Buying or selling a Business? You need to know about “Restraints”!

Business RestraintBy Lachlan Commins, Patterson Houen & Commins, Solicitors, Sydney.

What is a ‘restraint’ in a sale of business contract?

If you have ever been involved as the vendor or purchaser in a sale of business contract, most likely you have come across something known as the ‘Restraint of Trade’ (otherwise referred to as a ‘limitation’ or ‘restriction’ on competition or the right to trade). For instance, Clause 17 of the New South Wales Law Society’s standard contract for the sale of business (2004 edition) is entitled “Restriction on vendor’s competition”. Similar clauses are contained in the standard forms in other states.

Well, what does it mean?

Essentially, a Vendor may be validly restrained from engaging or participating in certain trade or business in competition with the Purchaser so long as:

  1. The Purchaser has an interest which it is entitled to have protected (‘a protectable interest’);
  2. The scope and effect of the restraint given by the Vendor is no more than that which is reasonably necessary to protect the protectable interest; and
  • The terms of the restraint are not against the public interest.

What is critical to remember is that any restraint is prima facie void (that is illegal and unenforceable) unless each of the above conditions have been met. The onus falls on the Purchaser to show that a particular restraint has and will continue to satisfy each of the above conditions.

Why are restraints prima face void?

Unless a particular restraint satisfies each of the conditions outlined above, it is void. That is, any competition restriction is prima facie void as an infringement on the public’s interests in the freedom of trade and commerce.

Accordingly, to enforce a restraint you must be able to show that it is both reasonable and necessary in order to protect its protectable interest, and that it is not against the public interest.

What to do when confronted with a restraint clause?

If you are the Purchaser of a business, you will naturally want any restraint clause imposed on the Vendor to be as wide as legally possible. The benefit is that the Vendor will be restrained from competing against you within the parameters of the restraint clause so that the profits and success of your newly acquired business are protected as much as possible.

If you are the Vendor on the other hand, you will want any restraint clause imposed on you to be limited and your rights to compete unfettered to the extent acceptable to the Purchaser.

It follows that restraint clauses will usually be included in the contract for the sale of business at the instigation of the Purchaser.

The question is, ‘How can you as the vendor maximise your freedom to trade and to engage in the business of your choosing after the completion of the sale at hand?’  Most often, you will want to minimise the scope of the restraint clause (unless the sale is part of an exit plan or the sale price is to be increased in proportion to the scope of the restraint).

What is it that the purchaser seeks to have protected?

The Purchaser is not entitled to enforce a competition restraint (even if given by you willingly and for valuable consideration) which fails to meet the conditions outlined above.

What the Purchaser is entitled to protect is a ‘protectable interest’ which generally in the sale of a business will include a component of the business comprising ‘goodwill’.

In order to know your rights (and obligations), know your goodwill

Armed with the knowledge that you cannot be restrained from competing with the purchaser of your (former) business unless the restraint meets the conditions set out above, as the Vendor you will need to be clear about what it is that the Purchaser is entitled to protect through the restraint. To answer this question, you must understand ‘goodwill’.

When you sell your business, you will generally sell the shares of the company operating the business, or the business’s designated assets. Either way, the goodwill of the business is a valuable commodity which is capable of being priced.

For instance, the goodwill in a café business may consists of the café’s reputation for great coffee and friendly service which it has built up over the years; its list of long-standing regular customers; and its convenient location right next to a major bus stop. All these intangible factors combine to generate ‘goodwill’ which manifests itself in customer loyalty, market presence, and customer preference in the face of competition from other like businesses.

Put it this way: on your way to work each morning you have the option of buying your coffee from two cafes. The first one is the most convenient and the cheapest; the coffee is excellent, but you find that the quality of the service is poor and unfriendly.

The second one, on the other hand, is not as convenient and the coffee is dearer, but the quality of the coffee is equally excellent to the first. In your mind, the critical difference between the two is that the second cafe gives you great, friendly service every time you walk in the store; that is the reason why you choose the second café (despite the added inconvenience and price).

In the example given above, the ‘add on’ goodwill of the second cafe is the quality of the friendly service, which is so valuable that it has the power of ‘pulling in’ customers from within a wide radius that would otherwise visit a more convenient or less expensive café.

How can a purchaser protect the goodwill in their newly acquired business?

Following on from the example give above, a proposed Purchaser of the second café would probably be willing to pay a high purchase price in consideration of the business’s ‘goodwill’ and consequent higher earnings. After all, it is this goodwill that has attracted the ‘punters’ in the face of nearby competition from other cafes. In fact, the bulk of the purchase price may be referenced entirely to ‘goodwill’ as opposed to other tangible assets of the business such as its equipment or machinery.

Having parted with considerable sums of money in consideration of the business’s goodwill, it is understandable and reasonable that the Purchaser should become entitled to the ongoing protection of the business’s goodwill acquired at completion. Like any other asset of the business – whether it be the business’s coffee machines or its rights under a lease – the Purchaser is entitled to exploit the goodwill of the business (acquired at completion) for their own benefit.

So what if the Vendors (the previous owners of the second cafe) decided to set up shop right after the completion of the sale of and nearby the second café? (let’s call this the ‘third café’). What if these Vendors were so well-known in the community (and, as we have seen, responsible for such great service) that word quickly spread about their new digs? What if those punters, who had previously been drawn to the second café, now flocked to the third café, hoping to get the same great service which they used to receive from the Vendors at the second cafe?

Such a situation as outlined above would be detrimental to the business of the second café. The goodwill, which the Purchasers had paid such considerable sums of money for, would be severely derogated. The previous Vendors of the second café don’t undermine the value of the coffee machines, or the other tangible assets, which they have sold to the Purchasers, so why should they be allowed to undermine the value of the goodwill which was also acquired by the Purchasers? The simple answer is, if a properly drafted restraint clause is included in the sale agreement they are not.

What can the vendors be restrained from doing?

As mentioned above, the Vendors cannot be restrained from competing with the Purchasers post-sale per se. But they can be restrained from acting to derogate from the goodwill. The questions is, how can a restraint clause in the contract for sale be framed so that it is wide enough to protect the value of the goodwill, but yet not so wide that it does more than is reasonably necessary to protect the goodwill?

If the restraint is just wide enough, it will be upheld and enforceable. If it is too wide, it will either be read-down or completely avoided (depending on the jurisdiction and the drafting of the restraint clause) as an invalid fetter on the Vendor’s right to compete. The right balance to be struck will be different in each case as the nature and effect of the goodwill attached to each business is different.

Take a business with little to no goodwill: let’s say a typical convenience store in the central Sydney CBD. Such businesses are ubiquitous to the area and punters are rarely more than a two minute stroll to their nearest outlet. They are mostly similar to one another in terms of their product offering, store layout and customer service. In fact there is little – apart from a store’s immediate location – that separates one store from the next.

In the contract for the sale of such a business, a restraint clause framed in terms that the Vendor could not be involved in or conduct a similar business within a 10km radius for a period of 6 months after sale would clearly be too wide. Considering the ubiquitous nature of these stores, and their near identical service and product offering, the scope and effect of the store’s goodwill at completion could at the most be said to extend to the surrounding city-block. Beyond these borders, punters have a plethora of similar stores with identical service offerings from which to choose.

Likewise, a restraint period of six months is also unreasonable in the circumstances. A restraint period (as opposed to a restraint distance) will be upheld where the specified period of time is considered necessary to allow the Purchaser opportunity to utilise the full extent of the goodwill purchased. During this time (‘breathing space’ as it were) the Purchaser can reasonably be expected to have built up and consolidated its own goodwill.

In the café business example used above, the Purchasers of the second café could only reasonably be allowed to rely on the goodwill of the acquired business (that is, its excellent reputation for customer service) for a limited period after sale (for example, 6 months). During this time, the memory of the excellent customer service established and on-sold by the previous owners will fade as customers experience the customer service implemented by the new owners.

In the convenience store example, on the other hand, a period of 6 months would probably be unreasonable. What little ability such a store has to establish its own unique brand of goodwill vis-à-vis other competitive stores (such as store layout or product offering) could normally be reasonably achieved in a comparatively short period after the sale.

Major restraints

Some restraint clauses in sale of business agreements, which appear draconian on their face, have been upheld and enforced by the courts as being no more than reasonable and necessary in the circumstances to protect the Purchaser’s legitimate protectable interests.

The Supreme Court of West Australia in a recent interlocutory decision[1] upheld the terms of a restraint incorporated in the sale of business agreement by which the vendor of the business agreed to be restrained from becoming or being engaged in any business or activity similar to the business under sale for a period of ten years throughout West Australia. The business in question involved the service and repair of hydraulic cylinders and associated components to customers in Perth and regional West Australia.

Although only an interlocutory decision – meaning the injunction granted by the Court is an interim measure designed to protect the interests of the plaintiff until such time as the Court reaches its final decision at a full hearing – the judge nevertheless decided that the plaintiff had established a prima facie case in arguing for the restraint’s validity. To this extent, the plaintiff was successful in submitting that it was at least arguable that the restraint period of ten years was a reasonable and necessary period of time for the defendant vendor to be restrained as a means of preserving the plaintiff’s goodwill in its newly acquired business.

At the date of writing, the matter has not yet proceeded to a full trial. Nevertheless – by the judge’s own omission – it is fair to say that this particular restraint, in terms of the length of the restraint period, exists at the outer edge of what would be considered reasonable and necessary to protect a legitimate commercial interest.

What happens if a restraint is cast too widely?

The answer to this question will depend on the applicable jurisdiction which applies to your contract of sale. In NSW, the Restraint of Trade Act gives the Supreme Court jurisdiction to effectively ‘read down’ any restraint clause which has been cast in excessively wide terms which would, otherwise, result in its invalidity. That is, the Court will uphold and enforce the restraint on its terms but only to the extent that those terms, when modified by the Court, are reasonable and no more onerous than is necessary to protect the covenantee’s protectable interest.

If you are outside NSW, on the other hand, the applicable Court will use its powers under the common law to sever any unreasonable restraint clause in its entirety (assuming that the relevant contract can withstand such severance). Alternatively, if the relevant restraint clause has been drafted so that its operative terms with respect to the restraint distance and period are ‘cascaded’ from a maximum sought-after to a minimum sought-after distance or period, then the Court may strike-out those terms which it considers unreasonable, leaving only those terms which it considers reasonable and valid.

For instance, with respect to restraint distance, a cascaded restraint clause may seek a maximum area extending to all of Australia; if such an area is considered or deemed unreasonable by a Court, the clause, in its place, seeks a restraint distance in respect of all of NSW; if such an area is considered or deemed unreasonable, the relevant clause seeks a restraint distance with respect to Greater Sydney; and so on down to the largest restraint distance the Court considers reasonable in the circumstances.

Take-away knowledge

  • As the Purchaser to a contract for the sale of a business, do not get greedy by trying to include in the contract a grandiose restraint clause, as such a restraint may be invalidated in its entirety, or at the least read-down.
  • As the Vendor to a contract for the sale of a business, do not blindly agree to a pro-forma restraint clause drafted simply in terms of a specified restraint distance and restraint period. Rather, consider the nature and scope of the goodwill of the business which you are selling, and remind yourself that the Purchaser is only entitled to adequate protection with respect to the maintenance and use of the goodwill.
  • The principles outlined above in relation to the restraint of trade doctrine apply similarly to restraints applicable in employment law. That is, employees may be subject to reasonable restraints in their employment agreements which operate to restrict the type, geographic area, or commencement date (or any or all of these factors) of any subsequent employment available to them.

[1] Devil Dog Pty Ltd v Cook [2017] WASC 27.

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