Validity of Post-Acquisition Restrictive Covenants

In the recent case of Cavendish Square Holdings BV and another v BV Makdessi (2012) the Court held that restrictive covenants which had the effect of lasting eight and a half years following completion of a share purchase agreement (‘SPA’) were not an unreasonable restraint of trade and assessed the validity of penalty clauses by reference to the commercial justification test.

The facts

The target company (Team Y&R Holdings Hong Kong Ltd) was a large advertising and marketing communications group in the Middle East. The sellers were two individuals (‘M’ and ‘G’), leading business personalities who had built strong personal relationships with their clients. The Claimant (‘Cavendish’) owned 12.6% of the company and in 2008 agreed to purchase a further 47.4% of the shares. The share purchase agreement (‘SPA’) provided for payment of initial consideration and two tranches of deferred consideration, which would not be paid under certain circumstances.

In 2010 Cavendish discovered that M had acted in breach of his duties to the company as a director and in breach of his obligations under the restrictive covenants of the SPA by continuing to be involved and interested in a competitor company.

Cavendish sought a declaration that M, as a defaulting shareholder, was not entitled to payment of the deferred consideration and was required to sell his shares to Cavendish at the defaulting shareholder option price, as set out in the SPA. In defence M submitted that:

      i.        the restrictive covenants were an unreasonable restraint of trade; and

     ii.        that the provisions relating to loss of deferred payments and the forced sale of his shares were penalties, and therefore void.

Restrictive covenants

The restrictive covenants in question were non-compete provisions in the SPA. The duration of the restrictions was 24 months after the later of:

      i.        the date of termination of employment;

     ii.        the date of ceasing to hold shares in the company; or

    iii.        the date of payment of the final instalment of deferred consideration,

which amounted to eight and a half years from the date of the SPA.

The ruling

The Court held that the restrictions were not an unreasonable restraint of trade as:

  • Cavendish had paid substantial consideration in anticipation of there being substantial goodwill in the business;
  • the clause had been fully negotiated on a level playing field between lawyers for the seller and buyer; and
  • the period of eight and a half years was tied to a relevant interest of the Claimant (being the minority shareholding interest of the Defendant, its calculation and its deferred acquisition).

Penalty clauses

The court also considered whether the clauses setting out the consequences for a defaulting shareholder amounted to penalties, and were therefore void. Clause 5.1 signified a loss of rights to future payments and clause 5.6 a provision that M and G’s remaining shares were to be sold to Cavendish at their Net Asset Value.

The ruling

  • In relation to clause 5.1, as the payments were staged, a connection was made between the value of the goodwill purchased and the level of damage caused by any default. The earlier the default the higher the level of damage. If the default occurred prior to the payment of both deferred sums, both would be lost; if it occurred after payment of the first deferred sum, only the second would be lost. This was seen to be sound commercial reasoning and it was clear that the intention of clause 5.1 was not simply to deter. Clause 5.1 was therefore not a penalty.
  • Clause 5.6 served a commercial purpose, being the intention to de-couple the parties on a speedy and conventional basis. As such, the clause did not seek to act as a deterrent, and again did not amount to a penalty.
  • The court also gave weight to the fact that the clauses had been negotiated by solicitors and had not been shown to be oppressive.

Commentary

It should be noted that neither UK nor EU competition law applied on the facts. Under the European Commission Guidelines 2004 on ancillary restraints (which are also applied by the UK competition authorities) a three year non-compete period will generally be acceptable where both goodwill and expertise have been acquired, and a two-year period where only goodwill is involved.

It is significant that the judge specifically notes that there is no reported case in which a restrictive covenant which is otherwise reasonable has been held to be unreasonable purely on grounds of duration. The judgment also confirms that it is not always necessary for the duration of the restriction to be framed by reference to the completion date of an acquisition, and that a deferred restraint is capable of being upheld in appropriate circumstances.

The decision is also another example of a court explicitly deciding that a penalty clause issue can be assessed by a more flexible and commercial approach than the exclusive alternatives of either a genuine pre-estimate of loss or penalty.

This case indicates that a buyer would have the scope to build in more protection for itself when acquiring a company, particularly one which consists mostly of goodwill.

This article was written by Tristan Murtimer, Solicitor, with assistance from Emily Kozien-Colyer.

This guide is for general information and interest only and should not be relied upon as providing specific legal advice. If you require any further information about the issues raised in this article please contact the author or call 020 7404 0606 and ask for your usual Goodman Derrick contact.