June 2010 - What every employer needs to know about restrictive covenants

A practical guide by Bruce Gardiner of Two Temple Gardens Chambers

When a client is seeking advice about restrictive covenants, time is often in short supply. An ex-employee may be poaching customers and his former employer fears a catastrophic effect on his business. Or an ex-employee may have started a new business and fears his former employer may be threatening to obtain an injunction that could close his business down. In both these situations, the client needs help, and needs help fast. Can he obtain an injunction? Can he resist an injunction? What are the risks of doing nothing?

This two-part article which first appeared in New Law Journal identifies and addresses 10 key questions to ask and answer when a business finds itself in this situation.

1 Is the covenant a term of the employment contract?

This fundamental question is often overlooked. If the restrictive covenant is not a term of the employment contract, then it will obviously not be enforced by an injunction. There are several situations where the ex-employer’s understanding of the contractual position may not be the true position. These can be broadly divided into two situations:

• First, where the ex-employer has never attempted to include such a term in his employee’s contract. This may be because the employee was never given any terms and conditions when he joined, or because he has become an employee as a result of a TUPE transfer, and so retains the terms and conditions from his ex-employment;

• Secondly, where the ex-employer has never achieved the inclusion of that term in the contract. This may arise where the employee has never signed up to a new version of the terms and conditions containing the covenants, or where the restrictive covenants are contained in a staff handbook which has no contractual status.

In the absence of valuable consideration to support a valid contractual variation, he will remain employed on his original terms and conditions. If restrictive covenants are introduced at the same time as a pay increase, then the variation is likely to be considered binding. However it is dangerous to assume that an employee has impliedly agreed to the incorporation of restrictive covenants merely by continuing to work after they have been drawn to his attention. The fundamental question is this: “Is the employee’s conduct, that is continuing to work, only referable to his having accepted the new terms offered by his employer?”. Given that post-termination restrictive covenants have no immediate impact on the employment relationship, the employee’s conduct may be equally consistent with the continued application of the old terms.

2 Have the circumstances of the employee’s departure rendered the restrictive covenant unenforceable?

If the employee’s departure amounts to a wrongful dismissal, then the employment contract ceases to be effective, not merely in relation to the terms during his employment, but also as to any terms which purport to restrict the employee’s behaviour after employment.

A wrongful dismissal can be an express dismissal or a constructive dismissal. The employer may have summarily dismissed the employee for gross misconduct, where in fact the employee has not committed the alleged misconduct, or where the misconduct does not amount to a repudiatory breach of the employment contract. There will also be a wrongful dismissal if the employer has dismissed the employee and made a payment in lieu of notice where there is no PILON clause permitting this. If so, then the contract ends and with it, the effectiveness of post termination restrictive covenants. If advising an employer during a disciplinary or redundancy process, this is a factor to bring to the employer’s attention.

Alternatively the employee may have resigned in circumstances where he alleges he has been constructively dismissed. Here there are three well established questions:

1. was the employer in repudiatory breach of the contract;

2. if so, has the employee lost the right to terminate the contract by affirming the continued existence of the contract, and

3. did the employee resign in response to the breach. From an evidential point of view, the employee’s resignation letter is an important document as to the reasons for leaving, and how recently those events occurred.

Occasionally restrictive covenants will state that the restriction continues to apply “howsoever employment is terminated”. Such wording is of no effect in circumstances of wrongful dismissal.

In practice, a repudiation argument raised by the ex-employee is unlikely to defeat an application by his ex-employer for an interlocutory injunction unless the evidence is very strong, but this argument may well be resolved on its merits shortly thereafter at an expedited trial or a preliminary hearing of the issue.

3 Is the clause unenforceable as an unreasonable restraint of trade?

If the clause amounts to an unreasonable restraint of trade, then the restrictive covenant is not enforceable.

In assessing whether the covenant is reasonable, there are three issues to consider:

• What does the covenant mean?
  As to the first issue, the court should construe the meaning of the covenant in the light of the object and intention of the contract as a whole, and not construe it literally. If there is an element of ambiguity such that there are two possible constructions of the covenant, one which would lead to a conclusion that it was an unreasonable restraint of trade and unlawful, but the other would lead to the opposite result, recent authority suggests that the court should adopt the latter construction on the basis that the parties are to be deemed to have intended their bargain to be lawful. The contrary argument to run when acting for an ex-employee is that principles of contra proferentem should resolve the ambiguity in favour of the employee and render the covenant unenforceable.
  

  On an interim application for an injunction, the Court should reach a concluded view on the meaning of the covenant at that stage, unless there are disputed facts that bear on the question of construction.

• Is there a legitimate business interest capable of protection?
  As to the second issue, case law recognises at least three potentially legitimate business interests. First, client connection. In many businesses, it is vital to future business to maintain personal contacts with existing customers. Those personal contacts form part of the goodwill of the business. In order to protect that goodwill it is legitimate to restrain an ex-employee from exploiting for his own gain the personal contacts he has developed whilst an employee of his ex-employer. So it is potentially legitimate to prevent an ex-employee from soliciting clients of his ex-employer, or even from dealing with clients of his ex-employer.
  

  It is also potentially a legitimate business interest to seek to maintain a stable workforce. So a clause that prevents an ex-employee from poaching other employees from his ex-employer is potentially enforceable.
  
  Thirdly, restricting the disclosure of confidential information is also potentially a legitimate business interest. However it is not legitimate to prevent an ex-employee from using his skills and experience. The crucial question is : “Whose property is the information in question?”

• Is the covenant no wider than is reasonable to safeguard those interests?
  When considering the third issue – whether the covenant is a proportionate means of safeguarding the legitimate business interest – the reasonableness of the restriction must be interpreted in accordance with what was in the contemplation of the parties at the date when the contract was made and not as matters turned out. As a result, supervening events cannot be relied upon to determine whether the clause is reasonable or unreasonable. In Allan Janes LLP v Johal [2006] IRLR 598 a covenant preventing Ms Johal from dealing with any of her ex-firm’s clients, regardless of whether she had recently dealt with them personally, was held to be reasonable - at the time she was recruited to a senior position there was a mutual hope that it would mature into a partnership offer. Judged at the time she joined, it was reasonable to infer that some of the clients on whose files the defendant did not work during her final year might well have been clients for whom she had worked in a previous year, or were clients to whom her own skill and expertise had been promoted by the firm. The clause was therefore held to be reasonable.
  
  If the clause as drafted is broader than necessary to safeguard the legitimate business interest then it will be struck down, even if tighter wording would have been enforceable.

There are several ways in which the drafting of a clause may be too broad:

• In scope: Many clauses seek to prevent an ex-employee from soliciting or dealing with existing customers of the ex-employer. This is potentially too broad because it would prevent the ex-employee from dealing with many existing customers with whom he has never had any dealings during his employment. As a result, good drafting usually limits the restriction to dealing with existing customers with whom the ex-employee has had material dealings in the twelve months before the termination of his employment. In the case of a non-poaching covenant, the covenant would be too broad to prevent an employee from recruiting a person with whom he has had no dealings during his employment with his ex-employer; or preventing the employee from recruiting a person who is of little strategic value to the potential employer.

• In geographical extent: In the employment context it will often be difficult to justify as reasonable a restraint preventing the ex-employee from carrying on business in a particular area. This is usually too blunt an instrument to protect client connection, which is better protected by a non-dealing or non-solicitation clause.

• In duration: There may be no time limit stated on how long the restriction is to continue, or it may be considered excessive. If the clause is intended to protect client connection, the clause should only last as long as is necessary to give the ex-employee’s successor a fair opportunity to establish a personal connection with existing customers. Where the client base is small and contact frequent anything other than a short period of restraint may be considered unreasonable. If the client base is large and the contact on an annual basis, then a period of a year or perhaps more might be considered reasonable. In judging whether a period of restraint is too long, it is relevant to consider the length of any restraint which precedes the employee’s departure – if, for instance, the employee has been put on garden leave for a period of three months or more before the end of his employment, this may render a long post-termination period of restraint unreasonable.

Non-compete covenants may be held to be reasonable in limited circumstances as the only effective means of policing whether ex-employees are disclosing confidential information to a competitor or are continuing to deal with existing clients, particularly where the employees are highly paid and the post-termination covenants are part of the consideration for the substantial remuneration.

Sometimes the restrictive covenant may be contained in a termination agreement. Such covenants are to be approached in the same way, although anecdotal evidence suggests that courts may be less willing to strike down such covenants where it seems that the employee has received a substantial pay off in return for agreeing to the restraint.

A legitimate tactic when acting for the ex-employee is to contend that the same legitimate business purpose could have been achieved with a narrower covenant, such that the clause as drafted is unreasonably broad.

4 Can the clause be severed so as to restrict its scope and render it enforceable?

In certain limited circumstances, a restrictive covenant can be rewritten to restrict its scope, by severing phrases which would otherwise make the covenant too broad. This is the application of the so-called blue pencil test. In Beckett Investment Management Group v Hall [2007] IRLR 793, the following three stage approach was approved:

• The unenforceable provision must be capable of being removed without the necessity of adding to or modifying the wording of what remains;

• The remaining terms must continue to be supported by adequate consideration;

• The removal of the unenforceable provision does not so change the character of the contract that it becomes “not the sort of contract that the parties entered into at all”.

For instance, in TFS Derivatives Limited v Morgan [2005] IRLR 246 a restrictive covenant purported to restrict business activity which was not only competitive with but “similar to” a relevant business. The words “similar to” were severed, with the result that the clause was not considered unreasonably wide. But what if there are no enforceable restrictive covenants? In the second part of this article we will consider this question, how to go about getting or resisting injunctive relief and what practical issues arise when seeking an interim injunction.

5 Can the employer rely on any implied terms or intellectual property rights?

In the absence of valid post-termination restrictive covenants, it is worth considering possible pre-termination breaches of other contractual terms, particularly implied terms. All employees are under implied duties of fidelity, encompassing several separate strands, including duties of honesty, good faith and a duty to preserve confidences. Consistent with this term, during employment, an employee cannot compete with his employer or work for a rival. However, he is not restricted from taking preliminary steps to set up in competition with his employer. The dividing line between permissible preparatory steps and impermissible competition is often very difficult to define and much will depend upon the particulars of the employee’s job and the nature of his contractual obligations: Helmet Integrated Systems Ltd v Mitchell Tunnard [2007] IRLR 126.

Directors are under a fiduciary duty and so are under a more onerous duty to act in the best interests of the company. Senior employees may be under a similar fiduciary duty (discussed recently in Crowson Fabrics v Rider [2008] IRLR 288). The distinguishing mark of the obligation of a fiduciary is that a fiduciary owes a duty of single-minded or exclusive loyalty. However, it is important to define the extent of the fiduciary duties owed, as employees may have fiduciary obligations only in relation to certain aspects of their role.

Generally, ordinary employees are not under any obligation to disclose their activities to their employer. In some circumstances, the position of a senior employee may be such that he is under a fiduciary obligation to tell his existing employer of his plans to set up in competition. He may also come under an obligation to disclose misconduct by his fellow employees.

Duties of confidentiality and intellectual property rights

The temptation for employees to take and use documents, information or property belonging to the employer is often too strong to resist. Employees owe an implied duty not to disclose to third parties trade secrets or confidential information acquired by reason of their employment. A distinction has to be drawn between trade secrets such as formulae, technical know-how and production techniques, which are protectable after the employment relationship has ended even in the absence of an express covenant, and other types of confidential information which do not attract protection after termination of employment in the absence of an express covenant.

To determine whether information falls within the implied term not to disclose after termination the following issues have to be considered:

• the nature of the employment;

• the nature of the information, i.e. whether it could properly be classed as a trade secret or of a highly confidential nature;

• the attitude of the employer to the information and whether the confidentiality of the information had been impressed on the employee;

• whether the information could be isolated from other information which the employee had been free to use or disclose.

The employer may also be able to rely upon copyright, database or other intellectual or physical property rights.

6 What is the evidence of potential breach?

Often an employer’s basis for believing that an ex-employee is in breach of restrictive covenants may be little more than office gossip. This will probably not be sufficient to persuade a court to award an injunction or to make an award of damages.

In other cases, the tip-off may have come from a customer or supplier who has been approached by the ex-employee. It is important that the employer carries out an investigation to obtain some credible evidence, even if only on a hearsay or circumstantial basis. For commercial reasons, the employer may be reluctant to make enquiries of existing customers. One potentially valuable source of information may be the ex-employee’s work computer. Emails or documents may show that the employee has been lining up potential customers during his employment. Alternatively the computer files may have been deleted shortly before his departure, indicating that there may be something to hide. Paper files containing customer lists may be missing, so suggesting that the ex-employee has stolen such documents in order to contact those customers after his departure. In some circumstances it may also be appropriate to hire a private investigator or surveillance operative to gather evidence.

7 Is there any loss?

This is a question which is often overlooked. An ex-employer does not necessarily have to show loss in order to enforce a restrictive covenant by way of an injunction, as the employee will generally be held to his bargain if the covenant is valid and enforceable (see Dyson Technology v Strutt [2005] EWHC 2814). However, it is still important to focus on the question of loss before starting legal action to ensure that the substantial time and money involved in issuing proceedings is a worthwhile investment. The ex-employer’s first reaction may be to assume, inaccurately, that the ex-employee’s activities are having or about to have a catastrophic effect on its business.

Even if there is evidence that an existing customer has been buying goods or services from an ex-employee, the ex-employer has not necessarily suffered any loss. The existing customer may have become disillusioned with the service provided by the ex-employer and decided to look elsewhere in any event.

If representing the ex-employer, the client should be asked to analyse recent sales figures for evidence of an otherwise unexplained drop in sales or loss of customers, and forecast the ongoing effect on existing or anticipated projects. Where there has been a breach of fiduciary duty, then an account of profits may be a more valuable remedy.

If representing the ex-employee, it is helpful to obtain letters from those customers who have transferred their business to him to explain why they have done so.

8 Should an injunction be sought, and if so how?

Reasons for seeking injunctive relief

In many cases the losses to the ex-employer are continuing or threatened. In addition the restrictive covenants will often have expired by the likely date of any trial. The ex-employer may therefore wish to seek an interim injunction pending trial. Often, an interim injunction represents a substantial costs saving as in most cases it resolves the issues and avoids the expense of a full trial.

The ex-employer must be able and willing to provide a cross-undertaking in damages. This is an undertaking that in the event that the underlying claim is ultimately unsuccessful, the ex-employer will pay damages to the ex-employee for any losses caused by the injunction. When advising whether it is appropriate to seek an injunction, the risk of liability in damages as well as costs must be borne in mind. However, the risks are often outweighed by the benefits of an injunction.

Where there is evidence that the ex-employee has possession of the employer’s confidential information or property, it is worth considering applying for a search order or an order for delivery up at the same time as an interim injunction.

Obtaining an injunction

It is important for those representing the employer to draft the wording of the injunction to reflect the wording of the covenants as closely as possible.

• The test for an injunction

As in any other context, in order to persuade a court to grant an injunction to enforce a restrictive covenant, the ex-employer must establish three matters. First, that the ex-employer has a good arguable claim to the right which he seeks to protect, i.e. that there is a serious issue to be tried on the merits that the ex-employee is in breach of a contractual term. The normal position in relation to injunctions is that the threshold is not high and the court will not conduct a mini-trial; it will be sufficient that the claim is not frivolous or vexatious. However, in the context of restrictive covenants of limited duration the decision of the court is likely to render the decision at trial academic (as to the imposition of an injunction, although not as to damages and costs) due to the lapse of time between the interim application and trial. Accordingly, although evidence of breach is important, in reality the key issue for the court will be the enforceability of the clause.

Where the construction of the clause is a complex issue involving disputed facts, the court may be prepared to grant the injunction on condition that there is an expedited trial or alternatively a trial in respect of enforceability as a preliminary issue.

Secondly, that the balance of convenience favours the grant of an injunction. The court will take into account various factors in assessing the balance of convenience. The court will usually need to consider whether more harm will be done by the grant or refusal of an interim injunction. An injunction may be refused if it would be oppressive. Where the balance of convenience is unclear the court will favour maintaining the status quo.

Finally, the ex-employer will need to show that damages would not be an adequate remedy. This tends to be accepted by the court, given that it is inherently difficult to prove the loss that results from such competitive activity. Furthermore, as the defendant is an individual, there is often a substantial risk that any award of damages would not be satisfied. Where there has been significant delay since the potential breaches were identified then this may be more difficult.

• Notice applications and contractual undertakings

Except in cases of extreme urgency or secrecy, it is generally appropriate to write to the ex-employee or his solicitors putting him on notice that the ex-employer is considering obtaining an injunction, and seeking agreement to give an undertaking in the terms of the restrictive covenants set out in the employment contract within a short timeframe. If there is no response by the deadline, this can be used as further evidence in support of the injunction.

There is a considerable advantage in obtaining a contractual undertaking. An undertaking is generally enforceable regardless of whether a similarly worded contractual covenant would be regarded as unenforceable. For that reason, when acting for the ex-employee in circumstances where there are strong arguments that the restrictive covenants are unenforceable, it may be appropriate to decline to give an undertaking. Alternatively, it may be appropriate to negotiate a more restrictive undertaking maximising the client’s freedom to conduct his business, but which buys off the risk of costly and time consuming litigation.

It is important to bear in mind the difference between a contractual undertaking and an undertaking to the Court. A contractual undertaking has contractual status only, whereas an undertaking to the Court is equivalent to an injunction, in that breach amounts to a contempt of court with the potential sanction of imprisonment. In certain circumstances where trust between the parties has been completely eroded, it may be appropriate for the employer to insist on an undertaking to the Court.

• Without notice applications

If it is necessary, a without notice or short notice application for an injunction can be made within a very short period of time. On the subsequent return date at which both parties are present, a key issue may be whether the employer has complied with his duty of full and frank disclosure at the earlier hearing. Clients may have some difficulty with the requirements of this duty and it is essential to make detailed enquiries particularly where the employer and the ex-employee have a long history.

9 Are there any other potential defendants?

If representing the ex-employer, you should consider whether to join the ex-employee’s new employer as a further defendant. Whilst there is no contractual relationship between the two employers, the new employer may be guilty of the tort of interference with contractual rights (also known as inducing breach of contract) in enabling the ex-employee to breach his covenant with his ex-employer. The House of Lords has recently confirmed in Mainstream Properties v Young [2007] IRLR 608 that to establish such a tort it is necessary to show that:

• the new employer knew that he was procuring an act which was a breach of contract, or was recklessly indifferent to whether it was a breach or not; and

• the new employer intended to induce or procure a breach of contract. It is not enough if the breach of contract was neither an end in itself nor a means to an end, but merely a foreseeable consequence of the new employer’s actions; and

• that there was a breach of contract by the employee.

As a result it will generally be necessary for some evidence of the new employer’s intention.

Alternatively, a springboard injunction may be available to prevent the new employer from taking unfair advantage of the employee’s breaches of his previous employment contract (see USB Wealth Management (UK) Ltd v Vestra Wealth LLP [2008] IRLR 965).

10 Can the employee take pre-emptive action?

An employee may leave his employment in circumstances where it is clear to both himself and his ex-employer that he wishes to engage in activities that may be in breach of restrictive covenants. The ex-employee may want the peace of mind of trading without the threat of facing an injunction from his ex-employer.

If there are strong arguments that the covenants are not enforceable, for example where the employee has been wrongfully dismissed, then the employee should consider issuing proceedings seeking a declaration that he is not bound by the restrictive covenants, together with an expedited trial.