Restrictive Covenants: What is reasonable?

In Quantum Actuarial LLP v Quantum Advisory Ltd [2021] EWCA Civ 227 the Court of Appeal provided helpful guidance as to when restrictive covenants will be considered reasonable.

Introduction

It is not uncommon for commercial contracts to include restrictive covenants which seek to prevent a party taking certain steps.  For example, many employment contracts will include provisions prohibiting certain steps from employees for a period after the employment ends; similarly, share purchase agreements may seek to limit the sellers from setting up in competition with their previous business.

However, there are limits on what restrictions one party can seek to impose on another.  The general principle is that any clause which seeks to prevent a party doing business with another party must extend no further than legitimately required to protect the other party’s interest.  This is because, as a matter of public policy, freedom to trade, and to protect competition, is fundamental.  This is referred to as the “restraint of trade doctrine” (“Doctrine”).    

The Doctrine states that a restraint of trade clause will be invalid unless it is:

1. designed to protect a legitimate business interest;
2. no wider than reasonably necessary to protect that interest; and
3. not contrary to the public interest. (Esso Petroleum Co Ltd v Harper's Garage (Stourport) Ltd [1968] AC 269).

Traditionally, when deciding whether a covenant engages the Doctrine, the courts have applied the ‘pre-existing freedom test’.  In other words, the Courts have asked whether the party is giving up a pre-existing freedom when entering into the covenant. If, prior to the covenant, it was entirely free to trade as it wished, the Doctrine would apply.

However, in the Supreme Court case of Peninsula Securities Ltd v Dunnes Stores (Bangor) Ltd [2020] UKSC 36 (“Peninsula”) the Supreme Court instead suggested that a “trading society test” should apply, i.e. the Court should consider whether the  restraint of trade is of a sort which has become generally accepted as appropriate to the type of transaction in issue.  If it has, then the Doctrine does not apply and the restraint is enforceable. 

In Peninsula, the dispute arose from a restrictive covenant given by a landlord to a commercial tenant under an anchor lease, with restrictions placed on the landlord preventing it from taking on other leases for similar businesses within the same shopping centre.  The Supreme Court accepted that such restrictions are accepted as a matter of commercial practice when granting leases in shopping centres, and therefore the covenant had not engaged the Doctrine. 

The facts in Quantum Actuarial LLP

In 2004 by a company called Quantum Advisory Ltd (“Quad Ltd”), which provided actuarial services for defined benefit pension schemes, formed a joint venture.  The joint venture vehicle, RPS, offered similar services to Quad Ltd.  The aim was that, after 3 years, RPS and Quad Ltd would merge.

By 2007, the majority shareholder in Quad Ltd wanted to move on but buying him out was not possible so a restructure was instead agreed.  The agreement was that a new LLP (“Quad LLP”) would be set up to look after the legacy clients of both Quad Ltd and RPS, in exchange for a fee.  Effectively, the goodwill of both Quad Ltd and RPS was ringfenced, and the Service Agreement (“SA”) contained covenants preventing Quad LLP from interacting with any of Quad Ltd’s clients in particular ways, for example from obtaining instructions from or undertaking defined services for any of those clients (“LLP Covenants”). It was agreed that the LLP Covenants would be in place for the duration of the agreement and one year beyond.  Initially the parties had discussed a term of 10 years, but this was extended to 99 years, with the LLP Covenants to last 100 years.

The parties operated under the SA without material difficulty for a number of years. However, Quad LLP grew dissatisfied with the fact that it was carrying on a significant part of its business activities on a basis that provided profit for other companies.  In 2018 Quad LLP notified Quad Ltd that it intended to proceed on the basis that the LLP Covenants were an unreasonable restraint of trade.  Quad LLP stated that the LLP Covenants should be amended to ones which would be “reasonable”, being between 5 and 10 years – leaving Quad LLP free to deal with whoever it saw fit.   

Court of Appeal judgment

In support of its case that the LLP Covenants were unreasonable, Quad LLP argued that:

• As a result of the Peninsula decision, the pre-existing freedom test had fallen away. Further, the SA was sufficiently unusual that it failed the ‘trading society’ test set out in Peninsula;
• There had been an imbalance of bargaining power in the negotiation of the SA; and
• Quad Ltd had no legitimate interest which could sensible be protected for a century. The absence of a legitimate interest, together with the breadth of the clause, rendered it unreasonable.

The Court concluded that the doctrine of Restraint of Trade did not apply to the LLP Covenants. It held that the trading society test could not be of universal application, otherwise an entirely novel kind of contract would also attract the application of Doctrine which, the Court said, would be ‘a most surprising result’.

Instead, the Court was at pains to stress that the SA needed to be considered on its own terms and circumstances. Whilst the SA was a private bespoke agreement created in very specific circumstances, it did fall within the ambit of one type of contact identified in Esso as satisfying the trading society test – namely, where a vendor sells a business and covenants not to compete. Here, Quad LLP was carrying out the business, but not acquiring it. The situation was “the mirror reverse” of the vendor-purchaser situation.

On the imbalance of bargaining power, Quad LLP argued that the SA was the product of discussion between three colleagues, out of whom only one had any financial interest. In addition, Quad LLP had had no separate legal representation, unlike Quad Ltd. The Court disagreed; the SA was entered into by sophisticated professional parties.

Quad LLP also argued that the length of the LLP Covenants was unreasonable, with the term of 99 years having only been agreed late in the negotiations.  Again, the Court disagreed, noting that the Covenants were the front and centre of the main operative provision in the SA.  The Court felt that neither the timing or circumstances of the extension of the terms gave rise to any cause for legitimate concern. The extension of the term was significant but it was also clear and obvious.

The Court noted that Quad LLP had no prior existence or business before the SA. The SA was therefore the essential condition of Quad LLP’s ability to carry on business at all and could not be considered a restraint of trade, but rather a means of providing the opportunity to trade. The LLP Covenants were not oppressive, but rather fairly and properly ancillary to the appointment of Quad LLP to provide the Services.

Conclusion

It is clear from both the Peninsula case and the Quantum Actuarial case that, when reviewing restrictive covenants, the Courts are very much looking at the drafting in context.  That context will include the sector in which the parties operate, established commercial practice and the companies and individuals involved.

It is worth noting that, while the Court held that the trading society test could not be of universal application, they did not identify an alternative test which is to be applied in circumstances where the trading society test is inappropriate. It remains to be seen whether this omission will open the way for a further appeal to the Supreme Court.

At this stage, however, parties should consider context carefully when entering into restrictive covenants.  Parties entering into contracts with lengthy restrictive covenants should not automatically assume they will be unreasonable.