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Non-compete clauses: Issues to consider on business sale/merger

Print publication

11/01/2021

The purchaser of a business will often want to ensure that any goodwill associated with the business is protected.  In particular, they will not want the seller to set up a competing business following completion, attracting many of the business’ customers, utilising business secrets to gain an unfair advantage, or poaching staff.

Walker Morris’ Commercial Dispute Resolution specialists Gwendoline Davies, Rebecca Jackson and Jack Heward explain some of the ways in which UK contract and competition law can afford protection for a purchaser/employer, and some of the risks and issues to consider.

Stop press…Brexit impact

The Brexit transition period ended on 31 December 2020.  From and including 1 January 2021, agreements or conduct of UK companies that have an effect within the EU from a competition perspective will still be subject to EU competition rules.  UK competition law largely mirrors EU law and new section 60A of the Competition Act 1998 (CA 1998) [1], means that, as a default position, UK authorities will ensure that competition law in the UK is dealt with in a way consistent with the treatment of corresponding competition under EU law.

For the purposes of this article, relevant principles of EU law have been retained into UK law post-Brexit, albeit the EU only has active jurisdiction over UK market aspects where an investigation was initiated before the end of the transition period.  

Section 60A may, however, result in some divergence between UK and EU approaches over time, as it does allow UK authorities to depart from EU principles and case law in some limited, prescribed circumstances.  Walker Morris will monitor and report on any key developments.

Competition law in the UK/EU

It is common for employers/purchasers to include in sale and purchase agreements and employment contracts various express contractual restrictions designed to prevent competitive behaviour.  That is, of course, a sensible commercial option, but it is important to ensure that any such restrictions do not fall foul of competition law, or there is a risk that they will be unenforceable and/or will expose the employer/purchaser to other penalties.

Anti-competitive behaviour which may affect trade within the UK is specifically prohibited by Chapters I and II of the CA 1998, whilst mergers and certain joint ventures are considered by reference to the Enterprise Act 2002 (EA 2002). In circumstances where the effect of anti-competitive behaviour extends beyond the UK to other EU Member States, it is prohibited by Articles 101 and 102 of the Treaty on the Functioning of the European Union (TFEU).

Both UK and EU competition law prohibit market operators entering into agreements, arrangements and concerted business practices which appreciably prevent, restrict or distort competition (or where this is the intended result) and which affect or may affect trade within the UK or the EU respectively.

Specifically, that might include:

  • directly or indirectly fixing purchase or selling prices or any other trading conditions;
  • limiting or controlling production, markets, technical development, or investment;
  • sharing markets or sources of supply;
  • applying dissimilar conditions to equivalent transactions with other trading parties, thereby placing them at a competitive disadvantage; or
  • making the conclusion of contracts subject to acceptance by the other parties of supplementary obligations which, by their nature or according to commercial usage, have no connection with the subject of such contracts.

Agreements that seek to prevent, restrict or distort competition (i.e. are anti-competitive by object) are deemed to constitute an appreciable restriction of competition, regardless of their actual effect or the market shares of the parties. In the absence of any “hard-core” restrictions of competition (that is, agreements that contain restrictions that have as their object the distortion/restriction of competition) an agreement is only caught by Article 101 TFEU or the CA 1998 Chapter I prohibition if it has an appreciable effect on competition.

Non-compete clauses on a business sale

Business sales often simultaneously combine the sale of a business with an employment contract, by which the purchaser retains the seller and/or a shareholder’s services as an employee once the sale has completed.  Such transactions often involve restrictive covenants within both the sale and purchase agreement and within any employment contract[s].

The covenants contained in the sale and purchase agreement are often more extensive than those in the employment contract.  That is because, in this purely commercial context, there is an assumption that the parties are of equal bargaining power: any negotiated non-compete restrictions protect the goodwill of the business for the benefit of the purchaser and, at the same time, enable the seller to obtain a better sale price. The opposite is generally the case, however, in the context of restrictive covenants in an employment contract, where the employer is more likely to have the ‘upper hand’.

Case law demonstrates that the courts are more willing to afford a greater level of protection to an employer/purchaser in a business sale context.  For example:

  • In Allied Dunbar (Frank Weisinger) Ltd v Weisinger [1988], the court upheld a two-year non-compete provision preventing a salesman from selling financial services anywhere in the UK. The restriction was entered into in consideration of a payment for the purchase of the goodwill in his business.
  • In Cavendish v Makdessi [2012], the court upheld a series of covenants on the part of sellers in a share sale agreement, each with a minimum period of eight and a half years. The court said that the quantum of consideration exchanging hands may affect the ‘reasonableness’ (and therefore the enforceability) of a restrictive covenant.

As a slight corollary to that, however, the court indicated, in Dawnay Day & Co v de Braconier d’ Alphen [1998], that a global approach should be taken to the assessment of reasonableness of restrictive covenants in both any sale and purchase agreement and any employment contract, rather than consideration of them in isolation.

Non-compete clauses in an employment contract

The courts have developed the common law doctrine of restraint of trade to afford a certain level of protection for employers.  The doctrine provides that any contractual term restricting an employee’s activities after termination of his or her employment is void for being in restraint of trade and contrary to public policy unless the employer can show that: (1) it has a legitimate proprietary interest that it is appropriate to protect; and (2) the protection sought is no more than is reasonable, having regard to the interests of the parties and the public interest.  The aim of preventing competition alone is not sufficient in itself – the covenant must be intended to protect the employer’s confidential information or customer contacts and to prevent a former employee from unfairly using that information/those contacts for their own benefit.

There are, however, additional risks associated with non-compete restrictions in employment contracts.  For example, all too often, contracts seek to provide an absolute prohibition on the disclosure of undefined or loosely defined ‘confidential information,’ or ‘information related to the company’s business and finances’, but the courts will not enforce confidentiality provisions which are too vague or broad in nature.  In addition, where obligations relating to confidentiality are not mutual (that is, only the employee is agreeing to them), there is a risk that, unless the employment contract expressly clarifies what consideration is being given by the employer in return for the employee agreeing to any such obligation, the provision could be adjudged unenforceable.

For more information on non-compete restrictions in the employment contract context – in particular for advice on what employers/purchasers can do in the event of an actual or anticipated breach of restrictive covenant – please see our recent briefing.

Ancillary restraints – Business mergers

In the context of a business merger, if “merger control approval” is required under EU or UK competition law, then restrictive covenants can also be deemed compatible with competition law where they are an “ancillary restraint” to that merger.  A restriction may be an ancillary restraint if it is “directly related and necessary to the implementation of that merger”.

The EA 2002 governs the UK merger control regime, which is enforced by the Competition and Markets Authority (CMA). The EA 2002 will apply where there is a “relevant merger situation” in the UK.

A relevant merger situation arises where two or more “enterprises” (at least one of which is carried out in the UK or by or under the control of a body corporate incorporated in the UK) cease to be “distinct” as they are brought under common control or ownership, or there is a proposal that they should do so.

The CMA then has jurisdiction under either of the following criteria: the value of the turnover in the UK of the company being taken over exceeds £70 million; and/or as a result of the merger, a share of 25% or more in the supply or purchase of goods or services in the UK (as a whole or substantial part of it) is created or extended.

If a restriction does not fall within the definition of an “ancillary restraint” then it will be necessary to consider whether it is caught by Chapter I of the CA 1998 and/or the common law doctrine of restraint of trade as set out above.

Under EU law, large scale mergers (referred to as concentrations) must be notified to the European Commission in advance to obtain clearance.  The principles that the European Commission applies in assessing commercial restrictions are set out in the “Ancillary Restraints Notice”. Non-compete obligations which are imposed on the seller can be directly related and necessary to the implementation of the merger. Such restrictive covenants are only justifiable as an ancillary restraint if their duration, geographical scope and subject matter and persons they apply to do not go beyond what is reasonably necessary [2].

The EU Ancillary Restraints Notice has also been followed in the UK and similar provisions have been adopted by the CMA (see page 137 onwards of the CMA’s Mergers Guidance published December 2020).

Non-compete clauses are justified for periods of up to three years in instances where the merger includes the transfer of goodwill and know-how from the seller. When only goodwill in the business is being sold, non-compete clauses are justified for periods of up to two years. Where there are very specific circumstances, non-compete clauses have been justified occasionally for longer periods. However each instance will turn on its own facts and many of these cases are quite old.  For example:

  • In a shareholder agreement, a seller agreed not to compete in respect of the products manufactured by the buyer, on the basis that the seller had decided to continue on the same business of the buyer. This decreased the value of the purchased company, but the non-compete clause of five years guaranteed that the buyer obtained the full value of the assets purchased (Commission Decision of 27 July 1995 (IV/M.612 – RWE-DEA/Enichem Augusta)).
  • The parties agreed to a non-compete clause for a period of seven years in which the seller agreed not to compete with the purchaser in the medical imaging market. However, the restriction was only upheld for a period of five years, on the basis that the lifecycle of the products concerned was around five to seven years. When this was taken in to account with the know-how that the buyer had purchased, the duration of the restriction agreed by the parties was considered to be unreasonable. In respect of the other aspects of the business that were transferred, a non-compete clause was accepted only for a duration of three years as it did not concern either a special technology nor was there any know-how to be protected (Commission decision of 23 October 1998 (IV/M.1298 – Kodak/Imation)).
  • In the Commission decision of Reuter/BASF 76/743/EEC an eight year covenant which also extended to non-commercial research by the seller was not accepted as an ancillary restraint for that amount of time, although the Commission held that a five year period would have been acceptable.

In circumstances where the merger only concerns the sale of physical assets such as land, buildings and machinery, non-compete clauses cannot be considered necessary to the implementation of the merger.

How can we help?

Protecting employers/purchasers against anti-competitive practices on a business sale or merger is a complex, multi-layered area of law and practice.  Employers/purchasers should therefore work with specialist advisers to ensure that any non-compete clauses negotiated – whether in a sale and purchase agreement or an employment contract – are reasonable, effective and enforceable.

Gwendoline Davies (Head of Commercial Dispute Resolution), along with Nick McQueen, Rebecca Jackson and Jack Heward in Walker Morris’ Commercial Dispute Resolution team specialise in this area and work closely with the firm’s dedicated corporate, employment and competition teams to offer comprehensive, expert advice in all aspects of contract negotiation, risk management and dispute resolution.  Please do not hesitate to get in touch if you have any queries or concerns and we will be very happy to help.

 

Register for our upcoming webinar ‘Stopping departing employees taking confidential information and competing’ here.

 

[1] inserted by The Competition (Amendment etc.) (EU Exit) Regulations 2019 and The Competition (Amendment etc.) (EU Exit) Regulations 2020

[2] Questions can also arise as regards clauses preventing the seller from soliciting employees of its former business.  Such clauses also require to be appropriately limited in scope and duration.

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