UK: Casting The Net: Restrictive Covenants For Web-Based Businesses

Last Updated: 23 July 2012
Article by Kemp Little’s Employment Pratice Group

In today's challenging economic climate, many companies are working extra hard to bring in business, and those which are doing well are trying to ensure continued success.  But their efforts may be in vain unless the company is protected against rogue departing employees who might otherwise make off with valuable business information.  All too often, such employees will use their knowledge and relationships with clients, distributors, colleagues and / or suppliers for the benefit of their new employer - a competing business. 

At this stage, the former employer may pick up the phone to lawyers such as us, asking what can be done.  The first thing any lawyer will ask is to see a copy of the individual's employment contract, which will hopefully contain some post-termination restrictions on working for a competitor, soliciting customers, poaching employees and the like.  But the degree of protection offered by such restrictions depends entirely on how well they are drafted.  It is well established that post-termination restrictions on employees are, on the face of it, unlawful restrictions on trade.  Because of this, the courts will only enforce such restrictions where they go no further than necessary to protect the legitimate interests of the business.  But what does that actually mean?  Case law provides some guidance– but much of it is outdated and does not reflect the digital age in which we now live.  We have found that some creative thinking is required when it comes to protecting less traditional types of businesses – particularly those which are web-based. 

In the paragraphs that follow, we draw on our experience of advising online businesses and set out some ideas to consider when drafting restrictions for such companies.  These considerations will be relevant both to restrictions in service agreements for employees, and transactional documents, such as a sale and purchase agreement, although the courts tend to take a more lenient approach to restrictions imposed as part of arm's length commercial transactions, as opposed to those which form part of an employment relationship.

The "what" – defining the business

Often, the most powerful way to protect your business against departing employees will be to prevent them from working for a competitor for a defined period following termination.  This sounds simple, but because of the onerous impact of such "non-compete" provisions on individual employees, they must be carefully worded in order to stand a chance of being upheld in the courts.   In order to articulate who your competitors are, you need to first define your own business.  For fast-paced technology companies, this may not be easy – they may quickly move into different areas, meaning that by the time the employer comes to rely on the restrictions, the focus of the business has changed significantly.    Cast the net too broad and the restriction risks being invalid; define the business too narrowly and you may not have adequate protection.

One way of addressing this is to have separate clauses restricting the employee from working for companies competing with the employer's existing business, and its prospective business.  It is also important that the definition of the business is limited to areas with which the employee was directly involved prior to his departure – as the employer has no legitimate interest in stopping the employee from competing in areas with which he had no prior involvement.

The "where" – establishing the appropriate geographical reach of the restrictions

The geographical scope of internet businesses may change rapidly, almost overnight, meaning that in an ideal world, the company would like to be protected globally.   Traditionally, courts have taken the view that the wider the geographical area, the less likely it is that the restriction will be enforceable.   However, whether this is still true depends very much on the nature of the interest being protected.  If the purpose of the non-compete is to protect confidential company information, there is a persuasive argument that the restriction must be worldwide, given that information can now be dispersed globally at the click of the button.  In contrast, if the purpose of the restriction is to protect customer or other critical business relationships, the scope of the restriction must correspond with the location of the clientele or other key business. 

When asked where their customers are based, some of our clients have told us that they are potentially in every country in the world.  In this case, it becomes necessary to look at market share in each jurisdiction.  By applying a threshold of, say, ten per cent of market share, the company can identify which jurisdictions can legitimately be covered by the restriction.

An additional complication which arises with internet businesses is that they can be run from any location, meaning, for example, that an individual may operate a business targeting a European market from the United States or some other jurisdiction.  In cases where the geographical reach of the restriction is limited to certain markets in which the employer is operating, it will therefore be necessary to stipulate that the employee is not permitted to operate a business from anywhere in the world where that business competes in the market that the employer is in.  The reality is of course that no matter how well drafted the restrictions are, there will be practical difficulties associated with enforcing them against former employees who have moved abroad.

The "who" - identifying the relationships you want to protect

The courts have always recognised that it is legitimate for businesses to protect their customer relationships.  But the customers of internet businesses will often be in their millions and will have no personal contact with anyone at the company – interacting solely through the company's online user interface.  In this scenario, the former employee will have no special influence over the customers.  It cannot therefore be said that the company has a legitimate interest in preventing such employees from soliciting or otherwise dealing with its customers.   

The customer base may also not be easily identifiable, meaning the former employee would have no way of ensuring that he or she did not inadvertently contact a customer during the course of marketing activities on behalf of a new employer.  Case law makes it clear that non-solicitation covenants will not be enforceable in these circumstances.   However, it might be legitimate for the employer to require the former employee not to knowingly interfere with its customer relationships. 

Scratch beneath the surface and you will probably find that there are also other business relationships which are critical to the company and which have features more akin to a traditional customer relationship, such as personal connections built up over time between the individuals involved.  For example, a music streaming service provider may place a high value on its exclusive relationships with record labels, without which, it would fail.  Equally a company selling online advertising may have no direct relationship with the "customers" of the site – those who buy the products and services being advertised, and it will not have a protectable relationship with the millions of advertisers using the site.  But there may be agents placing multiple adverts who are very important to the company and who can be identified.  Once these critical business relationships have been identified, there is no reason in principle why they cannot be protected, provided that the scope of the restrictions is sufficiently precise.  Again, this would be done by way of a non-interference clause.  While such clauses have been upheld in the context of protecting supplier relationships, it does however remain to be seen exactly what approach the courts would take in relation to non-interference with customers, agents etc.

The "when" – for how long should the restrictions apply?

This again comes down to the nature of the interest being protected.  Where the goal is to protect confidential information, a court will ask what the shelf life of that information is – i.e. when it will cease to be current.  If the aim is instead to protect customer relationships or other key business connections, the question is how long it would take the company to recruit replacement staff and for such employees to establish connections with customers.  This in turn depends on the degree of customer loyalty, which may be closely connected with the industry's specific sales cycle.  For example, in the insurance business, the courts have placed emphasis on the fact that many insurance policies are renewed annually, which gives weight to one year being the appropriate duration for post-termination restrictions in this context.

When deciding on the appropriate duration, it will also be necessary to factor in the role performed by the employee you are seeking to restrict; onerous restrictions with a long duration will only stand up to scrutiny if they are applied to employees who pose a real threat to the business on departure.  These are likely to either be very senior staff, such as directors, or those who are otherwise key employees, such as salespeople.  In either case, it will also be necessary to think about why they pose a threat – for example, a finance director may have access to lots of confidential information but is unlikely to have formed relationships with clients.  In this situation, the only legitimate interest the employer may have in restricting the employee will be in relation to protecting confidential information.

We know that a "cascade" approach of listing varying durations and asking the court to strike out those which are deemed too long does not work in the UK (unlike in some other jurisdictions).  This means that some analysis must be done before the duration of the restrictions is decided on.  It may be helpful to document this analysis so that it can be relied upon should the restrictions be tested in court.  At the time of writing, it is generally accepted that twelve months is the longest duration which is likely to be acceptable in an employment context.   In the scenario where the individual is a shareholder signing up to a sale and purchase agreement, a restriction in the region of two years may be valid.

Final thoughts

With inspirations such as Huddle's recent $24m Series-C round investment, a $10 million dollar kickstarter project, and Google's recent back to back acquisitions of Meebo and Quickoffice there never has been a more exciting time to run an online business.  This makes it all the more vital that these companies put appropriate protection in place early on to ensure they can retain the value of their business when the time comes to seek investment or sell.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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