Most sale of business contracts will include a restraint of trade clause designed to protect the purchaser by preventing the vendor from opening up a competing business nearby. As a purchaser or a vendor, it is important to know what kind of restraint is suitable for the type of business the vendor is selling and will depend on factors, such as:
- the industry the business operates in;
- vendor’s reputation in the community;
- vendor’s plans following the sale of business; and
- bargaining power between the parties.
We examine how parties draft a restraint of trade clause, the law regarding these provisions and set out the potential consequences for breaching a restraint of trade.
Drafting a Restraint of Trade Clause
The standard form contracts in NSW, QLD and Victoria include a general restraint of trade clause that applies to a range of circumstances and industries. The restraint clause prevents the vendor, for a specified period or geographic area, working for another business similar to the one they are selling.
The phrasing differs depending on jurisdiction. For example, in NSW, the standard form contract prevents the vendor from ‘being involved’ in the same or similar business in a range of positions such as manager, agent, director or shareholder.
In Victoria, the vendor cannot promote, carry on, assist with, participate in or be directly concerned with any business or activity which is the same or substantially similar to the business the vendor is selling. The Victorian clause is broader than NSW. Parties should then consider whether the standard form provisions are suitable.
When drafting a bespoke clause, a cascading clause usually protects the purchaser to the greatest extent possible. A cascading clause is one that progressively decreases (e.g. three years, two years, one year). If the parties do not provide different cascading options for restraint periods and distances, a court may rule that the clause has no effect because it’s too broad. Essentially, it acts as a fallback position should the vendor challenge the initial restraint as being unreasonable.
A cascading clause might look something like this:
- In consideration of and for the mutual benefit of all parties entering into this contract, the vendor must not, during the Restraint Period in the Restraint Area:
- Promote, participate in the operation of a café, undertake or enter into (whether on their own account or in partnership or by joint venture), the operation of a café;
- Be concerned or interested, directly or indirectly in any capacity including as principal, agent, manager, associate, partner, trustee shareholder, unitholder, director, employee, beneficiary, independent contractor, consultant, adviser or financier in, any café.
- Restraint Area means each of the following areas separately:
- 10 kilometres from the premises (or if this restraint area is not held to be reasonable);
- 5 kilometres from the premises (or if this restraint area is not held to be reasonable);
- 3 kilometres from the premises.
- Restraint Period means each of the following periods separately:
- 3 years from the date of completion (or if this restraint period is not held to be reasonable);
- 2 years from the date of completion (or if this restraint period is not held to be reasonable);
- 1 year from the date of completion
Courts interpret restraint of trade clauses depending on the facts of each case and prior determinations for similar businesses at the time.
Assessing a Restraint of Trade Clause
The leading case on this point is Nordenfelt v Maxim Nordenfelt Guns & Ammunition Co Ltd  AC 535 (‘Nordenfelt case’). Here, the key decision is that a restraint of trade is presumed to be unenforceable and void unless a party can justify that it is reasonable.
For a restraint to be reasonable, it must satisfy two requirements:
- it must be reasonable between the parties to the agreement; and
- it must not be harmful to the public interest.
A restraint will be reasonable between the parties if it gives the purchaser no more protection than what is reasonable. If the vendor challenges the restraint in court, the onus lies on the purchaser to prove the restraint was reasonable.
The first step in assessing reasonableness is to identify a legitimate protectable interest of the purchaser. A protectable interest is a property right or interest (for example, the business’ goodwill) but can also include commercial interests such as interest in confidential information, trade secrets or economies of scale.
A number of interests will be relevant when determining whether the restraint is reasonable, including:
- activities and conduct caught by the restraint;
- duration of the restraint (including whether it will continue after the contract between the parties comes to an end);
- geographical scope of the restraint;
- any benefits the vendor receives;
- commercial context (including standard practice in industry); and
- relative bargaining power of the parties.
The High Court noted in Geraghty v Minter (1979) 142 CLR 177 that they will determine reasonableness and validity at the time the parties entered the agreement.
While Australia’s position stems from the Nordenfelt case, the courts also consider the facts of each matter. For example, courts have held the following restraints to be reasonable:
- A two-year restraint across Australia was reasonable as the purchaser’s accounting practice operated Australia wide (Complete Business Strategies Pty Ltd v AFA Wealth Pty Ltd  QSC 043);
- A five-year restraint which stopped a partner who exited a partnership from competing with the business was held to be reasonable when the partner had contacted previous customers through a company his wife owned (Hunter v Koulouris  NSWSC 887).
Similarly, the court has dismissed a case where the restrained party’s son operated a business in direct competition with the purchaser, and the restrained party was the son’s landlord (WPS Enterprises Pty Ltd v Radford  VSCA 22).
As can be seen from an overview of these recent cases in the states of QLD, Victoria and NSW, the court’s interpretation of the validity and enforceability of a restraint is a fact-driven inquiry and will differ with each particular circumstance.
Consequences for Breaching a Restraint of Trade
If the vendor has violated the restraint of trade, the court may order an injunction (i.e. an order that stops a party from doing a particular thing) and/or damages. The court will calculate damages according to the lost income or profit the purchaser suffered as a result of the vendor’s actions in breach of the restraint.
The facts of the case will determine whether or not the purchaser suffered any actual loss, and if so, what amount the court should award.
Assessing whether a restraint of trade clause in a sale of business agreement is reasonable is driven by each case’s unique facts. It’s essential for any purchaser or vendor in a transaction to protect their interests while agreeing to some degree of compromise. Both parties should seek legal advice on the impact and validity of any restraint contained in the contract to determine whether the clause is suitable for your business, and whether enforceable. If you have any questions, get in touch with our business lawyers on 1300 544 755 or fill out the form.