Validity of Non-Compete Clauses in Business Sales: Serious Stuff

Legitimacy

It is legitimate for a buyer of a business to protect its investment in goodwill by restraining the seller from detracting from the goodwill sold. Whilst this is clear, the formula for drafting non-compete provisions (restraints) for particular circumstances is far from it. Every case is determined on its own facts.

Balance must be struck between protecting the interests of the buyer whilst not crossing the line of being unreasonable and therefore becoming invalid.

Generally, restraints that are unlimited geographically and in time are unenforceable. However, there are examples of when unlimited time, and in some cases the seller’s lifetime, have been held reasonable. In respect of a shoe manufacturer in Melbourne, a restraint for over 100 kilometres and unlimited as to time was enforceable.  Similarly, geographical restraints taking in a whole State have been found reasonable when applied to a small business.  However, there are also examples to the contrary. One example is where a restraint for a one kilometre radius for 3 years applied to a hair dressing salon in the Sydney CBD was held to be too wide.

The Question

When involved in drafting or completing these clauses, a very important, if not the most important, question to ask the parties (particularly the buyer) is this:

To sever the seller’s relationship with the customers after settlement:

1. what activity must be stopped?
2. by who?
3. for how long? and
4. where?

A considered answer to this question(s) will normally provide sufficient guidance on the restraint provision that should be implemented. This answer should also be recorded and held on file as valuable evidence should the buyer need to enforce the restraint clause in a Court.

Restrained Party

Further, it may be the case that restraining the seller (and its directors) alone may not be sufficient. Restraints of shareholders, managers and key employees may also be appropriate.

Cascading Clauses

Another drafting technique with restraint provisions to minimise the risk of a finding that a clause is invalid for unreasonableness is to impose “severable” restraints, often cascading in nature. For example, if the buyer believes that a reasonable length of the restraint is say three (3) years, the clause could be drafted so that the definition of “restricted period” is reflected as follows:

Restricted Period means:

(a)        three (3) years from completion;

(b)        two (2) years from completion;

(c)        one (1) years from completion.

Therefore, if a Court was to find that 3 years was excessive, clause (a) would be severed leaving sub-clause (b) i.e. 2 years as the applicable restricted period. Similarly, if 2 years was also to be found invalid then that sub-clause would also be severed leaving sub-clause (c) i.e. 1 year.

Activities

What activity does the buyer seek to restrain? The buyer should consider:

1. restraining business activities: the seller buying, selling, importing or manufacturing products competitive with products dealt with or distributed by the business sold.
2. assisting competitors: the seller promoting or assisting any other business which competes with the business sold.
3. soliciting customers: the seller soliciting the customers of the business sold.
4. Interference with employees: the seller attempting to entice away the employees of the business sold.
5. Disclosure of confidential information: keeping or revealing the confidential business and financial information of the business.

Issue with the Standard Condition

Some standard contract restraints, such as the standard Queensland Contract, the REIQ Business Sale Contract, are limited to competition over a time and place. While this may be useful when a majority of a business’s customers are based within a certain radius of the business premises (takeaway shops, grocery stores & newsagencies), it may not be when the business’s customers are spread far and wide (professional service firms, specialised retail shops & manufacturing businesses). Further, the Contract does not address other important activities that may be done whilst the seller’s new business is bases outside the “prescribed area” that impact on the goodwill of the purchased business, such as:

1. the seller soliciting the customers of the business from outside the “restricted area”.
2. the seller attempting to entice away the employees or contractors of the business sold.

Conclusion

If in answering the question: what is required to sever the seller’s relationship with the customers? you find that the standard business sale contract’s provision is inadequate, then the clause should be varied by special condition to accommodate what is reasonably required, but no more!