Share purchase – restrictive covenants – how do you prevent a seller from setting up in competition?

Most business sale agreements have clauses which attempt to prevent or restrict the seller from setting up in competition with the business the seller has just sold.

One of the difficulties is how to enforce that clause.  Going to court to get an injunction is a very expensive business and although the courts are willing to uphold fairly lengthy periods of non-competition, no business wants to waste time or money going to court to uphold their rights.  If a buyer decides not to try to get an injunction then they can start court proceedings in the normal way, which is less costly, but then there are difficulties in assessing just how much money the buyer has lost as a result of the seller’s breach of the restrictive covenants.
In a recent case, Cavendish Square Holding BV v Talal El Makdessi the court was asked to decide whether clauses in an agreement linking the seller’s compliance with the restrictive covenants to other clauses in the agreement to do with deferred earnings or an obligation to sell further shares were penalties and therefore enforceable.
The court set out a test for deciding whether a clause is a penalty and therefore unenforceable – it is whether the secondary obligation which imposes the detriment (or possibly the penalty) is out of all proportion to a legitimate interest that the party, who hasn’t breached the agreement, has suffered.   Having viewed the two clauses in question the court decided that given both parties had been extensively advised by their lawyers, were reasonably evenly balanced in terms of bargaining power and that a large part of the value of the business was attributed to goodwill, the clauses were not penalties and were therefore enforceable.  The court acknowledged that although the purpose of the clauses was to influence the seller’s actions post completion, the clauses were acceptable as their intention was not to punish the seller but had a legitimate purpose to ensure the value in the business attributed to goodwill was not affected by the seller’s conduct, and if it was to seek a reduction in the price paid for that goodwill.
If you are thinking of buying or selling a business then it is important that you take advice early as that advice may affect the final version of the heads of terms and it may now include clauses such as the ones referred to in this recent court case.
For further information or advice please contact Nina Wilson.