Enforcement of Restrictive Covenant Clauses
If a party is buying a business then, more often than not, they will insist on a restrictive covenant clause being included in the Asset Purchase Agreement or Share Sale Agreement.
Including this clause means that restrictions will be placed upon on the selling party (and any related persons e.g. directors, shareholders etc.) from carrying on the same type of business within a certain distance from the business being sold and for a certain period of time. If a party is buying a business they do not want to find that the seller immediately sets up exactly the same business next door with most of their former clients returning to them.
The enforcement of restrictive covenant clauses by Courts has always been quite a grey area and, as a general rule, those clauses tend to be interpreted fairly strictly. The Courts are not keen to interfere with “free trade” and tend to take a fairly conservative approach in interpreting them.
A recent case involved the buyer of a business looking to enforce the restrictive covenant clause in their Asset Purchase Agreement. The restrictive covenant provided that “for a period of five years the seller would not operate, carry on or be employed, concerned, engaged or interested in any business in Scotland which was in competition with the business being sold.” In addition the seller provided not to give advice to any of its competitors.
The seller argued that the restrictive covenant was unreasonable in going further than was required and that a five year restriction was not justified.
The Court made some interesting comments namely:-
• The transaction was at arms-length and the seller had the benefit of legal advice – therefore the seller was aware of the implications of including the restrictive covenant clause in the Asset Purchase Agreement.
• The purchaser, in this case, had paid a significant price which pointed towards the restrictive covenant being a reasonable one. In addition the tangible assets of the business were of modest worth with the business’ real value lying in its goodwill. If the seller set up in competition then the value of the goodwill would be materially diminished.
• If the business was set up in any part of Scotland there was a high probability that this would damage the business acquired by the purchaser.
• A period of five years was reasonable in that the purchaser was entitled to a proper opportunity to develop its customer connection.
• The purchaser was paying the price over a period of time and the Court commented that it was clearly envisaged, by both parties, that the restrictive covenant would remain in place for the same period as payments were being made.
The Court, in this in this case, applied quite a liberal interpretation to the covenant wording.
If including restrictive covenant clauses in Asset Purchase Agreements or Share Sale Agreements it is important to balance both the interests of the purchaser in terms of protecting the goodwill that they have paid a price to acquire as also the interest of the seller to continue to trade freely.
This information in this publication is based on our current understanding of the Law. It has been produced for information purposes only. Professional advice should always be sought before taking any action.
Macleod and MacCallum cannot take any responsibility for loss incurred for acting or failing to act on the basis of anything contained in this publication.