Restraint of trade clauses in business sale agreements must be drafted with enough specificity to avoid being struck out by the Court as unreasonable.
This article will provide a few pointers on what not to do when drafting restraint clauses in business sale agreements.
What is a restraint of trade?
A restraint of trade is a restriction on a person’s freedom to engage in business, trade or employment. Every restraint of trade is presumed to be unenforceable[1] until the party seeking to enforce it can rebut that presumption. The presumption is rebutted by showing that the restraint is reasonable in reference to the interest of the parties concerned and the interests of the public. In New South Wales this is reflected in section 4 of the Restraint of Trade Act 1976 (NSW) which provides that a restraint of trade is not void against public policy provided the restraints it seeks to impose are reasonable.
Business Sale Agreements
Business sale agreements commonly include clauses which seeks to restrain a vendor from starting or joining a competing business within a defined area and for a defined period after completion of the sale.
A restraint clause is desirable for the purchaser because if the vendor starts or joins a competing business and pulls with them existing clients, suppliers and employees, then the value of the business purchased may be substantially reduced.
Notwithstanding their legitimate purpose, the Courts are quick to find restraint clauses void where they go beyond what is reasonably necessary.
Here are a few examples of failed restraint of trade clauses below.
Failed restraint clauses
- Restraint area
A failure to expressly limit the geographic area of the restrained business can be fatal to a restraint of trade clause.
In the case of Butt v Long (1953) 88 CLR 476, the restraint clause was silent as to the geographical coverage of the restrained business. The purchaser sought to infer a restraint by arguing that the business purchased was only carried out in a particular locality and the parties could only have that locality in their minds at the time of the agreement[2].
The High Court of Australia however rejected that argument. The failure to expressly limit the geographical boundaries of the restraint caused the clause to be set aside as being unreasonable and too wide.
- Length of restraint
The length of time of the restraint imposed on the vendor cannot go on for longer than necessary.
In the case of DXC Eclipse Pty Ltd v Wildsmith [2023] NSWCA 98, the New South Wales Court of Appeal held that a restraint period of 7 years was unreasonable in circumstances where the purchaser was unable to demonstrate why such a long period of time was reasonably necessary to protect the goodwill of the business acquired.
The purchaser attempted to argue that it required 7 years to recoup its full investment based on the purchase price. The Court regarded that argument as being irrelevant in justifying such a long restraint period.[3] The question which arises in such cases is, how long does it take to protect the goodwill from being subtracted from by the vendor joining a competitor or opening their own business?
- Future business
A restraint of trade only protects any existing business not an alternative venture or activity which the vendor is considering pursuing in the “future”.
In DXC Eclipse Pty Ltd v Wildsmith case, the NSW Supreme Court was only willing to look at what comprised of the restrained business as at the date of the agreement, and not what might prospectively be part of the business in future.[4]
- Allocation of purchase price
The business sale agreement should expressly acknowledge that part of the purchase price is allocated to the goodwill of the business acquired.[5]
In the case of Cream v Bushcolt [2004] WASCA 82, the Court of Appeal of Western Australia found that the restraint of 10 years was excessive and beyond that required for the reasonable protection of the goodwill of the business being purchased, particularly where no part of the consideration was allocated to goodwill.[6]
- Relevant time of contract
While the reasonableness of the restraint is usually assessed at the time the agreement was entered into, a discretion exists for the Courts to be informed by considerations at the time enforcement is sought.
In DXC Eclipse Pty Ltd v Wildsmith, the fact that the vendor was only obliged to remain with the purchaser’s company for 12 months provided some indication as to how long the purchaser considered was necessary to realise the goodwill it had acquired.
In that case, by the time the purchaser sought to enforce the restraint clause against the vendor, the vendor had actually stayed with the purchaser’s company for 3 years, being three times as long as he was contractually obliged to do. The Court found that the purchaser enjoyed the vendor’s skill and expertise for a much longer period than the contractual minimum and a restraint of 7 years was therefore unreasonable.[7]
Concluding remarks
Purchasing or selling a business is an exciting event for even the most experienced businesspeople. Regardless of how many times you have done it, each transaction is unique and there will be different considerations at play. It is always advisable to work with legal professionals to get the restraint clauses right in the context of that particular transaction.
If you have any queries or would like to discuss this topic further, please contact David Greenberg, Partner, or Alison Chow, Associate on (02) 9261 5900.
[1] West Harbour Rugby Football Club Ltd v New South Wales Rugby Union Ltd [2001] NSWSC 757, [19].
[2] Butt v Long, [483].
[3] DXC Eclipse Pty Ltd v Wildsmith, [157].
[4] DXC Eclipse Pty Ltd v Wildsmith, [111].
[5] Cream v Bushcolt Pty Ltd [2004] WASCA 82, [52].
[6] Cream v Bushcolt Pty Ltd, [54].
[7] DXC Eclipse Pty Ltd v Wildsmith, [162].