Restrictive covenants in shareholders’ agreements

Restrictive covenants will often be incorporated into a shareholders’ agreement to prevent the relevant party from acting in a way that might cause damage to the business.

Companies are justifiably concerned that a key departing employee might set up a competing business and draw clients, employees and suppliers away from their former employer. And the buyer of a company will also be concerned that the sellers will not immediately set up a new, competing company and proceed to significantly diminish the value of the acquisition.

However, there are limitations as to the extent that a party may seek to restrain the trading activity of another. In order to be enforceable, a restrictive covenant must seek to protect a legitimate business interest and go no further than reasonably necessary to protect that interest.

The recent case of Guest Services Worldwide Limited v David Shelmerdine [2020] EWCA Civ 85 provides some useful reminders about the enforceability of restrictive covenants for a consultant and shareholder, rather than an employee, and the approach of the court to interpreting contracts.

Restrictive covenants case facts

Guest Services Worldwide Limited (“GSW”) runs a business that produces maps for distribution to the guests of luxury hotels. The business had been founded by Mr David Shelmerdine who, in 2011, sold it to a company, which subsequently went into administration. GSW then acquired the business from the administrators and retained Mr Shelmerdine as an employee. Mr Shelmerdine’s role at GSW was to visit overseas luxury hotels and organise maps for them.

In 2015, Mr Shelmerdine agreed with GSW that he would work on a consultancy basis, rather than as an employee. The initial consultancy agreement between the two expired in 2017, but Mr Shelmerdine continued to work as a consultant on an ad-hoc basis. Mr Shelmerdine also owned shares in GSW and, in 2016, GSW and its shareholders entered into a shareholders’ agreement.

In February 2019, the consultancy arrangements between GSW and Mr Shelmerdine were terminated, and it was alleged by GSW that, shortly afterwards, Mr Shelmerdine attempted to solicit business from the Ritz Carlton in Budapest and the Metropole in Monaco. As a result, GSW brought a claim against Mr Shelmerdine for breaching the post-termination restrictive covenants contained in his consultancy agreement and the shareholders’ agreement.

At trial, the High Court found in favour of Mr Shelmerdine. As no consultancy agreement was in place at the time the consultancy arrangements were terminated in 2019, the restrictive covenants contained in the consultancy agreement that expired in 2017 were not effective. Similarly, due to the way they had been drafted, the restrictive covenants contained in the shareholders’ agreement were unenforceable against Mr Shelmerdine.

GSW appealed to the Court of Appeal on the question of the enforceability of the restrictive covenants in the shareholders’ agreement. Looking at the relevant clauses in the shareholders’ agreement, the court considered that there were two issues to resolve:

• whether Mr Shelmerdine fell into the class of shareholders to whom the restrictive covenants applied, and
• whether the duration of the restrictions was reasonable.

Definition of employee shareholder

In the agreement, there were two classes of shareholders: Shareholders and Employee Shareholders, the latter being a subcategory of Shareholders who were also employees, agents or directors of GSW. Only the Employee Shareholders were subject to the restrictive covenants which included standard restraints on carrying on a competing business, soliciting the business of customers and suppliers, and enticing away employees.

However, the restrictive covenants took effect on the basis of a person’s shareholder status rather than their employment status. The periods during which the restrictions applied were:

• (a) any time when the party in question is a Shareholder; and
• (b) for a period of 12 months after the party in question ceases to be a Shareholder.

The High Court applied a strict interpretation to these clauses. In its view, as soon as a shareholder ceased to be an employee, agent or director of GSW, he did not fall into the definition of Employee Shareholder and was therefore not subject to the restrictive covenants. Once Mr Shelmerdine had ceased to be a consultant (or “agent”) of GSW, he was no longer an Employee Shareholder and could not be bound by the restrictive covenants. GSW appealed this decision.

The Court of Appeal rejected this interpretation on the basis that it made no commercial sense. GSW sought protection against exploitation by departing employees, agents and directors of the skills and knowledge they had gained at GSW. Under the High Court’s interpretation, the covenants would be rendered ineffective if those people fell outside of the restrictive covenants as soon as they left the company.

In its opinion, no reasonable person with the relevant background knowledge would have understood that to be the intention of the parties when the shareholders’ agreement was entered into. The court looked at the transaction as a whole, which included taking into account GSW’s articles of association (adopted about a month after completion of the shareholders’ agreement).

The articles contained compulsory transfer provisions obliging an employee, agent or director to transfer their shares to the remaining shareholders if they left the company. Therefore, the situation the shareholders’ agreement actually envisaged was that any Employee Shareholder leaving the company would necessarily be in the process of disposing of their shares at the same time or shortly afterwards. As such, the Court of Appeal held that Mr Shelmerdine remained an Employee Shareholder on ceasing to work for GSW in February 2019 and was therefore subject to the post-termination restrictive covenants in the shareholders’ agreement.

Duration of restrictive covenants

Setting an excessively long period of time restraining competition post-departure would be considered unenforceable by the courts. In determining what is reasonable, the court will look to the relationship between the parties: it is an established principle that the court will be more stringent when dealing with an employer/employee covenant than a covenant negotiated in a commercial context between two experienced parties.

As mentioned above, GSW’s shareholders’ agreement provided that the restrictive covenants would apply for so long as an Employee Shareholder held shares in GSW, plus 12 months after he ceased to be a shareholder. Mr Shelmerdine argued that, if a restrictive covenant is to apply against a departing employee, agent or director for so long as he remains a shareholder (even though, having left employment, he should be in the process of disposing of his shares), this is an indefinite period and therefore unenforceable. Indeed, Mr Shelmerdine was still a shareholder of GSW when the trial took place in July 2019.

The Court of Appeal disagreed. First, in light of the commercial experience of the parties to the shareholders’ agreement, it found that a period of restraint lasting 12 months was a reasonable length of time for protecting GSW’s business interest. Then, returning to the fact that, on a shareholder ceasing to be an employee, agent or director of GSW, he would be obliged to give up his shares in the company, the court considered that the cessation of work and the disposal of shares would, in all likelihood, take place at the same time or with a short intervening period. Considerable delay to a sale would be relatively unlikely and a shareholder being locked in indefinitely would be very unlikely, so the restriction was not unreasonable.

The Court of Appeal therefore found that the restrictive covenants in the shareholders’ agreement were enforceable against Mr Shelmerdine.

Conclusions

GSW v Shelmerdine demonstrates the varying approaches the court may take to interpreting a contract. When interpreting a contract, the court will apply a strict literal meaning first and foremost, but will also look at the document as whole and may take the wider context into consideration.

This case also highlights the risks of ambiguous drafting, particularly with regard to restrictive covenants. Given that the court will not enforce a restrictive covenant that goes beyond what is reasonably necessary to protect a business interest, precision over the scope of the restriction, e.g. duration, is key.

The fact that the restrictive covenants in this case were included in a shareholders’ agreement also worked in favour of the party seeking to enforce them. Not only did it protect the company for longer in the initial phase, but it is clear that English law makes distinctions between restrictive covenants in employment contracts and commercial agreements. The provisions in a shareholders’ agreements will be subject to less vigilant scrutiny by the courts and are more likely to be interpreted as being reasonable and therefore enforceable.

Clear contracts and restrictive covenants

To avoid disputes over the meaning of clauses in an agreement and having to rely on favourable interpretations by the court, clear and unambiguous wording should always be the aim when drafting a contract. It is important to make it clear to whom the restrictions apply and when they will be triggered.

For expert legal advice on the wording of any restrictive covenants, either when drafting them or dealing with a potential dispute, please contact our employee competition and confidentiality team.