Restrictive covenants and penalty clauses: an update from the Court of Appeal

8 minute read
10 December 2013


Public policy dictates that competition is a good thing, as it means choice and competitive pricing for customers. However, those paying substantial sums to acquire businesses sometimes, understandably, take a different view.

There is a long line of cases covering the extent to which buyers can legitimately keep sellers out of the same market following a sale. This is usually done by contractual covenants, whereby the seller agrees not to take certain actions for a defined period. These restrictions may be backed up by provisions entitling the buyer to payment of specified amounts if the seller later breaches the covenants.

Sellers who are alleged to be in breach of these kinds of restrictive covenant have traditionally attacked their validity on two separate grounds:

  • that the restriction is an unlawful restraint of trade, going further than is required (either in time or in geographical scope) to protect the legitimate interests of the buyer; and
  • that any payment required for alleged breach of the restrictions is a penalty clause (i.e. the amount payable grossly exceeds the loss that could actually flow from the breach of contract, so the restriction is there purely to deter the seller from contemplating any such breach ).

In our earlier alert, we reported on the High Court decision in Cavendish Square Holdings BV and Team Y&R Holdings Hong Kong Ltd v Talal El Makdessi [2012] EWHC 3582 (Comm). That judgment gave support to buyers who are prepared to pay a premium for protection from competition after the sale completes. However, the Court of Appeal has now partially overturned that decision.

The case

A company in the WPP advertising and marketing communications group held a 12.6% shareholding in TYR - a prominent advertising and marketing business active in more than 20 countries in the Middle East.

In 2008, the WPP group company (WPP) acquired a further 47.4% of TYR's shares, taking the total WPP group holding in TYR to 60%. The price for the 47.4% holding was a maximum of around $150 million, payable partly on completion and partly by way of future instalments. This was against a net asset value for the whole of TYR's business of around $70 million. The sale and purchase agreement (SPA) also contained put options under which the sellers could force WPP to buy the remaining 40% of TYR at a price based on a profit multiple.

TYR's business had been built up mainly on the back of personal contacts established by its proprietors, one of whom (the defendant) was prominent in Lebanese business and society. It was not surprising therefore that WPP insisted that the SPA contained extensive non-competition covenants from the sellers.

The non-competition covenants were expressed to continue in force until two years after WPP acquired all of TYR's issued shares under the above options (or after earlier termination of the sellers' employment/directorships). This could have been as late as 2016, or around eight and a half years after completion of the SPA.

The SPA also provided that if there was any breach of the non-competition covenants:

  • WPP no longer had to pay a penny of the future instalments of the price for the 47.4% holding
  • the sellers lost their put options; instead WPP had an option to acquire the remaining 40% of the shares at a lower price (based on net asset value)

In spite of the very large amounts paid to the sellers, and the even larger amounts due in the future, the sellers carried on competing businesses after completion of the SPA. They did so at a time when they were either directors or employees of TYR. This meant that, leaving the SPA aside, the sellers were in breach of their fiduciary and other duties to TYR as its directors/employees. TYR sued them for those breaches and the action was settled with a payment of US$500,000 from the sellers to TYR.

WPP also pursued the sellers separately for breach of the restrictive covenants in the SPA. The sellers responded that the covenants and price adjustment clauses were unlawful and unenforceable because:

  • their duration was excessive and in restraint of trade
  • the forfeiture of future instalments of the sale price (which could have amounted to as much as $82 million) was an unlawful penalty

The High Court had rejected both of these arguments. It found that the provisions had been freely negotiated between sophisticated parties with expert advisers and that

  • the duration of the restrictions was not unreasonable in all the circumstances; and
  • the amount lost by the sellers was not disproportionate given the very substantial amount paid by the buyer for goodwill (i.e. over and above the asset value of the business)

There was no appeal on the first of those issues. However, the Court of Appeal upheld the sellers' appeal on the second issue. It pointed out that any breach of the restrictive covenants, however insignificant, meant that the buyer did not have to pay a penny of the future instalments. So, for example, if the sellers had made a single unsuccessful attempt to solicit business in breach of the restrictions, it could cost them $82 million.

That amount bore no possible relation to the loss actually caused to the buyer by that action. The buyer had insisted on the forfeiture provisions in an attempt to penalise the sellers for any breach of the restrictions or to deter them from any such breach. Penalty clauses of this kind are not enforceable in English law.

El Makdessi v Cavendish Square Holdings BV and another [2013] EWCA Civ 1539.

Action points

This case should certainly not be taken as authority that eight year restrictive covenants will be valid in every case. The fact that this aspect of the High Court judgment was not appealed may mean only that the sellers were confident that they had a strong case on the issue of penalty clauses. Any restrictive covenant must still pass the test of going no further than is required for the protection of the buyer's legitimate interests.

It should also be noted that neither UK nor EC competition rules applied in this case. Where those rules apply, any agreement restricting competition must clear additional hurdles. Published guidance states that a non-competition agreement is justified for a period of up to three years where both goodwill and know-how are transferred, but only up to two years where goodwill alone is transferred.

However, these are only the broadest starting points and each transaction must be considered on its own specifics. The geographic scope and subject matter of any restrictions must also be appropriately limited by reference to the specific business involved.

Accordingly, in framing non-competition clauses in an acquisition agreement, it is essential to analyse:

  • the respective bargaining strengths of the parties; is there a 'level playing field' or is one party in a position to force unreasonable terms on the other?
  • the extent to which value is being given for any restrictions accepted by the sellers; and
  • the relationship between the loss which will flow from a breach of covenant on the one hand and, on the other, any provisions of the agreement which deprive the sellers of future payments or other benefits on breach; if the amounts the sellers stand to lose are excessive in relation to the likely loss to the buyer, these provisions are likely to be invalid.

The nature and location of the target business should also be carefully considered before deciding what restrictions are reasonable and justifiable in each case. Any relevant anti-trust or competition legislation must also be identified and complied with.

The case has no relevance to the validity or otherwise of restrictive covenants in contracts of employment. Courts approach these on the assumption that there is rarely, if ever, a 'level playing field' as between employer and employee. It is therefore much more difficult to show that a lengthy restriction is reasonable and necessary and has been entered into of the employee's free will.

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