Exercising Restraint

What business owner in his or her right mind doesn’t want to restrict competition? Especially if it’s coming from a trusted employee or the person who sold you the business!

So which of the following business owners do you think succeeded?

A. The Putaruru food store owner whose employment terms prevented his store manager from working for any similar business within a 25km radius of the store for 3 years?

B. The purchaser of a Hamilton café (who had paid $327,000 for goodwill) under a contract restricting the vendor from opening a hospitality business within a 10km radius?

C. The purchaser of shares in a large Auckland printing company (who paid $2.7 million for goodwill) under a contract preventing any of the vendor parties from competing?

These are actual examples selected from over 20 reported restraint of trade or restrictive covenant cases heard in New Zealand courts over the past year.

The correct answer is B. Why did that business owner succeed and the others fail?

Restrictive or restraint of trade covenants can be very useful tools for business owners - if they work. However the high level of failure in practice points to a wide-spread lack of understanding of these potentially valuable intangible assets.

The court’s starting point is that covenants in restraint of trade are contrary to the public interest, and are presumed void unless reasonable. What is reasonable depends on the surrounding circumstances.

On the other hand, the law will generally uphold restrictive covenants preventing the business’s proprietary and/or confidential information from walking out the door when employees leave.

Coming back to the examples above:

A. The Putaruru store owner failed to prevent his ex-manager from working for a nearby competitor because:

  • He could not identify the proprietary information he was supposedly trying to protect; and
  • Even if he had, the term of the restraint was unreasonable and could never have been more than 6-12 months at most.

B. When the vendor of the Hamilton café opened a café/bar in the next block, the purchaser was able to recover his goodwill payment in full because the restraint of trade terms were clearly drafted and considered reasonable by the court.

C. The purchaser of the Auckland printing company shares was unable to stop the business’s operations manager from joining a direct competitor 6 months from settlement because:

  • It could not prove he had access to the confidential information (pricing and product data) which it sought to protect;
  • Furthermore, the restriction in the sale and purchase agreement did not extend to him as a beneficiary of a vendor trust.

Well, one out of three ain’t good! Leaving aside wasted goodwill payments, legal proceedings (particularly unsuccessful ones), are not getting any cheaper.

To avoid a misfire, here are some do’s and don’ts to consider:

Don’t

  • Assume you have a general right to prevent ex-employees from working for competitors;
  • Think you can secure an effective restraint of trade without compensating the person affected;
  • Rely on standard templates- each situation needs individual consideration .

Do

  • Think carefully about who and/or what it is you are trying to restrict and look at all your options for achieving this;
  • Consider the impact of social media (see http://www.btob.co.nz/article/social-media-can-compromise-database-assets);
  • If your major purpose is to protect business intangible assets, identify and legally secure them as a first step (see http://www.btob.co.nz/node/33263).

A very good way to approach this issue is to carry out an overall risk management assessment of your business. Ideally this should be one of the early foundations of your business growth critical path.

 

(From our Spring Newsletter 2011)

 

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