Restrictive covenants in investment agreements: a cautionary note

Insight

05.12.2024

A recent case in the High Court is a reminder of the need to exercise caution in drafting restrictive covenants. This case involved Literacy Capital Plc (the Claimant) applying to the High Court for an injunction against Webb (the Defendant) for breaching restrictive covenants in an investment agreement and loan note. The High Court refused the application and held that the restrictive covenants were unenforceable because they were too long, geographically too wide and they restricted too broad a range of business activity.

Comment

The case highlights the need to draft restrictive covenants carefully. They should be reasonable and objective, and protect a legitimate business interest. Restrictive covenants should be drafted in a way which allows them to be severable so that if the court deems an element of any covenant to be unenforceable that element may be severed, leaving a more moderate but still enforceable covenant.

Background

The Claimant was an investment company which, through a chain of subsidiaries, acquired the Defendant’s 25% shareholding in Mountain Healthcare Limited (Mountain) for £4.7 million in 2018. £215,000 was paid in cash and the rest by way of a deferred loan. The Defendant signed an investment agreement and a loan agreement and stayed on as a director of Mountain.

In October 2021 she resigned as a director and renegotiated her exit by entering into two new agreements, both of which contained restrictive covenants:

an investment agreement; and
a loan note agreement.

The restrictive covenants stated that until the loan notes were repaid, and for 12 months thereafter, she would not:

“In the Restricted Area carry on, or be engaged, employed or interested in, any business which is of the same or a similar type to any Restricted Business and which is in competition with any Restricted Business;
in competition with any Restricted Business, deal or seek to deal with any person who at any time during the year prior to the Commencement Date is or was a Customer;
in competition with any Restricted Business, deal or seek to deal with any Prospective Customer”.

“Restricted Area” was defined as the United Kingdom and the Channel Islands.

“Restricted Business” was the business of any of the Claimant’s group companies carried on at any time during the 12 months leading up to the Defendant ceasing to hold loan notes.

In practice, as the loan notes were only payable in 2028, the time period of the restrictive covenants was an effective period of 10 years. In addition, the Defendant agreed to a 12 month covenant relating to her employment as a director.

In December 2021 the Defendant formed a company, Nurture Health and Care Limited (Nurture) which initially traded in unconnected sectors, but after the expiry of the Defendant’s 12-month ex-employee non-compete Nurture started to provide potentially competing services.

The Claimant argued the Defendant had breached the restrictive covenants in the agreements she had entered into when she left Mountain and so sought an interim injunction to enforce them against her.

Issues for the court to consider

Did the Claimant have a realistic prospect of succeeding at trial?

As this was an application for an injunction rather than a full trial the key question for the court was whether the claimant had a realistic prospect of succeeding at trial.

The court will uphold a restrictive covenant if it satisfies two tests:

- The covenant must be reasonable as between the contracting parties – it must protect a legitimate business interest of the beneficiary of the covenant and it must not go further than is reasonably necessary to protect that interest.
- The covenant must be reasonable in the context of the public interest. This is based on the idea that public interest favours liberation of trade in a free capitalist society.

The court decided that the covenants were clearly and plainly unenforceable and dismissed the claim.

Their reasoning was that:

- The covenants were so broad that they extended to a wide range of services, beyond just the business of Mountain, to bring other businesses in the Claimant’s group in scope. They were “far beyond the core of Mountain’s services … [and] … any legitimate protectable interest”.
- The maximum duration of the covenants was 10 years (the renegotiated nine-year term of the loan notes, plus a further 12 months). This was “far past the duration allowed in ex-employee cases and in sale of business cases”. The court commented that such duration would have prevented the Defendant from working in her chosen field until retirement age which, again, went far beyond protecting the Claimant’s legitimate interests.
- Mountain could not demonstrate that it had business beyond two counties in eastern England and therefore the geographical scope of the covenants (the UK and the Channel islands) was not justified.

Could the restrictive covenants be severed by the court to make them partly enforceable?

If the court finds that a restrictive covenant is unreasonable it can strike out the offending part of the covenant to make it reasonable, and therefore enforceable. To be severable, a provision must be capable of being removed without adding to the remaining wording. The court can only exercise this power if the covenant makes sense once the offending section has been severed.

The court determined that the agreements in this case were not drafted in a way which made it possible to sever the covenants and therefore all aspects of the restrictive covenants were deemed unenforceable.

Impact

The outcome of this case is unsurprising, and the principles reflect market practice in relation to restrictive covenants. Ambitious drafting of covenants that are too extensive in terms of time or geography are unlikely to be enforceable, and this case provides further evidence of the court’s approach to strike out unreasonably onerous restrictive covenants. The decision brings into focus the need to carefully consider the extent of covenants and whether they are reasonable during any negotiation or drafting process.

The key points to consider when dealing with restrictive covenants are:

Duration of the covenant. When an agreement involves an employee any covenant of more than 12 months is likely to be considered unreasonable. In a non-employment context such as the sale of a business, there is no fixed limit after which a covenant will be considered unreasonable but the longer the covenant lasts the more likely it may be deemed unreasonable. The covenantee should ensure that the duration of the covenant is necessary to protect a legitimate interest.
Range of restricted business. The covenant should be limited to the type of business that the covenantee is carrying out and not extend beyond that even if other members of the same corporate group operate in different sectors.
Geographical extent. The geographical scope of the covenant must not go beyond what is reasonable and extend only to the designated area where the business currently operates and/or align with clearly identifiable areas of planned expansion.
Sophistication. The more sophisticated a party, the more likely the court is to uphold a restrictive covenant so there may be more flexibility when both parties are sophisticated businesses rather than individuals.
Bargaining strength. If the covenantor is in a substantially weaker position in the negotiation, such as in an employee-employer situation, the courts are more likely to decide that the covenant is unreasonable.
Legal advice. While the courts will generally assume that a party has taken legal advice and consequently understands the nature of the covenants they are entering into this does not preclude the court from finding that a restrictive covenant is unenforceable purely on the basis that the party took legal advice.

You can read the full judgment here.

Many thanks to trainee Emily James for their help in writing this article.

This publication is a general summary of the law. It should not replace legal advice tailored to your specific circumstances.