Non-competes and non-solicits in a sale of business context

Restraints in the context of a sale of business are more likely to be enforceable than employment restraints, but the courts continue to show a tendency towards taking a strict approach when assessing if they go beyond what is reasonably necessary to protect the legitimate interest being protected.

In a recent decision, the Supreme Court of Victoria has found a series of restraints against former employees in the context of a sale of business to be unenforceable and unreasonable, despite there being legitimate interests in which the plaintiffs were seeking to protect (i.e. the goodwill of the target being purchased).

In brief

• Escala Partners (Escala) attempted to restrain certain employees (two of which were also sellers) who left Escala and joined LGT Crestone Wealth Management Ltd (LGT Crestone) in October 2023 from working in the wealth management industry until expiry of all restraint periods.
• After a series of injunction attempts and appeals, Escala was denied damages and injunctive relief on the basis that none of the covenants or restraints in the former employees’ employment contracts and other documents (being a SPA, Shareholders Agreement and Management Deed) (the Agreements) were enforceable, as they went further than what was reasonably necessary to protect the legitimate interests of Escala.
• Key considerations involved questions of scope (where a restraint which extended to all clients of Escala, not just the clients of the former employees, was found unenforceable), and duration (where a five year restraint against the former employees under the SPA was held to be unreasonable).

Background

In 2nd Chapter Pty Ltd & Ors v Sealey & Ors (No 2) [2024] VSC 672, the Supreme Court of Victoria considered the enforceability of restrictive covenants on former employees contained in the Agreements. The restraints were entered into in connection with the acquisition of the Escala business by Focus Financial. Two of the former employees, who performed investment and financial advisory services for Escala, disposed of their shares in Escala as part of the sale to Focus Financial and became shareholders in the special purpose management company established for the acquisition.

Approximately three and a half years after the acquisition, the former employees left Escala and commenced employment with LGT Crestone. Escala attempted to restrain these former employees following their departure, relying on various restraints contained in the Agreements.

While Matthews J accepted that there were legitimate interests which Escala was seeking to protect (namely, the protection of the goodwill of the Escala business and protection of the customer connections), the Court found that none of the employment restraints in any of the Agreements were enforceable.

Key takeaways

While case law on restraints is highly fact specific, the judgment highlights that:

• (only what is reasonably necessary) only a restraint that is “no more than is reasonably necessary” will be enforced – this is a high standard and an overzealous approach to protecting a buyer’s interests may lead to the restraint as a whole being held to be unenforceable;
• (valuable consideration not determinative) even if a buyer spends considerable money on an acquisition, that alone is not sufficient to justify heavy restraints applying to all key persons irrespective of their relative shareholdings or positions in the business and consideration cannot cure fundamental issues of scope (though the Court leaves open the possibility that a robust restraint may be enforceable in the context of a key founder with a considerable shareholding who was personally involved in the negotiations);
• (scope is critical in all contexts) while restraints in a shareholders agreement may protect a legitimate interest (being the preservation of ongoing revenue through the protection, for example, of customer connections), the scope of such restraints must still be appropriately drafted and their purpose should not be to lock-in individuals;
• (SHA may be assessed in the employment context) where a person’s ongoing shareholding is linked to their employment, a court will likely assess any restraints in an employment context rather than a sale of business context (meaning they are less readily enforceable); and
• (Court cannot read down and amend) if the scope of a restraint is too broad, a court does not have the power to read it down – the court can only omit words, and cannot add words or amend drafting to refine its scope.

Why the restraints were unenforceable

The key factors taken into account by Matthews J in considering the enforceability of the restraints involved questions of scope, duration and confidentiality. The Court’s findings in relation to each of these are summarised below.

Scope of the restraints

While this was a context in which restraints are expected and an appropriately drawn restraint would likely be acceptable to the Court, the scope of the restraints must be appropriate. In this case, the restraints within the Agreements extended to non-solicitation of clients with which the former employees had no dealings with and no personal connection with (i.e. any clients of Escala, not just each former employee’s personal clients).

Escala contended that through access to company records, attendance at client events, participation in company meetings and general office discussions, the former employees had access to the identities of clients and potentially their fee structures which could allow them to offer those clients the same services on better terms.

The Court determined that even with access to that information, the close personal connection between advisor and client did not exist for clients of Escala who were not clients of the former employees, and therefore there was no relationship of trust or connection to be protected which was a negligible risk to Escala. The application of the restraints to solicitation of, or accepting approaches from, clients with whom restrained persons had no dealings went further than reasonably necessary to protect the legitimate interests of Escala.

On the question of whether the problematic aspects could be severed or read down, the Court found that it could only use the ‘blue pencil’ principle to omit words, but not add in or alter the drafting to render it enforceable. In this case, the principle could not be applied to give the scope of restraint an acceptable operation, and therefore the restraint as a whole was unenforceable.

Duration of the restraints

The following findings were made in relation to the duration of the restraints:

• the restraint under the SPA which lasted for a maximum of five years post completion was unreasonable, particularly in circumstances where the employees held shares in 2nd Chapter Pty Ltd (the bidder SPV incorporated to manage the Escala business) amounting to less than 0.1% of shares and 6.2% of shares respectively. The Court focused on the fact that no attempt was made to differentiate the duration of the restraint based on the size of each seller’s stake. The Court did however note that such a restraint may be reasonable for employees with larger amounts of equity;
• the restraint under the Management Deed was found to be unenforceable, including because it was tied to the termination of another document which could occur at any time at Escala’s election, and not necessarily tied to when the former employees ceased with Escala;
• the restraint under the Shareholders Agreement, which had the potential to last up to four years post-resignation, was unenforceable as no reasonable justification for a restraint of that length had been established. The Court viewed the restraints in the SHA in the same light as those in an employment context, which are more difficult to enforce, notwithstanding that the shareholders were receiving dividends (which could be argued to be partial consideration for the restraint); and
• the cascading restraint under the Employment Agreements was not considered in detail given a finding had already been made as to unenforceability on grounds of scope, but Matthews J noted that a 6 month or 3 month period post-employment for the restraint would be reasonable, rather than 9 or 12 months.

Confidentiality

Escala also sought to argue that there was a real risk that the former employees could take Escala’s clients and confidential information to LGT Crestone, or use confidential information obtained through their employment with Escala (such as the identities of clients, portfolio sizes and pricing structures) to offer to provide the same services at a lower cost to those clients.

While it is well established that employers have a legitimate interest in protecting confidential information, trade secrets, and the employer’s customer connections, the Court found that the risk that the former employees could misuse this confidential information was already protected against by confidentiality obligations within the Agreements, statutory obligations or obligations imposed in equity, and the restraints did not need to be relied on to address this risk.

Further commentary

Importantly, the Court noted that if the restraints applied only to clients with whom the restrained persons had dealings, it would allow those restraints to encompass both restrictions on solicitation and acceptance of approaches from clients. This serves as an important reminder that careful care should be taken when drafting restraint of trade clauses so as to not extend the scope of the restraint beyond what is reasonably necessary (or for longer than is reasonably required without a cascading series of time periods), to avoid the risk of the entire restraint being held unenforceable. As shown in this case, there is a careful balancing act between the desire to protect the value of the target business and the risk of having an unenforceable restraint.