The duration of a restrictive covenant is something that is frequently heavily negotiated in share or business sale agreements. The courts have interpreted such covenants by reference to various factors, one of the most important of which is the context of the “interest” which the covenant is aiming to protect. More freedom of contract prevails in covenants in business sale agreements than in covenants in employment contracts as it is considered in the public interest that a seller in a business sale agreement should be able to achieve a high price for what he wishes to sell (Nordenfelt v The Maxim Nordenfelt Guns and Ammunition Co Ltd  AC 535). Even in the case of a business sale, however, if a covenant goes further than is reasonably necessary to protect a legitimate business interest, it will be void and not enforceable (Nordenfelt v The Maxim Nordenfelt Guns and Ammunition Co Ltd  AC 535).
The duration of a restrictive covenant was one of the issues that arose in the case of Cavendish Square Holdings BV & Anor v El Makdessi  EWHC 3582.
The key facts
By an agreement dated 28 February 2008 (the “Agreement”), Cavendish Square Holdings BV (“Cavendish”), which is part of WPP (a world leader in marketing communications services and a constituent of the FTSE 100), agreed to purchase shares in Team Y& R Holdings Hong Kong Ltd (the “Company”) and provision was made for the purchase of all the shares in the Company Cavendish did not already own.
The aggregate maximum amount of all payments pursuant to the Agreement was $147.5million but the balance sheet of the Company for the year ending February 2008 showed assets of only $69million, giving rise to substantial goodwill on acquisition.
A number of restrictive covenants were incorporated into the Agreement, including a covenant to the effect that the Seller would not (without the prior consent of the purchaser) “carry on or be engaged, concerned or interested in competition with the Group” in certain restricted activities (as defined in the Agreement). The period of restraint was 24 months following the Relevant Date, which was defined in the Agreement as the later of a number of potential events, including the date of payment of a final instalment due under the terms of the Agreement. On the particular facts, this meant that the Seller would need to wait a minimum of 8.5 years from the date of the Agreement, until the summer of 2016, before being free from the covenant.
The Seller admitted acts which constituted a breach of fiduciary duty and which would also have amounted to a breach of the above mentioned restrictive covenant, if this was valid and enforceable. In the event of a breach of a restrictive covenant, the Seller would become a Defaulting Shareholder (as defined in the Agreement) and as a result would not be entitled to certain payments under the Agreement and would also be required to sell his shares in the Company at Net Asset Value (as defined in the Agreement and determined at the time the Seller became a Defaulting Shareholder). The Seller argued, however, that the restrictive covenant in question was an unreasonable restraint of trade.
It was held that the restrictive covenant was not an unreasonable restraint of trade. The judgement made reference to a number of key considerations, including:
- The Agreement was fully negotiated ‘on a level playing field’ with experienced lawyers on both sides. The Seller was keen to receive substantial consideration over and above the net asset value of the Company and Cavendish was keen to buy but on condition that it enjoyed the benefit of provisions to protect the goodwill in the business. Evidence showed that the duration of the restrictive covenant had been negotiated by the lawyers involved.
- The goodwill involved was substantial.
- The minimum period of 8.5 years was tied to protecting a relevant interest of Cavendish’s (protection from competition from an influential Seller who was continuing as a non-executive chairman/director) and in any event a minimum of 8.5 years was not an unreasonable period of protection for Cavendish. It was noted that in relation to a business sale, there was no reported case in which a restriction which was otherwise reasonable had been held to be unreasonable on grounds of duration alone.
The case brings into focus the need for both buyers and sellers to give careful consideration to the duration of restrictions under the different scenarios that might be provided for under the terms of a typical share purchase agreement. In this case, the restrictive covenant lasted for just 24 months, not an unusual duration, but the commencement of the 24 month period was triggered by the later of a number of alternative events, which in this particular case meant that the actual duration was not less than 8.5 years from the date of completion of the transaction, a period that many might assume to be excessive.
The case may serve to encourage buyers to seek to negotiate longer periods of duration for restrictive covenants but caution should be exercised here. The case does not depart from the principle that covenants must be reasonable having regard to the protection of a legitimate interest.
Corporate lawyers should be alive to the possibility that a covenant which may otherwise be unenforceable could be held to be enforceable where substantial goodwill is to be acquired. From an accounting point of view, goodwill can arise where the purchase price for the company being acquired is greater than the net book value of its assets at the time of acquisition. Substantial goodwill is perhaps more likely to arise in some sectors or types of business than others, for example:
- technology businesses, where the market value of the proprietary intellectual property may not be reflected in the target company’s balance sheet;
- branded consumer products, where the market value of the brands in a company’s portfolio may not be reflected in its balance sheet;
- businesses where the employees are one of the major assets of the business; this would be a typical feature of many technology companies (for example software businesses) as well as companies in the advertising and marketing space; and
- sectors where a substantial part of the market value in the business can be ascribed to the value of the customer (and supplier) relationships; again this would apply in the advertising and marketing services sector but is also likely to apply to many other services businesses.
Companies that have grown by acquisition rather than organically may already have considerable goodwill on their balance sheets that has arisen in relation to prior acquisitions.