Corporate Law Update

• Long restrictive covenants in a bespoke services agreement were not restraints of trade (and so were enforceable)
• The European Commission is consulting on a draft regulation setting out content requirements for the document replacing a prospectus on a takeover
• The FRC’s Financial Reporting Lab publishes guidance on reporting in times of uncertainty
• The FRC Lab also publishes a report on going concern, risk and viability disclosures during the Covid-19 pandemic

Covid-19 is affecting the way people conduct their business, retain their staff, engage with clients, comply with regulations and the list goes on. Read our thoughts on these issues and many others on our dedicated Covid-19 page.

Restrictive covenants were not subject to restraint of trade doctrine

The High Court has held that the doctrine of “restraint of trade”, which can render a restrictive covenant unenforceable, did not apply to restrictive covenants in a bespoke services agreement.

What happened?

Quantum Advisory Ltd v Quantum Actuarial LLP [2020] EWHC 1072 (Comm) concerned a pensions advisory business formed by various individuals. Over time, the business came to be split across three different limited companies, which we will call the “old group”. The individuals had originally intended to merge the activities of those three entities into a single company.

However, in due course, the interests of the individuals involved began to diverge. The largest shareholder in the business wished to diversify the group’s activities, whilst the other individuals wanted to focus on developing its existing lines of business.

The individuals devised a plan to allow them to pursue their different interests. In broad outline, the business would be transferred to a new limited liability partnership (LLP), but the name, goodwill and existing client base would be retained by the old group.

The LLP would service the existing client base, but clients would be invoiced by, and pay, the old group. The LLP would invoice the old group a fixed percentage of amounts received from existing clients, designed to cover the LLP’s costs but not provide it with a profit. However, the LLP would be free to pursue business with new clients, using the existing client base as a springboard. Meanwhile, the old group would continue with the original plan to merge the entities and diversify its business.

As part of this, the LLP would not pursue the existing client base for its own business.

The parties documented this arrangement in a “services agreement”. The agreement contained restrictive covenants that prevented the LLP from soliciting or performing services for existing clients or persons the old group had identified as potential clients. The covenants lasted for a period of 12 months after the expiry or termination of the services agreement.

Among other things, the agreement stated that either party could terminate it on three months’ written notice. However, it had an initial fixed term of 99 years, meaning the earliest it could be terminated by notice was 6 April 2106. In effect, this meant that the restrictive covenants would last for 100 years.

In due course, having become dissatisfied with the fee arrangement, the LLP attempted to remove itself from the arrangement by claiming that the restrictive covenants were unenforceable on the basis that they were an unreasonable restraint of trade. The original group brought proceedings to enforce the services agreement.

What is “restraint of trade”?

Under English law, any contractual provision that tries to prevent someone from trading or carrying on business is generally void and cannot be enforced. This is known as the “restraint of trade” doctrine.

Common restraints of trade include so-called “non-compete” clauses, where a person agrees not to run a competing business, and “non-solicitation” clauses, where someone agrees not to poach employees, clients or (sometimes) suppliers. These are more usually called “restrictive covenants”.

However, a restraint of trade can be enforceable if it protects a legitimate business interest, it is no wider than reasonably necessary to protect that interest, and it is not in some other way contrary to the public interest. Common ways to limit restrictive covenants (and so make them more reasonable) including imposing a geographical or time limit, and including certain exceptions to the covenants.

However, there is no golden rule that states when a restrictive covenant moves from reasonable to unenforceable. The courts have flexibility to decide this on a case-by-case basis in light of the surrounding circumstances.

What did the court say?

The court said that the restrictive covenants were not subject to the restraint of trade doctrine.

The judge noted that there is a line between contracts in restraint of trade, on the one hand, and ordinary contracts that, although usually involving “some necessary restraint on the freedom of trade”, merely regulate parties’ commercial dealings.

In particular, he said that, although there is no rule stating that certain contracts are subject to the restraint of trade doctrine and others are not, it is possible for a contract, in the right circumstances, to fall completely outside the doctrine. This will depend on the facts in each case.

In this case, the services agreement was a “bespoke agreement, fashioned to address the competing needs and interests of a group of professional people and, in particular, the practical issues involved in permitting one part of the group enjoy the benefits of [a] brand and business when they were unable to afford a buy-out of the interest of the other part of the group”.

In reaching this decision, the judge noted the following:

• The LLP had been brought into being merely to carry out the business under the services agreement. It had no pre-existing business, and so the argument that the restrictive covenants restrained its trade “[lacked] the kind of traction” normally found where the doctrine applies.

• In fact, without the services agreement, the LLP would never have been created. This showed that the agreement “was not, in any relevant sense, a restraint of trade but rather a means of providing the opportunity to trade”.

• The real purpose of the covenants was to set the ownership boundaries of the business’ existing client base and any new opportunities whilst allowing the LLP to build its own book of business and operate independently.

Even if the doctrine did apply to the contract, the court said the restraints were reasonable. The judge said the covenants were the result of “free agreement between experienced, intelligent, articulate and highly competent business people, who were properly able to look after their own interests and who expressly agreed that the restraints were reasonable”.

He said there was equal bargaining power between the parties, and the 99-year term, although seemingly long, was actually negotiated up from an original period of ten years on the basis that such a short period would have caused the LLP to suffer as clients withdrew shortly after it started trading.

What does this mean for me?

This judgment is interesting because most cases concerning restrictive covenants and restraints of trade normally revolve around employment contracts and business sales, where the doctrine is much more likely to apply.

The decision shows that the courts will give significant weight to the commercial context of an arrangement before contemplating striking parts of a contract out. The services agreement in this case was very much a bespoke arrangement that, in many ways, preceded the person whose activities it supposedly restricted. It was clear that the restrictions formed part and parcel of the core of the commercial agreement.

However, that is not to say that services agreements, or indeed any particular categories of contract, fall outside the doctrine. The courts will consider the question on a case-by-case basis, and it is important not to become blasé. The mere fact that an arrangement is “bespoke” will not automatically bring it outside the restraint of trade doctrine.

In any case where a clause is trying to limit a person’s trading activities, parties should ask themselves:

• Are the restraints reasonable? Do they protect a commercial interest?
• Could the restraints harm the interests of the public?
• Have the parties taken professional advice when entering into the covenants?
• Are the parties of similar or unequal bargaining power?
• Could the arrangement have an anti-competitive effect? If so, the parties will need to tread carefully and take legal advice to ensure it is not unlawful under competition law.

Draft requirements for takeover prospectus exemption published

The European Commission is consulting on a draft regulation which would set out the information to be included in a document to be issued instead of a prospectus on a share-for-share takeover.

Under the EU Prospectus Regulation (2017/1129), an issuer must publish an approved prospectus whenever it proposes to offer shares to the public or to admit shares to trading on an EU regulated market (or both).

The Prospectus Regulation contains various discrete exemptions from publishing a prospectus in respect of the public offers and admissions to regulated markets “triggers”. Under one exemption, an issuer does not need to publish a prospectus if it is offering securities in connection with a takeover (an “exchange offer”) or in connection with a merger or division. This exemption applies to both public offers and admissions to regulated markets.

However, the exemption applies only if the issuer makes a document available to the public that contains information describing the transaction and its impact on the issuer. The draft regulation, which refers to this as an “exemption document”, sets out the proposed content for this document. The regulation follows technical advice on the contents of the document published by the European Securities and Markets Authority (ESMA) in March 2019.

In brief, the draft regulation provides as follows:

• The exemption document would need to contain information necessary to enable investors to understand the prospects of the issuer and the target company, including any significant changes in their businesses and financial positions since the end of the previous financial year.
• It would also need to allow investors to understand the rights attaching to the equity securities to be issued, as well as the transaction and its impact on the issuer.
• More formally, the document would need to contain specific information set out in an annex to the draft regulation. This is a streamlined version of what would need to be included in a formal prospectus. It includes (among other things) a responsibility statement, an overview of the issuer’s and the target company’s business, financial statements for both entities, a description of the transaction (including its purpose, the price payable, any risk factors and any conditions) and a working capital statement for the issuer.
• In certain circumstances, the document would need to contain pro forma financial information showing how the transaction might have affected the issuer’s assets, liabilities and earnings if it had been undertaken at the beginning of the period being reported on or at the date reported.
• The contents are further streamlined if the securities being offered are to be admitted to trading on a regulated market and are fungible with and represent no more than 10% of the issuer’s equity securities already admitted to that regulated market.

The Commission has asked for comments by 14 July 2020.

Also this week…

• FRC Lab publishes guidance on reporting in times of uncertainty. The Financial Reporting Council’s Financial Reporting Lab (the FRC Lab) has published a report designed to assist companies with providing information to investors on certain areas it previously highlighted in March. The report concentrates on availability of cash, managing short-term expenditure and ensuring viability, and how decisions taken now can ensure the company’s sustainability and might impact on its customers, suppliers and employees.
• FRC Lab publishes report on going concern, risk and viability. The FRC Lab has also published a report to assist companies with reporting on going concern, risk and viability during the on-going Covid-19 pandemic. The report highlights key considerations for companies in each of these areas and provides links to examples. In particular the report notes that, for some companies, Covid-19 might not present a risk at all, whilst for others it may represent a significant risk in its own right.