The Enforceability of Restraint of Trade Clauses in Commercial Contracts
When parties enter into a commercial agreement, they may seek to safeguard their commercial interests in certain events by way of a restraint clause (Restraint Clauses). Restraints Clauses are often found in commercial agreements, such as partnership or shareholders agreements, franchise agreements and business or share sale agreements and employment agreements.
While Restraint Clauses may be included and accepted in commercial agreements on a regular basis, sometimes it is not fully understood if and how these seemingly standard and certain terms can actually be enforced.
The starting position is that any term that operates in restraint of trade is unlawful and void as being contrary to public policy.
Courts have refused to enforce Restraint Clauses if the party who has the benefit of the clause (Benefiting Party) is merely seeking protection against competition. However, Restraint Clauses may be enforceable if the Benefiting Party can establish that the Restraint Clause is reasonable.
The question of ‘reasonableness’ requires an examination of the effect and operation of the Restraint Clause against the relevant facts.
The Benefiting Party must show that the Restraint Clause is reasonably necessary to protect its legitimate business interests.
The reasonableness of the restraint is assessed as at the time the agreement was finalised and not at the time of enforcement of the restraint clause.
The onus of proving the reasonableness of the Restraint Clause rests on the Benefiting Party.
What are “legitimate business interests”?
This will vary from business to business and will depend on the nature of the contract that contains the Restraint Clause.
In commercial contracts, such as franchise agreements, the franchisor may disclose to the franchisee confidential and sensitive information such as trade secrets, business know how, training manuals, recipes, and even customer database. Franchise agreements can be extensive and may include elements of protection of goodwill, similar to a purchase of business contract and protection of confidential information which is generally more common in employer-employee restraint contracts. A franchisor’s legitimate business interest may also include the patronage built up through the operation of the franchise which requires some protection from a franchisee leaving the franchise system and operating a competing business. In franchise agreements, the franchisee operates the business of the franchisor and thus, has full access to the franchisor’s confidential information, provided to the franchisee which can constitute the franchisor’s legitimate business interest.
Reasonableness of the Restraint Clause
Once a legitimate business interest has been identified, the next question is whether the Restraint Clause is too wide.
When determining this question, Courts tend to balance the interest of both parties and look at:
- the duration of the restraint;
- the area where the restraint will be operative; and
- the nature of the restrained conduct.
In several cases Courts have concluded that enforcement of a Restraint Clause would be contrary to the public interest when the duration of the restraint on trade extends beyond the term of the parties’ relationship. In a franchising context, Courts may also look at what would be a reasonable and sufficient time period for a new incoming franchisee (or the franchisor) to create a business relationship with the customers.
The reasonableness of geographical of the operation of the restraint will vary from business to business and will depend upon the area from which the business draws most of its customers. A wider geographical area might be reasonable if the business is a “destination” business.
The nature of the restrained conduct can also be too wide. For example if the seller of a domestic cleaning business was restrained from conducting any type of cleaning, this would be too wide.
Some legislation also directly touches on Restraint Clauses. For example:
- the Restraint of Trade Act 1976 (NSW) gives a Court the power to read down and enforce what would otherwise be a void Restraint Clause; and
- the Franchise Code of Conduct renders Restraint Clauses unenforceable where a compliant franchisee requests, but is denied, an extension of the term of a franchise agreement and the franchisee did not receive, or was not entitled to, more than nominal compensation for the goodwill of the franchised business.
Restraint of Trade Clauses and Unfair Contract Terms Regime
In the recent years, unfair contract term provisions in the Australian Consumer Law (UCT Provisions) have provided an avenue for relief for small businesses and consumers where there are unfair terms in standard form contracts.
The test of unfairness under this legislation has some similarities to the tests applied by the Courts when considering Restraint Clauses. Under the UCT Provisions a term in a standard form contract is unfair if
- it would cause significant imbalance in the parties’ rights and obligations under the contract;
- it is not reasonably necessary in order to protect the legitimate interest of the Benefiting Party; AND
- it would cause detriment (whether financial or otherwise) to a party if it were to be applied or relied on.
Proposed reforms to the UCT Provisions (if enacted) will widen their scope and, importantly, allow for the imposition of civil penalties on parties who include unfair contract terms in their agreements.
If these reforms are enacted, the practice of some parties to include Restraint Clauses that are potentially unfair more as a deterrent, will need to be reviewed.
A critical analysis needs to be undertaken to identify what is truly the legitimate interests of the Benefiting Party, then fashion the clause to ensure that it does not seek to protect anything more than that party’s legitimate business interests.
How we can help
Our Commercial & Franchising team can help you review and re-draft your standard business contracts, including Restraint Clauses, so as to help your business avoid any exposure to liabilities under the new regime.
Our Dispute Resolution & Litigation team members can also assist with disputes and litigation in relation to Restraint Clauses, whether by taking act to enforce such clauses or to resist other parties from enforcing such clauses.
Our Employment Team can also help with the drafting and inclusion of Restraint Clauses in employment contracts.