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Law at Work — February 2014: reasonableness and extent of restrictive covenants did not apply to actions as a minority shareholder
28 February 2014
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13 May 2014
One of the most valuable assets of a partnership is its goodwill, and one of the essential elements of any well-drafted partnership agreement is the protection of that goodwill when a partner retires and becomes a competitor to the firm.
Partnership agreements have endeavoured to protect goodwill with restrictive covenants and case law has provided considerable guidance as to how the court will approach the enforceability of such restrictive covenants by continuing partners against a retiring partner.
There is no doubt that the protection of goodwill will be no less important for a limited-liability partnership (LLP), but in the absence of judicial authority, there is no guidance as to the approach the court will take in relation to the enforceability of restrictive covenants by an LLP against a former member.
Restrictive covenants and partnerships
Restrictive covenants are intended to protect the firm by imposing restrictions on the activity of former partners. Commonly used covenants include: non-solicitation of clients; seeking to prevent former partners from approaching clients of the firm with the intention of providing them with services that compete with those provided by the firm; and non-dealing with clients to prevent former partners from having business dealings with clients of the firm.
Such post-termination restrictions are a restraint of trade and, as such, are unenforceable. However, in certain circumstances restrictive covenants may be enforceable.
The onus of proving that a restrictive covenant is enforceable is on the party seeking to enforce it, namely the firm or, more precisely, the continuing partners. To discharge the burden of proof, the firm will be required to satisfy the court that the firm has legitimate business interests that require protection and the restriction on the activity of a former partner goes no further than is necessary to protect those interests. Only if the firm can satisfy the court on both these points might the court enforce the covenant.
In assessing the likely enforceability of covenants by a firm against a former partner, we have the benefit of a number of judgments, including that in the frequently cited case of Bridge v Deacons (1984).
Deacons is a firm of solicitors in Hong Kong. Bridge was an equity partner with a 5 per cent share. The partnership agreement provided that, for a period of five years, no retiring partner could act as a solicitor in Hong Kong for any entity which at the date of retirement, or during the previous three years, was a client of the firm. Bridge retired and transferred his share in the business to the continuing partners. Shortly thereafter the continuing partners issued proceedings against Bridge seeking an injunction enforcing the restrictive covenant.
Bridge claimed the restrictive covenant was unenforceable because it was excessive, arguing among other things that he had no contact with 90 per cent of the clients. The judicial committee of the Privy Council disagreed and identified a number of factors relevant to enforceability, including:
- partners were the owners of all the firm's assets, including goodwill;
- Bridge, in accordance with the partnership agreement, transferred his share of those assets to the continuing partners when he retired; and
- the covenant applied equally to all partners and this mutuality was a most important consideration in assessing whether it was reasonable.
From Bridge v Deacons and other authorities, it is clear that the courts are more inclined to hold restrictive covenants between partners as enforceable than covenants sought to be enforced by an employer against an employee. Between employer and employee, only restrictions much more limited than that in Bridge v Deacons are normally enforceable.
Restrictive covenants and LLPs
What, then, is the position in relation to restrictive covenants between an LLP and its members? Will the court be inclined to treat members more like partners, or will it be inclined to treat them more like employees and enforce only much more limited restrictions?
There will undoubtedly be similarities between the position of partners and that of members, which may give rise to the view that members should be treated as if they were partners in a traditional partnership. A well-drafted LLP agreement can ensure that any covenants are applied equally to all members and provision can be made that any interest in the LLP is to be transferred by an outgoing member to the continuing members at the date of cessation of membership.
However, there are also differences between partnerships and LLPs and between partners and members. An LLP is a corporate body with a legal personality separate from that of its members (Section 1(2) of the LLP Act 2000). Also, otherwise than as provided by the LLP Act 2000, or any other enactment, ""the law relating to partnerships does not apply to"" LLPs (Section 1(5) of the LLP Act 2000).
These differences may give rise to a contrary view that members should not be treated as if they were partners in a partnership, and should perhaps be treated more like employees. Clearly, there is room for uncertainty as to how covenants in LLP agreements will be approached by the court.
This uncertainty was raised when the LLP Bill was being considered. During the consultation process, concern was expressed that the court might find restrictive covenants unenforceable because the LLP might be viewed as more closely aligned to a company than a partnership. The issue was not conclusively resolved during consultation. All that was said was that a statement, made in an LLP agreement and noting that members were not employees, might go some way towards clarifying the position. Certainly, full equity members of an LLP will not be regarded as employees and fixed-share members may not be employees, depending on the circumstances.
But can it be concluded that, because members are stated not to be, or are not regarded as, employees, they will automatically be treated as if they were partners in a partnership in relation to restrictive covenants? Regrettably, until the issue comes before the court, the position will remain uncertain.
Clive Greenwood is joint head of partnerships and LLPs at Lewis Silkin