Court finds restrictive covenants in investment agreement were unenforceable

The High Court has held that restrictive covenants in an investment agreement were unenforceable because they were too long and geographically too wide and they restricted too broad a range of business activity.
 

What happened?

Literacy Capital plc v Webb [2024] EWHC 2026 (KB) concerned the sale of a company (Mountain) that provided medical services to assault referral centres, in which the defendant held 25% of the shares.

In 2018, the defendant sold her shares to the claimant. She was paid a small proportion of the price in cash on completion of the sale. The balance was left outstanding as a loan, which would be repaid on a long-stop date (or earlier if the claimant sold Mountain on in the meantime).

The longstop date for repaying the loan was seven years after the sale, although the parties later agreed to extend this to nine years.

On completion of the sale, the defendant stayed on as a director of Mountain and entered into an investment agreement with the claimant.

In October 2021, the defendant resigned from Mountain and all connected directorships. At the same time, she and the claimant entered into a new investment agreement (as a loan note holder) and a new loan note instrument.

The investment agreement and loan note instrument contained restrictive covenants by the defendant. (See box below “What are restrictive covenants and when will the court enforce them?” for more information.)

In relation to the defendant, those covenants stated, while the defendant held loan notes, and for a period of 12 months after ceasing to hold loan notes, she would not:

1. in the Restricted Area carry on, or be engaged, employed or interested in, any business which is of the same or a similar type to any Restricted Business and which is in competition with any Restricted Business;
2. in competition with any Restricted Business, deal or seek to deal with any person who at any time during the year prior to the Commencement Date [was] or [had been] a Customer;
3. in competition with any Restricted Business, deal or seek to deal with any Prospective Customer;”

“Restricted Area” was defined as the United Kingdom and the Channel Islands.

“Restricted Business” was defined as the business of any of the claimant’s group companies carried on at any time during the 12 months leading up to the defendant ceasing to hold loan notes.

In December 2021, the defendant and her business partner formed a new company, with the defendant taking a 28% shareholding. The new company initially traded in fields unconnected with the claimant’s business. However, more than 12 months later, it began to trade in the same field as Mountain and ultimately won tenders to provide those services.

The claimant applied to court for an interim injunction to enforce the restrictive covenants against the defendant.

What did the court say?

The proceedings in this case concerned an application for an injunction. As such, they were not a full trial and the key question for the court was whether the claimant had a realistic prospect of succeeding at trial. Only if the covenants were clearly and plainly unenforceable would the court dismiss the claim.

In the event, the court did precisely that. The judge gave the following reasons.

• The covenants would have prevented the defendant from undertaking not only the kind of business carried on by Mountain, but other businesses carried on by the claimant’s group that went “far beyond the core of Mountain’s services” (including management consultancy, software consultancy and staff provision, which the defendant was never involved in). This went “far beyond any legitimate protectable interest”.
• The maximum duration of the covenants was 10 years (the nine-year term of the loan notes, plus a further 12 months). This was “far past the duration allowed in ex-employee cases and in sale of business cases”. There was “no exemplar case approaching anywhere near 8-10 years”. In particular, the court noted that the covenants were so long, they would have banned the defendant from working in her chosen field until retirement age.
• The geographical scope of the covenants – namely, the entirety of the UK and Channel Islands – was not justified. The court was shown no evidence that Mountain had contracts outside of two counties in eastern England.

The court considered whether it could sever the covenants to make them reasonable but concluded that it could not.

In essence, the court found that the covenants were so unreasonably wide that there was no prospect of the claimant advancing any arguable case at trial to enforce them. It therefore dismissed the claimant’s application for an injunction.

What does this mean for me?

The comments in the judgment provide some useful guidance on how the courts will continue to approach restrictive covenants.

The judge’s reasoning for his conclusions reflects conventional thinking and advice. The longer and more expansive a covenant, the greater the risk it will be unenforceable.

First, the defendant argued that a duration of one or two years is usual on the sale of a business, stating that “there is no precedent in the case law for such restraint of trades upon vendors lasting longer than a year or two”.

Although the judge does not appear to have specifically agreed with this, he did note that the duration of the covenants in this case was “far past the duration allowed in ex-employee cases and in sale of business cases”.

However, the general view is that the courts will take a less restrictive approach to covenants given in a non-employment context, including by the seller of a business, and that covenants in this context can last longer. It is certainly not unusual to see restrictive covenants of up to three years on the sale of a business and occasionally longer.

Second, the defendant argued that the investment agreement and loan note instrument were “equivalent to hybrid contracts, mixing employment and sale of business elements, both of which attracted restraint of trade analysis of the validity [of] the restrictive covenants”.

Although the court did not endorse that precise wording, the judge did state that: “the leaving restrictions … arose as a result of [the defendant’s] status as founding director and it is not disputed that a 12 months, non-compete … would have been reasonable by way of duration and business scope. But the covenants also sought to restrict the Defendant as vendor of the business of Mountain.”

He also stated: “it is beyond argument that the restrictive covenants arose from the Defendant’s status as an employee of the Claimant and as a founder and grower of the business and as vendor of the Mountain business to the Claimant”

This does suggest the judge had sympathy for, if indeed he did not in fact proceed on the basis of, the “hybrid” characterisation of the covenants proposed by the defendant.

The question of the context in which a restrictive covenant is given can be difficult where an individual is selling a business but also staying on as a manager. In some cases, the individual may cash out completely, whereas in others they may acquire an equity stake at some level in the acquirer’s group.

In these cases, the individual is likely to be required to divest their shares if they ceased to be engaged by the group, and the tail end of the restrictive covenants will start from this point. Whether the covenants are given in connection with the individual’s engagement as a manager, their investment in the company, the sale of their shares, or some mixture could be an important factor.

The decision brings into sharp relief the need, when negotiating and drafting restrictive covenants in investment agreements, to consider carefully how far the covenants should go to protect the business in question. Key points to consider include the following.

• Consider including in the relevant contractual documents an express reference to the interest the covenants are attempting to protect. As a general rule, a non-compete covenant protects goodwill. There may be little or no goodwill at the start of a relationship or investment, but an expectation that it will build up over time. Any non-compete covenant should recognise this.
• Ensure the covenants go no further than reasonably necessary to protect the relevant interest, including in terms of duration, geographical extent and scope of business.
• A covenant of more than 12 months (or, in exceptional cases, two years) is unlikely to be reasonable for an employee. On the sale of a business, there is no fixed duration beyond which a covenant becomes unreasonable, but the longer it lasts, the harder it will be to enforce. There should be some logic tying the duration of the covenant to the interest being protected.
• Consider the territory to which the covenant applies. The starting point is normally the area in which the business is being conducted. It may be legitimate to widen that area, particularly if the business is in its start-up or growth phase, but too wide an area risks unenforceability.
• Include appropriate exceptions to the covenants in the contractual documents. This might include allowing the covenantor to hold a small interest in (say) a listed competitor, to invest in competitor through a discretionary fund manager or to respond to open advertisements.
• If the person giving a covenant has substantially less bargaining power than the person seeking it, the courts may be more likely to find it unreasonable. In this case, the person seeking the covenant could consider paring it back or suggesting to the other party that they seek legal advice on the covenant.
• Consider including in the contractual documents an acknowledgement that the parties have taken legal advice and they consider the covenants to be reasonable.

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