 3km to worldwide restraints. What is reasonable, will depend on the potential impact on the business.
So, an accountant who works with clients predominantly located in Queensland, Australia, might be able to be restrained form working within a radius of their former office, but are still unlikely to be able to be restrained in the whole of Queensland. If their work is conducted in Queensland and their client base is not, then a geographical limitation might not be supportable at all, and a different type of restraint should be considered.
Limits on contact with existing clients of the former employer
Limiting contact with existing clients and prospects is the most commonly supportable form of restraint because it is easy to demonstrate the benefit/ loss to the business. If a client that has spent $100,000 a year with their insurance broker suddenly leaves to follow the particularly broker they were working with, then that is a quantifiable impact on the broking business.
Limits on roles or the nature of work
It would be difficult to justify a restraint on anyone who does customer facing work in retail or hospitality simply because of the nature of the work, and personal service industries like hairdressing and beauty therapy may also be challenging. Someone in general management might be restrained from working in the same industry or for a competitor, but not as a general manager and not from managements roles.
Common sense dictates that a restraint won’t stop a former investor or shareholder from purchasing shares on the share market. This is sometimes specified as a carve of from a restraint in the restraint clauses.
A shareholder who has been involved in a startup and been involved in the initial ideation, strategy, implementation and changes required to develop the business is likely to be restrained from seeking to be involved (other than through the stock exchange) in a competing business for a period consistent with the initial development phase of that business – which might be 2 -3 years.
Sale of business
When buying a business, it is common to restrain the seller from competing for a period of time which reflects your investment in that purchase. If the purchase price has been based on a multiplier of the business revenue or profits, then that multiplier might also support a period of restraint. So if the business was sold for 3 x the value of the profits, then a 3 year restraint might be considered reasonable as the seller should recover its purchase price in that time frame.
It is difficult to restrain contractors. The nature of what they do requires a level of flexibility in what they deliver, and there is less certainty in their roles than that of employees. A contractor can be restrained from using or misusing confidential information and can be reasonably restrained from poaching clients and staff, but geographical restraints are rarely supportable. It might be reasonable to restrain a contractor from working with a direct competitor within a certain period, but that restraint will be more focused on how the use of confidential information might cause detriment to the party applying the restraint, or benefit to a future contracting partner.
Do restraints get enforced?
It is not unusual for businesses to send cautionary or potentially threatening letters when they are of the view that a restraint has been infringed. As with any kind of dispute, most are resolved without ever going to court. There are a variety of restraint cases reported in superior courts around the country in the last ten years including:
A 2014 Queensland Supreme Court case involving an ophthalmologist who sold his Rockhampton practice to a publicly listed company.
The restraint provision was held to be reasonable only in prohibiting the doctor from poaching clients or offering services to clients of the business he sold.
The court found the restraint unreasonable where it attempted to restrain the doctor from working as an ophthalmologist within any of the decreasing radii of 20, 15, 10, 5 or 2 kilometres of a clinic owned by the buyer, or him being employed by a competitor. It was also considered unreasonable to attempt to stop the doctor from attempting to poach employees from the buyer.
The reasonableness of the restraints in this case is impacted significantly by the standing of the buyer and might have been considered reasonable if the buyer was another small business owner.
A 2020 ACT Federal Court case involving a restraint against a shareholder of a financial planning business.
In that case the “restraint provisions were clearly the work of lawyers, each with one eye on drafting the greatest possible protection for the applicants and with the other eye firmly shut to the limits that the law places on such restraints by requiring them to be the least necessary to protect the applicants’ interests in the business of New Civic. The result is restraint provisions that are impossibly convoluted and complex and unjustifiably broad” and therefore unenforceable.
Can there be compensation offered in exchange for agreeing to a restraint?
Yes, it is possible for compensation (payment) to be offered in exchange for agreeing to a restraint of trade provision, which can be used as a way to “sweeten the deal.” However, the enforceability of such provisions and the compensation offered will depend on various factors, including the reasonableness of the restraint and the specific circumstances of the agreement.
The amount of the payment should have a direct correlation to the reasonableness of the restraint. So, if an executive is to be broadly restrained for 12 months in a way that impacts their ability to seek other employment, reasonable compensation for that restraint might be the equivalent of that person’s annual wage. However, the specific circumstances, the scope and duration of the restraint, and the legitimate interests being protected will all still need to be considered in determining the reasonableness of a restraint. It may still be challenged in a court.
Unless a restraint has been written into an agreement, such as an employment agreement, at the start of employment and therefore agreed in advance, an employer must offer some form of consideration for that restraint to form a binding and enforceable contract. Compensation offered as consideration can include monetary payments, shares, benefits, or other forms of value.
However, it’s important to note that even if compensation is offered, a restraint of trade provision may still be found unenforceable if it is found to be unreasonable or against public policy.
It’s recommended to seek legal advice from qualified professionals when drafting or entering into agreements containing restraint of trade provisions and compensation arrangements in Australia to ensure compliance with applicable laws and regulations.
What type of action could be taken against somebody if they were to breach the restriction?
A breach of a restraint provision is usually challenged as a breach of contract in superior court. Depending on the way in which the claim is stated, it may be open to the court to make orders such as:
A court order that requires the person who breached the restraint to stop the prohibited activity. Injunctions can be sought to prevent further breaches of the restraint and to protect the legitimate interests of the party seeking enforcement.
The party seeking to enforce the restraint may also seek damages, which are monetary compensation for the losses suffered as a result of the breach. Damages may be awarded to compensate for financial losses incurred due to the breach of the restraint, such as lost profits or other damages directly resulting from the breach.
An account of profits
In some cases, the party seeking to enforce the restraint may seek an account of profits, which requires the person who breached the restraint to account for any profits they have gained due to the breach. This can be a remedy to prevent unjust enrichment by the person who breached the restraint.
In certain circumstances, the party seeking to enforce the restraint may seek specific performance, which is a court order that requires the person who breached the restraint to fulfill their obligations under the restraint. This may be sought when damages are not an adequate remedy or when the party seeking enforcement wants to ensure compliance with the terms of the restraint.
Could a restriction of trade be seen as anti-competitive?
It is more likely that a court will consider a restraint provision to be unreasonable if it has the effect of limiting competition, rather than reviewing the restraint under competition law. This will depend on how a claim is structured when made to the Court.
If mutually agreed by all parties, could the restriction be waived or amended?
Any contractual provision can be waived or amended by later mutual agreement between parties.
This article contains general legal information and should not be relied upon without seeking appropriate legal advice specific to your circumstances.
How Can Onyx Legal Help You?
If you are concerned about a restraint provision you have in contract, book a short advice session to discuss with one of our team and assess its enforceability, and how to fix it.