Restrictive covenants and compulsory share transfer regimes

A recent Court of Appeal case considers the proper construction of restrictive covenants and suggests the possibility of such covenants applying without limit in time

12 May 2020

In the recent case of Guest Services Worldwide Limited v David Shelmerdine, the Court of Appeal considered the proper construction of restrictive covenants in a shareholders' agreement. Whilst not altering the traditional principles used to assess the enforceability of restrictive covenants, the case provides some important reminders for practitioners drafting such clauses. But perhaps more interesting is the enforceability of such restrictions in the context of a compulsory share transfer process where, if an outgoing employee’s shares are not acquired as part of that mechanism, they could be bound by the restrictions indefinitely.

The Facts

Mr Shelmerdine was a shareholder of Guest Services Worldwide Limited (GSW) and, having initially been an ‘employee shareholder’, was then appointed as a consultant to GSW. In his capacity as a shareholder of GSW, Mr Shelmerdine was party to a shareholders' agreement made between GSW and its shareholders (SHA). Clause 5 of the SHA contained a number of restrictive covenants that applied for such time as he was a shareholder and for a period of 12 months thereafter. Mr Shelmerdine ceased to be either an employee or a consultant and, as a consequence, it triggered a compulsory share transfer mechanism in GSW's articles of association. Ordinarily, the exiting employee’s shares would be acquired by the remaining shareholders (or the company) and the post-exit restriction period (in this case 12-months) would kick-in. However, as a result of a dispute, none of Mr Shelmerdine’s shares were transferred and he remained a shareholder.

Initial decision

Mr Shelmerdine’s argument that the restrictions were unreasonably wide and, as a result, an enforceable restraint of trade, was upheld. Had the restrictions ended 12-months after he ceased to be an employee or consultant, they would have been upheld. However, since there was no guarantee that the compulsory transfer mechanism would result in him ceasing to be a shareholder, the restrictions could last much longer, possibly indefinitely, and so were longer than necessary to protect the company’s legitimate business interests.

Court of Appeal

The Court of Appeal reversed the first instance decision, making it clear that GSW had a legitimate interest in seeking to prevent ‘employee shareholders’, who were likely to have detailed knowledge of the business, from competing with the company and soliciting clients. The court recognised it made no commercial sense that someone could avoid the restrictions simply by terminating their employment. The Court was quite clear that 12 months was reasonable even though it ran from when the individual ceased to be a shareholder rather than the cessation of their employment.

However, in reaching this conclusion, the Court stated that there was likely to be a short period of time between the cessation of employment and the share transfer due to the operation of the compulsory transfer provisions. The Court even recognised the possibility of a significant delay, but that in the context of a small private company, it considered it was unlikely the individual would remain as a shareholder indefinitely and, consequently, bound by the restrictive covenants.

Comment

Although most of the Court of Appeal’s comments on the enforceability of restrictive covenants come as little surprise, the case does highlight the risk that a compulsory share transfer regime which does not result in a transfer of shares could have the consequence of an individual, who is no longer an employee (and so not accessing key information or dealing with customers or suppliers), being indefinitely bound by restrictive covenants.

Notwithstanding the Court of Appeal upholding the enforceability of the restrictions, it is certainly possible that a court may in future take a different approach based on the specific facts and circumstances. Accordingly, to help mitigate against the risk of a different outcome, it may be worth considering defining the trigger for the run-off restriction period as either (i) the date on which the individual ceases to be an employee or, alternatively, (ii) where a compulsory transfer regime applies and the longstop date has been reached for the other shareholders/the company acquiring the employee’s shares (and those shares have not been acquired), from that longstop date.

This article is written by Danny Lee, with input from Nikoletta Zinonos. If you have any questions, please contact Danny Lee or your usual Burges Salmon contact.

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Danny Lee

Danny Lee Partner

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