Restraint of Trade clauses – How effective are they?

It is a common misconception held by employees and contractors that restraint clauses are “not worth the paper they are written on”. This is far from the legal truth. The starting legal position is that restraint of trade clauses in contracts are void, unless reasonable, and operate to protect a legitimate business interest. Historically this was interpreted very narrowly, and most restraint clauses were not enforced by the Courts.

However, that is not so today. In this client alert we examine the mechanics of restraints, both for employees and contractors.

Restraint of Trade principles

Restraints are useful to business where it is necessary to protect the legitimate interests and goodwill of the business from exploitation by a former employee or contractor. This is often the case where a former employee or contractor has access to a book of clients and wishes to solicit the custom of those clients for the benefit of a competing business; or where a former employee or contractor has intimate knowledge of the business and its confidential information, that they could use to the benefit of a competing business.

Restraints of trade in the employment context cannot be used and will not be enforced merely to prevent competition. However, if there is a legitimate protectable interest and the restraint is reasonable then the Court will usually enforce them unless there is some public interest not to do so.

What is a Restraint of Trade clause?

Companies often wish to have their employees or contractors make an express contractual promise not to engage in competitive activities or to use the company’s confidential information after the termination of their employment or engagement. Most often, this is achieved by requiring the employees or contractors to execute contracts which contain restraint of trade and confidentiality clauses.

A restraint of trade clause in a contract which takes the form of an outright prohibition on competition without anything to justify such a restriction will be unenforceable. However, a restraint of trade clause that does no more than protect the employer’s legitimate interests and which is reasonable will usually be enforced.

The competing interests that the Courts must consider when asked to enforce a restraint of trade clause are:

• The interests of the employee in being able to earn a living using his or her legitimately obtained skill, experience and knowledge;
• The public interest in being able to obtain the services of the employee or contractor and the freedom of trade; and
• The company’s interest in protecting confidential information, customer connections, staff and supplier connections, which the company has expended time, resources and money to develop.

Are restraints really enforceable?

The answer to that is, yes – but it depends. More and more often, the Court has shown its willingness to hold employees to their contractual promises and enforce restraint of trade clauses that are reasonable.

So, what does the Court consider in determining whether to enforce a restraint?

The first question that must be answered, is what is the interest that the employer seeks to protect by having the restraint enforced, and is it a legitimate protectable interest? An employer cannot just seek to stop ex-employees from competing. To do so they must show that if the employee is allowed to compete, the employer will suffer real harm to a protectable interest. The recognised protectable interests are:

• Client connections;
• Confidential information; and
• Springboard conduct (conduct where the ex-employee uses their knowledge gained from the old employer to provide a springboard to another employer to gain the benefit pursued by the former employer).

Once there is a protectable interest identified, the Court will then determine whether the restraint clause seeking to be enforced is reasonable. In order to determine whether a restraint is reasonable, the Court will consider the duration of the restraint, and its geographical operation in so far as they are necessary to protect the protectable interest. For example, if the protectable interest is a salesperson’s client contacts, a duration clause that is longer than would be reasonable for a new salesperson to establish the same connections will be unenforceable as it is unreasonable. This would equally apply to a geographic area in which the salesperson had no client activity. Restraints that do not meet the test of “reasonableness” may be struck out by the Court, so prudently drafted contracts will draft these clauses with cascading degrees of length and breadth, expressed as a ‘cascading restraint’ so that a Court has the option to enforce a lesser period than was ultimately contemplated. It is worthy to note that in NSW, as a result of the Restraints of Trade Act 1976 (NSW), a NSW Court does not have to be bound by the contractual clause and can decide for itself what would be reasonable in the circumstances, and read down the clause accordingly.

Restraints applicable to employees are relatively straight forward; however, it can become more complex when dealing with restraints contained within independent contractor agreements as the goodwill and/or interests of the business can be hard to distinguish from the contractor’s own business interests.

Consequences of breach

We have recently had some dealings with a range of clients seeking information as to the consequences of taking up an opportunity with a potential competitor where restraint clauses exist in their operative contracts of employment. In such instances, there may be non-compete restraints, non-solicitation restraints or both and, in some cases, the period of restraint can be quite excessive, for example up to 24 months.

Assuming the existence of valid restraint clauses, where the new role with the potential competitor is materially similar to the role performed with their original employer and in circumstances where the relocation to the competitor could cause damage to the original employer’s legitimate business interests, there exists a very real possibility the old employer could seek injunctive relief from the Court to prevent the individual concerned from commencing with the competitor for a specified duration, or within a specified geography.

Another consequence of breaching a restraint, other than being forced to ‘sit-out’ for a period of time prior to commencing employment with a competitor, is a claim for damages against the employee or an ‘account of profits’. In circumstances where an employee commences with a competitor in breach of a non-compete clause or solicits business away from the old employer for the benefit of the new employer in breach of a non-solicitation clause, the original employer might seek the assistance of the Court to recover damages for the quantum of their loss arising from the breach. In this instance, a Court may make an order that the profits generated by the employee and enjoyed by the new employer be paid to the old employer to compensate for the breach of the restraints.

Employees should tread carefully if they are considering acting in breach of any contractual restraint clauses. They should not assume they will not be enforced. To the contrary they should assume they may be and seek advice.

What should employers do? 

Prudent employers should take the following steps to properly protect their business goodwill:

• Ensure their contracts are up to date and have reasonable confidentiality and restraint of trade clauses;
• Ensure that the restraint of trade clauses sufficiently protect the employer’s legitimate interests and are tailored to suit individual circumstances;
• Conduct exit interviews with former employees and contractors to remind them of their post-employment/engagement obligations;
• Write to high risk departing employees reminding them of their post-employment obligations; and
• If there is a concern the employee or contractor may be breaching restraint obligations, act quickly to put the employee or contractor on notice that the conduct is unacceptable, and the restraints will be enforced.

What should employees and contractors do?

Employees and contractors should carefully review their contracts and consider:

• Whether a restraint provision exists in the contract and the extent of its operation;
• If any restraint is overly burdensome or oppressive and seek amendment before executing the contract; and
• Treat restraints of trade clauses seriously and inform prospective new employers or principals of any post-employment or engagement obligations they owe.

If you wish to discuss any aspect of this client alert or require specialist advice or assistance in relation to an employment law matter, please do not hesitate to contact us.