Introduction
A restraint of trade is a contract, or a covenant, in which “a party (the covenantor) agrees with any other party (the covenantee) to restrict his liberty in the future to carry on trade with other persons not parties to the contract in such a manner as he chooses.” [1]
Restraints of trade present an interesting dichotomy. Whilst it is in the public interest to encourage competition which suggests restraints of trade should, prima facie, be invalid, they are not and employers and businesses have a legitimate interest in preventing former employees and owners competing with them by plundering customers using the employer’s confidential information or the benefit of a relationship formed during, and because of employment or ownership,[2] using a restraint of trade.
Typical restraint of trade covenants
Restraints of trade take different forms and employ various expressions. They are worded similarly to the clauses below with the term’s “Employer,” “Employee” and “Client” having self-explanatory definitions:
The Employee shall not for a period twelve (12), nine (9), six (6) or three (3) months after termination, either directly or indirectly, do any of the following:
(a) work for or be engaged in the same field or endeavour as the Employer, unless agreed otherwise by the Employer in writing.
(b) perform work for a Client.
(c) induce, solicit, entice, or attempt to induce solicit or entice from the Employer any Client.
(d) employ or otherwise engage or solicit or offer employment or other engagement, to any of the Employer’s employees or contractors.
In the preamble, the restraint applies for cascading terms of 12, 9, 6 and 3 months. The pretext for a cascading term is that if a restraint is challenged because it is “unreasonable” (see below) the longer term may be struck down but a shorter time will be deemed “reasonable” and the restraint upheld.[3]
In subclause (a), the covenant prevents an employee working in the same field (or endeavour) as an employer. This is antithetical to competition. A variation imposes geographical constraints so that an employee may not work within say 10 kilometres of an employer’s place of business, or if a field of work or business is broad, in a specified field. Alternatively, both criteria are found and a “cascading” provision is specified in which different geographical areas and fields of work are set out, again on the pretext that if a restraint’s “reasonableness” is challenged, a different restriction may be upheld.
The rationale for a covenant of this kind is that an employee ought not be permitted to accept employment in a position in which she would be able to use to her own advantage, and to the disadvantage of the former employer, knowledge of, and intimacy with, customers obtained in the course of employment, by using the connection to take customers away from a former employer and thereby affecting the proprietary interest of that employer in the goodwill of his business.[4]
Subclause (b) provides that an employee is not to do any work for a client post-employment. This is antithetical to competition. Nevertheless, where there is "some element” in the employee customer relationship which causes customers to rely on the employee and to regard the employee as the business to the exclusion of the employer, a covenant restraining a former employee from dealing with an employer's clients is enforceable because it protects customer connection.[5]
The rationale for the covenant is twofold. Firstly, it is difficult to prove that an employee laid the groundwork for post-employment competition by “surreptitious solicitation” during employment. Secondly, situations arise where the client’s connection with an employee is strong and the customer will follow an employee unsolicited because of his or her connection with the employee, notwithstanding that the connection belongs to the client.[6]
Subclause (c) prevents “solicitation” of clients and this too is antithetical to competition. There are difficulties proving solicitation and as will be seen below, an employer is permitted time to be protected against solicitation of clients when an employee had contact and influence with clients during employment.[7]
Subclause (d) prevents solicitation of other employees in the expectation that if this occurs, an employer will lose the benefit of a stable workforce and be less competitive.
Protectable interests
The usual justification for a restraint of trade is a “protectable interest,” which is something akin to a proprietary interest.[8] Protectable interests include trade secrets and confidential information and goodwill including customer connection and staff connection.
Confidential information
An employer or business has an interest in keeping confidential information,[9] confidential and in preventing a former employee or owner using that information for their benefit. [10]
Information that comes into a party=s possession because of his or her position, is classified into three categories, which in turn determines if information is protectable.[11]
First category
The first category comprises information which is trivial or easily accessible from public sources. This is not confidential information and it may be imparted during service, or afterwards, to anyone. Neither disclosure of this information during employment, nor post-employment use of the information, are protectable.
Second category
The second category comprises information which an employee or servant must treat as confidential, either because she is expressly told so, or it is obviously so from the information’s character. Once learned though, the information may remain in the employee’s head, become part of her skill and knowledge and is applied in the course of the employer’s business. This information cannot be disclosed during the course of employment because it would breach the employee’s fiduciary and fidelity[12] duties and therefore a contract of employment. But when the employment ends, the law allows the employee to use her full skill and knowledge for her benefit, in competition with the former employer. In addition, this information may be disclosed to another employer or used by the employee in another business or trade. Disclosure of this information during employment and post-employment use of the information, are protectable within reasonable limits of time and space.
There is an obvious tension between an employee being permitted to use knowledge acquired because of her employment, after employment and protection of that information. In Stenhouse Australia Ltd v Phillips [1974] AC 391 at 400, Lord Wilberhouse observed that an employee was entitled to “use to the full any personal skill or experience” acquired during employment but the obligation ended with the employment’s termination which marked “the boundary between what the employee may take with him and what he may legitimately be asked to leave behind to his employers. Deductions from this are: (a) if an employer wants to protect “know-how” it must be by an express covenant; and (b) if an employee objects to a covenant’s terms post-employment, its reasonableness will be examined by the courts.[13]
Third category
The third category comprises trade secrets so confidential that, even though they may necessarily have been learned by heart and the employee may have left the employer, they cannot lawfully be used for anyone's benefit but the employers. Disclosure of this information during employment and post-employment use of the information, are protectable with, or without, a restraint and an employee has statutory[14] and equitable duties[15] not to disclose the information.[16]
Goodwill
In Box v Taxation Commissioner (1952) 86 CLR 387 at 397, Dixon CJ defined goodwill as “whatever adds value to a business, and different businesses derive their value from different considerations.” In Commissioner of Taxation of the Commonwealth of Australia v Murry (1998) 193 CLR 605; [1998] HCA 42 at [24], goodwill was described as the product of combining and using the tangible, intangible and human assets of a business for such purposes and in such ways that custom is drawn to it and “as the quality or attribute that derives inter alia from using or applying other assets of the business.”
(In Whiteman Smith Motor Co v Chaplin [1934] 2 KB 3, Scrutton and Maugham LJs gave more amusing descriptions of goodwill.[17])
Two kinds of interest arise, “customer connection” and “staff connection.”
Customer connection
Usually, employees conduct the employer’s business. Because of this, an employee builds a relationship with customers (customer connection) which may lead to customers believing they are dealing with the employee, or the employee is the employer or business (when in fact they are dealing with the employer) and post-employment, the customer continues dealing with the employee, so that the business is lost to the employer.[18] The employer is entitled to protection from this unfair competition because the employee’s status has only arisen from the customer’s perspective, because of the employment.
Staff connection
An employer has an interest in maintaining a stable trained workforce (staff connection) and this constitutes part of the intangible benefits, which may give a business value over and above the value of the assets employed in it, and thus comprises part of its goodwill. Staff connection is amenable to protection by a covenant in a manner similar to customer connection, even in the absence of protectable confidences. It is an open question though whether that is sufficient to make non-solicitation of staff a valid restraint. The cases denying that there is any such legitimate interest emphasise that an employer does not own the workforce, as if employees were akin to stock in trade. But nor does an employer own the customers, who are also not akin to stock in trade but customer connection receives protection. Similarly, employees are not property, but a business with a stable trained workforce will be more attractive to a purchaser and command a higher price than one with a workforce which is unstable, disruptive or poorly trained, just as a loyal and satisfied clientele makes a business more attractive and valuable. More recent cases have tended to support restraints on recruitment on the basis of protection of confidential information.
The legal starting point when considering a restraint of trade’s validity
If competition was a public policy imperative as the common law suggests, it might follow restraints of trade were invalid unless they were justifiable. This is not so and subsection 4(1) of the Restraints of Trade Act 1976 (NSW) (the Act) provides that a restraint of trade is valid to the “extent to which it is not against public policy, whether it is in severable terms or not.”
Reasonableness
The term “public policy” is not defined in the Act and the common law has held that a restraint of trade is not contrary to public policy if two requirements are satisfied; (a) it was reasonable as between the parties which requires the covenantee to have a legitimate protectable interest and the restraint was no more than reasonable for the legitimate protection of that interest; and (b) it was not unreasonable in the public interest.[19] Generally, this is taken to mean that a restraint of trade is not against public policy if it is reasonable. In determining this, the following matters are considered.
Firstly, a covenantee is not entitled to be protected against mere competition and the legitimate interests which may be the subject of protection are protectable interests.
Secondly, when the validity of a restraint is challenged, the onus of proof lies on the covenantee to establish that the restraint is reasonable and if the burden is discharged the onus shifts to the covenantor to establish that the restraint is not in the public interest. A party may succeed on one point but fail on the other.[20]
Thirdly, the validity of a restraint is judged at the time the contract is made, by reference to what the restraint entitles or requires the party to do, rather than what they intend to do or have actually done.[21]
Fourthly, for a restraint to be reasonable in the interests of the parties, it must afford no more than adequate protection to the covenanter.[22]
Fifthly, the reasonableness of the duration of an otherwise justifiable restraint is often difficult to gauge and where the parties have equal bargaining power, it may be appropriate to regard the parties as the best judges of what length of period is reasonable, so if the parties have allowed a time for a restraint that is a good indicator the duration is reasonable.[23] Common experience suggests that in most employment contracts, employees (covenantors) do not read a contract beyond its remuneration provisions and that restraint durations are common in industries, consequently, when restraints are enforced employees are caught by surprise when the duration of a restraint in contracts are identical. A moral here is that it is never a bad thing to read a contract and to contend for appropriate terms before it is executed.
Sixthly, generally, the test of reasonableness of the duration of a non-solicitation covenant, when it is supported by customer connection, is what is a reasonable time during which the employer is entitled to be protected against solicitation, which in turn depends on how long it would take a reasonably competent replacement employee to show his or her effectiveness and establish a rapport with customers.[24] A related, albeit subsidiary consideration is how long might the hold of the former employee over the clientele be expected to last before weakening. But where protection of confidential information is involved, considerations such as how long the information is likely to remain current and of commercial advantage are also relevant.
Seventhly, whilst a vendor of a business may not derogate from his grant, absent a restraint of trade covenant, remedies against a seller competing with a purchaser of a business are few.[25]
Eighthly, in sale of business contracts, provided a restraint is necessary to protect the covenantee, no account can be taken of the covenantor’s hardships apart from such matters as duress in the formation of the contract.[26] There are also suggestions that the more that is paid for goodwill, the slower the courts will be to set a covenant aside and validity can be inferred from a large consideration.
Ninthly, restraints in partnership agreements are treated similarly to goodwill covenants and as partnership restraints are often mutual, this assists a conclusion they are reasonable.[27]
Lastly, though the same general principle applies in all cases of restraint of trade, a stricter and less favourable view is taken of covenants in employment agreements than in commercial agreements for sale of goodwill.[28] JD Heydon says that the reasons for this are: (a) the inequality of bargaining power between the parties; (b), the employee may be giving up her only asset which depends on specialised training and is not negotiable at all; (c) where labour is hired it remains available whether or not the employee later competes; and (d) once the employee accepts the post-employment restraints, the employer’s power during the contract is much increased because the restraint inhibits the employee’s ability to threaten to leave and seek work elsewhere.[29]
Conclusions
Restraints of trade are neither novel nor new; the earliest reported case was in 1414[30] and the foundations of the restraint of trade doctrine existing today were established in 1711[31] and they have survived as the economy and workplace has changed and evolved.[32]
Once a covenantee's protectable interests have been established, the validity of the restraint must be determined by (a) reference to those interests and (b) whether the restraint is “reasonable.”
Restraints will be reasonable (i.e., afford no more than adequate protection to the covenantee) if: (a) they do no more than prevent an employee from competing against an employer, during or after employment, by preventing the employee stealing way the employer’s customers or revealing secrets; (b) they protect the goodwill of a business after its sale; and (c) they prevent a partner competing against the partnership during, or after, the partnership’s termination.
In deciding whether a restraint is unreasonable (i.e., afford more than adequate protection to the covenantee), various matters may be considered, including: (a) the extent of the restraint; (b) its duration; (c) the geographical area to which the restraint applies; (d) whether the restraint operates after the termination of any contract in which it is contained; (e) the benefits received by the covenantor in agreeing to the restraint; (f) the commercial setting of the agreement; and (h) the relative bargaining powers and strengths of the parties.
[1] Petrofina (Great Britain) Ltd v Martin [1966] Ch 146 at 180; [1966] 1 All ER 126 at 138 (Diplock LJ).
[2] The seller of the goodwill of a business, and a partner departing from a partnership, are entitled to set up a competing business, wherever, and whenever, he or she likes. In Trego v Hunt [1896] AC 7, Lord Macnaghten gave this explanation of the principle (at 24 – 25): “How far may he go? He may do everything that a stranger to a business, in the ordinary course, would be in a position to do. He may set up where he will. He may push his wares as he pleases. He may thus interfere with the custom of a neighbour as a stranger and an outsider might do; but he must not, I think, avail himself of his special knowledge of the old customer to regain, without consideration, that which he has parted with for value. He must not make his approaches from the vantage-ground of his former position, moving under cover of a connexion which is no longer his. He may not sell the custom and steal away the customers in that fashion.”
[3] Sub-section 4(3) of the Restraints of Trade Act 1976 (NSW) permits the Supreme Court of NSW to read down or uphold a restraint of trade “on such terms as the Court thinks fit”.
[4] Lindner v Murdock's Garage (1950) 83 CLR 628 (1950) at 636 (Latham CJ).
[5] Informax International Pty Ltd v Clarius Group Ltd (2011) 277 ALR 495.
[6] Koops Martin Financial Services Pty Ltd v Reeves [2006] NSWSC 449.
[7] Stenhouse Australia Ltd v Phillips [1974] AC 391.
[8] Vandervell Products Ltd v McLeod [1956] RPC 185 at 192; Tank Lining Corp v Dunlop Industrial Pty Ltd (1982) 140 DLR (3d) 659 at 664.
[9] E.g., customer lists, trade secrets (i.e., KFC’s chicken is fried but are its Aeleven secret herbs and spices@ merely different varieties of salt and pepper or does the product taste different because the company is the major sponsor of the BBL?), an algorithm or financial data.
[10] E.g., significant capital may have been expended developing or generating the information, it may be the element that gives a business a competitive edge, or it may be information that a business simply does not want to share.
[11] Faccenda Chicken Limited v Fowler and Ors [1985] 1 All ER 724; [1985] FSR 105; [1984] ICR 589; Wright v Gasweld Pty Ltd (1991) 22 NSWLR 317.
[12] An employee’s duty of fidelity (see Wessex Dairies Ltd v Smith [1935] 2 KB 80) provides that an employee, whilst in employment, has an overriding obligation to act in the employer's interest rather than in her own interest although an employee is entitled to make certain preparations for leaving employment and setting up a business in competition with an employer and the obligation to act in the employer's interests ceases when the employment contract ceases. This obligation precludes an employee soliciting clients during employment, even though the transfer of custom is only to occur after termination of employment (Robb v Green [1895] 2 QB 1). There are also circumstances where an employee cannot work for a rival of an employer during employment (e.g., Hivac Ltd v Park Royal Scientific Instruments Ltd [1946] Ch 169; [1946] 1 All ER 350).
[13] Balstone Ltd v Headline Filters Ltd [1987] FSR 330 at 351-352; Liberty Financial Pty Ltd v Scott (No 4) (2005) 11 VR 629 at 639 [35].
[14] Corporations Act 2001 (Cth) ss 182–185.
[15] In Seager v Copydex Ltd [1967] 2 All ER 415; [1967] 1 WLR 923; [1967] RPC 349, Lord Denning MR described the equitable duty of confidence this way: “It depends on the broad principle of equity that he who has received information in confidence shall not take unfair advantage of it. He must not make use of it to the prejudice of him who gave it without obtaining his consent.”
[16] Faccenda Chicken Limited v Fowler and Ors [1985] 1 All ER 724; [1985] FSR 105; [1984] ICR 589.
[17] Scrutton LJ described goodwill this way: “The cat prefers the old home to the person who keeps it and stays in the old home though the person who has kept the house leaves. The cat represents that part of the customers who continue to go to the old shop, though the old shopkeeper has gone; the probability of their custom may be regarded as an additional value given to the premises by the tenant’s trading. The dog represents that part of the customers who follow the person rather than the place; these the tenant may take away with him if he does not go too far. There remains a class of customer who may neither follow the place nor the person, but drift away elsewhere. They are neither a benefit to the landlord nor the tenant and have been called ‘the rat’.” Maugham LJ added: “[R]eally there should be a fourth animal, the rabbit to indicate the customers who come simply from propinquity to the premises; and ... it will be apparent that the rabbit may be much bigger than the cat, who ... may well shrink to the dimensions of a mouse.” (Whiteman Smith Motor Co v Chaplin [1934] 2 KB 35 at 42 and 50.)
[18] Arthur Murray Dance Studios of Cleveland Inc v Witter 105 NE (2d) 685, 706 (Ohio, 1951); Cactus Imaging Pty Limited v Glenn Peters [2006] NSWSC 717; Wallis Nominees (Computing) Pty Ltd v Pickett (2013) 45 VR 65; [2013] VSCA 24; Isaac v Dargan Financial Pty Ltd ((2018) 98 NSWLR 343; (2018) 279 IR 400; [2018] NSWCA 163.
[19] Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd [1894] AC 535 at 565 (Lord Macnaghten); Tullett Prebon (Australia) Pty Ltd v Purcell [2008] NSWSC 852; 175 IR 414 at [47].
[20] Herbert Morris v Saxelby [1916-17] All ER Rep 305.
[21] Koops Martin Financial Services Pty Ltd v Reeves [2006] NSWSC 449 at [88].
[22] Herbert Morris v Saxelby [1916] 1 AC 688 at 707 (Lord Parker).
[23] Aussie Home Loans v X Inc Services [2005] NSWSC 285 at [36].
[24] Stenhouse v Phillips [1974] AC 391; Daly Smith Corporation (Australia) Pty Ltd v Cray Personnel Pty Ltd (Supreme Court of NSW, Young J, 14 April 1997, unreported).
[25] Ennis Paint Australia Holding Pty Ltd & Anor v Jimmy Poh Wing Lieu & Ors [2015] NSWSC 1933.
[26] Leighton v Wales (1838) 3 M & W 545; JD Heydon, The Restraint of Trade Doctrine (4th edition, 2018, LexisNexis Butterworths at 213.
[27] Gerahty v Minter (1979) 142 CLR 177 at 198; 26 ALR 141 at 158 per Mason J; Bridge v Deacons (A Firm) [1984] AC 705 at 716; [1984] 2 All ER 19 at 23 – 4; Rouen & Ors v Ryan [2001] NSWCA 230.
[28] Nordenfelt v Maxim Nordenfelt Guns & Ammunition [1894] AC 535 at 566; Mason v Provident Clothing & Supply Co Ltd [1913] AC 724 at 731 and 738; Herbert Morris Ltd v Saxelby; Geraghty v Minter (1979) 142 CLR 177 at 185; Woolworths Ltd v Olson [2004] NSWCA 372 at [38].
[29] JD Heydon, The Restraint of Trade Doctrine (4th edition, 2018, Lexis Nexis Butterworths) at 96-97.
[30] Dyer’s case 2 Hen 5, f 5, p 26.
[31] Mitchel v Reynolds (1711) 1 P Wms 181 at 185-6; [1558 - 1774] All ER Rep 26 at 29 (Parker CJ).
[32] JD Heydon says that restraints of trade were partly developed because of the law’s response to three problems: private individual’s attempts to make a profit by interfering with food supplies, the power of guilds and the medieval kings practice of granting monopolies for purposes (JD Heydon, The Restraint of Trade Doctrine (4th edition, 2018, LexisNexis Butterworths).