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Seller lock in: an 8 year non-compete obligation

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It is common practice to include restrictive covenants in share purchase agreements.  One of the standard restrictive covenants in such an agreement is a clause restricting the seller of the company from establishing a business in competition with the business of the company being sold, after completion of the sale. However, the starting point is that such a restriction is void at common law as an unlawful restraint of trade unless the person seeking to enforce it can show that the restriction is in the public interest and goes no further than is necessary to protect the buyer’s legitimate business interests.

A recent High Court case has considered whether such a restriction amounted to an unlawful restraint of trade. It also looked at whether certain other provisions relating to the cancellation of the buyer’s obligations to pay future instalments of the purchase price in the event of a breach of the restrictive covenant amounted to a penalty.  As a matter of common law, penalties are not enforceable.   The case was of particular interest given the potential length of the restriction.  


The case (Cavendish Square Holdings BV and another v Talal el Makdessi [2012] EWHC 3582)

A company in the WPP marketing communications group (WPP) held a 12.6% shareholding in TYR, the largest advertising and marketing communications group in the Middle East. In 2008, under a heavily negotiated share purchase agreement, WPP acquired a further 47.4% of TYR's shares, for a significant amount - $34m on completion, a second payment of $31.5m and two further payments referable to operating profits. There were also put options over the remaining 40% of the shares, enforceable by the seller, at a price based on a profit multiple. The total consideration payable was capped at $147.5m, against a net asset value of $69m.

Much of TYR's success had been due to one of the sellers (the defendant), a high profile figure in Lebanese business and society and his personal relationships with TYR’s clients. For this reason, WPP insisted that the share purchase agreement contained extensive restrictive covenants from the sellers. These included a non-compete covenant that ran until 2 years after the date the seller no longer held any shares in TYR or (if earlier) the termination of the seller's employment. This meant the covenant could potentially run for eight-and-a-half years after completion of the share purchase agreement. The share purchase agreement also stated that if the seller breached the restrictive covenants: (i) the buyer would not be obliged to pay any future instalments of the consideration; and (ii) the seller lost his put options. Instead, WPP could acquire the remaining 40% of the shares at a lower price based on net asset value.

Post- completion, the seller competed with the business. WPP sought to enforce the non-compete covenant and sued the seller for breach of the share purchase agreement. The seller challenged the claim on the basis that the covenant and price adjustment clauses were unlawful and unenforceable as: (i) they were too long and an unlawful restraint of trade; and (ii) the price adjustment clause was an unlawful penalty. The court held that the provisions were not an unreasonable restraint of trade and the loss of future payments did not amount to a penalty. The court noted:

  • the share purchase agreement provisions had been fully negotiated "on a level playing field" between experienced lawyers;
  • there was substantial goodwill in the business, for which WPP had paid a substantial premium; and
  • the value of TYR's business depended heavily on the seller's personal connections, a fact acknowledged in the share purchase agreements.

 The duration of the covenants was also acceptable. The judge ruled that the eight-and-a-half year duration was tied to a relevant interest of the buyer and was therefore not an unreasonable protection for WPP.

On the penalty clause issue - although loss of rights to future payments could amount to a penalty, on these facts, the provisions were deemed justified and did not amount a penalty. The court decided that the principal purpose of the clause was not to deter breach of contract or be oppressive. There was commercial justification – it was a reflection of the loss of goodwill that might accrue to WPP from a breach.


Conclusion

The structure of the sale (in particular, the fact that the seller retained shares and had a put option) and the facts of the case are important but the case does show that there is considerable flexibility in certain transactions to have longer non-compete periods and to tie parts of the consideration to compliance with key obligations. In fact, the judge noted that there was no reported English case in which a seller’s restrictive covenant had been held to be unreasonable in an acquisition context solely on grounds of its duration.

However, this does not mean that non-compete covenants of up to eight years will be valid in every case. The covenants need to be structured in light of the underlying transaction and business.  Any non-compete covenant must pass the test of going no further than is necessary for the protection of the buyer's legitimate interests and other considerations apply when considering the legitimacy and enforceability of restrictive covenants, such as: the geographic scope; the nature of the business being protected; as well as the value attributed to the restrictions and the bargaining strengths of the parties.

One further point to note was that the sale involved the acquisition of a business which was not in the European Union therefore the restrictive covenants were not tested against the more stringent UK or EU competition rules governing restraints of trade whose guidance states that generally a non-compete restriction in the context of a share purchase agreement can be justified for a period of up to 3 years where both goodwill and know-how are transferred but only 2 years where only goodwill is involved.

Finally, it is important to distinguish non-compete covenants in share purchase agreements from non-competes in employment contracts. Courts approach the latter on the assumption that there is rarely a 'level playing field' for negotiation between employer and employee. It is therefore much more difficult to show that a lengthy restriction is reasonable and necessary and has been entered into of the employee's free will. A twelve-month non-compete is the longest period we have seen enforced in the English courts and only for the most senior executives with access to extremely sensitive confidential information, which it is not possible to protect by other means (such as clauses preventing the solicitation of customers).

For further information, please contact Charles Claisse, Deborah Angel or Kathryn Dooks.