Tue 25 Feb 2020

Court decision on Shareholders' Agreement restrictive covenants welcomed by businesses

Court of Appeal finds restrictive covenants can be enforced despite potential for indefinite application.

Where an employee, agent or director of a business is also a shareholder, termination of their position may trigger compulsory share transfer provisions under either the company's articles of association or a shareholders' agreement.  Usually these provisions being triggered result in a deemed offer to sell shares either to other shareholders or back to the company.  Shareholders' Agreements will commonly include restrictive covenants preventing, amongst other things, the individual who is leaving the business from setting up in competition for a period of time following termination.

The case of Guest Services Worldwide Limited v Shelmerdine considered a scenario where no purchaser is found for the shares resulting in the individual leaving the business having no active interest in it but being subject to restrictive covenants for an indefinite period of time.  

Mr Shelmerdine was a consultant and shareholder, and was subject (as an "Employee Shareholder" as defined in the shareholder agreement) to the restrictive covenants set out under the shareholders'  agreement.  The restrictions applied for as long as an individual remained a shareholder and for a period of 12 months thereafter. 

The consultancy ended in February 2019, and the termination triggered compulsory transfer provisions set out in the articles of association.  Following the price of the shares being determined the other shareholders could purchase Mr Shelmerdine's shares.  If they did not do so the shareholder could sell to a third party, if such a purchaser could be found.  If no purchaser was found Mr Shelmerdine would remain subject to the covenants, potentially indefinitely. 

After Mr Shelmerdine's consultancy ended the Company took steps to enforce the covenants contained in the shareholders' agreement.  Before the High Court, Mr Shelmerdine argued that, firstly, the restrictions only applied to those who were Employee Shareholders - as his position was terminated he no longer met that requirement and accordingly the restrictions could not apply to him.  Secondly, he argued that even if the restrictions continued to apply to him the possibility of them applying indefinitely meant they were unreasonably wide and therefore an unenforceable restraint of trade.  The High Court accepted both these arguments so the Company appealed.

The Court of Appeal disagreed with the High Court on both counts.  As regards the first argument, the purpose of the provisions were to protect the company for 12 months after a person ceased to be a shareholder - if they no longer applied as soon as Mr Shelmerdine's consultancy ended then their inclusion in the Agreement was pointless. 

The Court also found that the 12 month restriction was enforceable.  The Company had a legitimate interest to protect, the restrictions appeared in a shareholders' agreement (rather than an employment contract of any sort) and 12 months was a reasonable period of restraint even though it ran from the date Mr Shelmerdine would cease to be a shareholder and not the date of termination of his consultancy.  While there was a risk of delay in the shareholding being transferred, in the context of a small private company it was very unlikely that a shareholder would be kept locked in indefinitely.

This judgement demonstrates the courts willingness to put practical realities ahead of possible but "extremely unlikely" scenarios when considering restrictive covenants in shareholders' agreements.  In coming to its conclusion the Court noted that while restraint clauses in employment contracts had to be subject to very rigorous and careful scrutiny, and only enforced if they went no further than was necessary to protect the interests of the employer, restraint provisions in shareholders' agreements require less rigorous scrutiny having been made between "experienced commercial parties".  The case demonstrates the value of including restrictions in shareholders' agreements and not just employment agreements when dealing with employees who are also shareholders.

The Court in its judgement did though consider another case which made the point that the context will need to be considered when deciding whether a covenant is enforceable in a shareholders agreement. In that case the point was made that non compete provisions which are part of a wider commercial transaction involving, for example, the sale of a business will generally be enforceable. At the other end of the spectrum there might be an ordinary employee who has been granted a small shareholding only. As such, it cannot be assumed that restrictive covenants in shareholders' agreements will always be upheld.

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