A restrictive covenant for “employee shareholders” was still binding on a shareholder after they ceased to be an employee

We considered when a restrictive covenant might be an unreasonable restraint of trade in our recent update, when reporting on Harcus Sinclair LLP v Your Lawyers.

What happened?

GSW produces maps for distribution to guests at luxury hotels. Revenue is generated from advertising fees paid by businesses highlighted on the maps. Mr S was the founder of the business and, on acquisition of the business by GSW, he was retained as an employee. He remained with GSW as either an employee, agent or consultant until February 2019.

Mr S was also a shareholder of GSW. As a shareholder, he was a party to GSW’s shareholders’ agreement (the Shareholders’ Agreement). The Shareholders’ Agreement included various restrictive covenants which applied to “Employee Shareholders” (defined as “any Shareholder who is also an employee, agent or director of the Company and those Shareholders who are Employee Shareholders as at the date of the Agreement are identified as such in the table at Schedule 1”). Mr S was identified in the schedule as one of the Employee Shareholders at the time the Shareholders’ Agreement was entered into.

The restrictive covenants in the Shareholders’ Agreement were to apply for (1) the time the party in question was a Shareholder, and (2) 12 months after the party ceased to be a Shareholder.

Once Mr S was no longer employed or engaged as a consultant by GSW, Mr S was deemed to have served a transfer notice in respect of his shares in GSW under the compulsory transfer provisions in GSW’s articles of association (the Articles). However, at the date of the judgment Mr S remained a shareholder of GSW.

In March 2019, Mr S allegedly used a map produced for GSW to solicit business in Switzerland, Budapest and Monaco. In April 2019, GSW issued proceedings against Mr S seeking an injunction restraining breach of the restrictive covenants in the Shareholders’ Agreement.

Considering the covenants in the Shareholders’ Agreement, the High Court had held that the restrictive covenants did not apply to an individual once they ceased to be an employee, even if they remained a shareholder. The judge had determined that because the restrictive covenants were to apply only to “Employee Shareholders”, the covenants did not apply to Mr S once his employment ceased.

The High Court had also held that, even if the restrictive covenants did apply to Mr S, they were unenforceable because their scope, nature and extent were in excess of what was reasonably necessary to protect the legitimate business interests of GSW.

GSW brought an appeal on the grounds that the judge had misconstrued the provisions of the Shareholders’ Agreement and had erred in concluding the restraints extended further than was reasonably necessary to protect GSW’s legitimate interests.

What did the court say?

The Court of Appeal disagreed with the High Court and allowed GSW’s appeal on both grounds.

The judge considered the objective meaning of the language used in the Shareholders’ Agreement, taking into account the factual and commercial context. The restrictive covenants had to be construed in the context of the Shareholders’ Agreement as a whole, and alongside the Articles. The judge took into account that there were various rights and obligations in the Shareholders’ Agreement which were clearly designed to protect GSW, its goodwill and the value of its shares. She also considered the compulsory transfer provisions in the Articles, which were designed to ensure a person would only remain a shareholder of GSW for a short period of time on ceasing to be an employee of GSW.

The judge held that it would make no commercial sense if the restrictive covenants could be avoided altogether by a person simply terminating their employment. The restrictive covenants had to be interpreted as still applying to a person once they ceased to fall within the definition of an “employee“, otherwise the provision had no real force. She held that a person who was an Employee Shareholder and to whom the restrictive covenants applied would remain subject to them for as long as they remained a shareholder, and for 12 months’ after ceasing to be a shareholder. Mr S was therefore subject to the restrictive covenants in the Shareholders’ Agreement.

In considering whether the restrictions were reasonable, the judge noted that where such covenants are contained in a shareholders’ agreement, rather than an employment contract, the court is less vigilant in its scrutiny. This has been considered in a number of cases and is a now an established principle.

The judge held that the 12 month restriction period was reasonable. The 12 month period runs from when the “Employee Shareholder” ceases to be a shareholder and, because of the compulsory transfer mechanism in the Articles, it was very unlikely a shareholder would be “locked in” to the company or be unable to transfer its shares. GSW had a legitimate interest in seeking to prevent Employee Shareholders, who were likely to have detailed knowledge of the business, from competing with the business and soliciting clients.

What does this mean for me?

• The case emphasises the importance for companies of ensuring that restrictive covenants are very clearly drafted. In particular, it is important to make it clear to whom the restrictions apply, and when they will be triggered.
• It is also a reminder that it is good practice to include restrictive covenants in any shareholders’ agreement (or equivalent) as well as in any employment contract. The provisions in the shareholders’ agreement will be subject to less vigilant scrutiny by the courts and are more likely to be interpreted as being reasonable, and therefore enforceable.