Unfair by definition
April 2021
Rating system:
Reading time (mins): 4
Sophistication level (1 (idiot) – 10 (expert)): 7
Entertainment value (1 (turgid) – 10 (side-splitting)): 4
Background
The law says that a restrictive covenant cannot be enforced if it is worded in a way which could in some circumstances make it more onerous than is reasonably necessary to protect the other party’s legitimate business interests.
The courts are usually very ready to say a restrictive covenant is unenforceable if they see anything about it which could possibly make it unfair in certain circumstances (even if those circumstances never actually ended up happening). This previous article Restrictive covenants case – form over substance shows a good example.
Every case has to be judged on its own facts and merits, which makes it very difficult to know in any particular case when drafting a contract what level of covenants it will be reasonable to include.
Courts are more willing to uphold covenants by people selling their shares in a company than they are with covenants by employees in their employment contracts. This makes good sense, particularly where sellers are getting good money for their shares and don’t need another job, and generally have more bargaining power.
Courts are also as a rule more willing to uphold covenants by minority shareholders in shareholders agreements, including where those shareholders are employees.
One standard type of restrictive covenant says that you mustn’t get involved with a business which competes with the other party’s business for a period of time after your contract ends. If this period might be longer than reasonably necessary to protect the other party’s legitimate business interests it will be completely unenforceable. The court doesn’t have the general discretion to insert a shorter period which would have been acceptable.
So, was the Court of Appeal’s decision right in this recent case?
Recent case
Mr Shelmerdine had founded a business which produced promotional maps for distribution to the guests of various luxury hotels around the world. It made money from advertising fees paid by local businesses shown on the maps. Mr Shelmerdine sold the business in 2011 to a company which later went bust. Another company, Guest Services Worldwide Ltd (‘GSW’), then bought the business off the administrator. GSW took Mr Shelmerdine on, originally as an employee and later as an agent/ consultant. He also became a shareholder, with about 10% of the shares, and signed a shareholders agreement.
The company’s bespoke Articles of Association defined an ‘Employee’ as ‘any person who is or has been a director, employee, consultant or agent of the company’. They had quite standard compulsory transfer provisions which said that any Employee shareholder who ceased to be an Employee would immediately be deemed to have offered all their shares up for sale to other shareholders for a ‘fair value’, following which if the shares were not purchased as a result of the operation of the pre-emption mechanism, the shareholder could sell them to a third party.
The shareholders agreement had a definition of ‘Employee Shareholders’ as any shareholder who was also an employee, agent or consultant, and it stated specifically that Mr Shelmerdine was currently an Employee Shareholder. It contained various restrictive covenants on Employee Shareholders, such as not to be involved with a competing business, and not to go after the company’s customers. These covenants were to apply for so long as an Employee Shareholder remained a shareholder and then for 12 months after he ceased to be a shareholder. Mr Shelmerdine’s consultancy agreement came to an end in 2019. This would have triggered the compulsory transfer provisions under the Articles, but for various reasons by the time of the court case none of the other shareholders had bought Mr Shelmerdine’s shares.
Shortly after the consultancy agreement ended Mr Shelmerdine did various things which the company said were in breach of the restrictive covenants. So the company sued him.
The trial judge agreed that the company did have a legitimate business interest to protect, and Mr Shelmerdine could be treated as an experienced commercial party (rather than just a humble employee), and that therefore it would be legitimate for the shareholders agreement to contain reasonable restrictive covenants. However, he ruled that the restrictive covenants in the agreement were unenforceable, for one of two reasons:
- The ‘construction issue’: the judge read the definition of ‘Employee Shareholder’ to mean that the covenants were only meant to apply to shareholders so long as they remained employees or consultants. So they stopped applying at all as soon as Mr Shelmerdine stopped being a consultant.
- The ‘duration issue’: the judge said that if he was wrong on the construction issue, and the drafting meant that the covenants did apply to shareholders after they had ceased to be employees or consultants, then the restrictive period was unreasonably long because the restrictive covenants would continue to apply for so long as he remained a shareholder (let alone for another 12 months after he ever ceased being a shareholder) even though he might long ago have ceased to be an employee or consultant. He said that Mr Shelmerdine “could remain subject to the restrictions for a potentially indefinite period whilst he remains a shareholder before he can be bought out, if indeed, he is bought out at all . . .”.
The company thought this ruling was unfair, so it appealed to the Court of Appeal.
What did the Court of Appeal decide?
On the construction issue, the Court of Appeal said that the shareholders agreement couldn’t be read to mean that an ‘Employee Shareholder’ ceased to be an ‘Employee Shareholder’ as soon as they ceased to be an employee or consultant, as that would make a nonsense of much of the agreement, and would also not be consistent with what the company’s Articles of Association said.
But on the duration issue, the Court of Appeal said that the 12 month post-termination restrictive period was reasonable and therefore enforceable, even though time would only start to run from when Mr Shelmerdine ceased to be a shareholder.
Comments and tips
- The Court of Appeal’s decision on the construction issue makes some sense. But it does then mean that an ‘Employee Shareholder’ must by definition continue to be an ‘Employee Shareholder’ for so long as they remain a shareholder, even after they cease to be an employee or consultant.
- There seems to have been no certainty in this case that Mr Shelmerdine would ever cease to be a shareholder of the company if the other shareholders weren’t going to take up their compulsory purchase rights under the Company’s Articles. So the decision on the duration issue seems wrong to me. It meant that Mr Shelmerdine could actually end up being bound to the restrictive covenants for ever, if he never managed to sell his shares.
- One of the problems of being a minority shareholder in a private company is that you can be stuck with a minority shareholding and have no way to sell it (at least for a decent price). So this is yet another thing (see my last article Fair’s fair? Minority shareholders beware for others) to be careful about if you are an employee or consultant of a company and are offered shares in it, as the way this case was decided means that if you stop being an employee or consultant you could end up being prevented from working for a competitor ever again in the future!
- Just being a shareholder in a company does not make you a threat to the company. It does not necessarily give you give you rights of access to any sensitive information about the company which might make you a threat to the company. So it’s not necessarily fair to say someone cannot be involved in a competing business just because they are a shareholder. Shareholders don’t owe particular duties of care to their company – unlike directors and employees.
- It would have been perfectly possible and simple to have drafted the restrictive covenant provisions in a clearly more reasonable way, for example by saying the duration period of the restrictive covenants lasted so long as an Employee Shareholder was an employee or consultant, and then for another year after they ceased to be an employee or consultant.
- Once again a lot comes down to courts having to make sense of unclear and imprecise drafting. You have to try to be very careful whenever you draft any legal agreement, particularly when it comes to defined terms. Defined terms are very important. You have to think about how they might work in every situation which might arise.
- Here are some other previous articles I have written on this subject, worth reading if just for the tips and comments at the end:
Case: Guest Services Worldwide Ltd v Shelmerdine [2020] EWCA Civ 85 (2020)
