Non-compete clauses in employment contracts are being more closely scrutinised by the Courts and the Federal Government is currently considering proposals to limit their use. They have long been a tool for businesses to protect their confidential information, and relationships with clients and staff.
However, the Supreme Court of Victoria in 2nd Chapter Pty Ltd & Ors v Sealey & Ors (No 2) (No 2) [2024] VSC 672 recently declined to enforce a suite of non-compete and non-solicitation of client clauses in employment agreements and other commercial agreements.
Facts
The case involved three financial advisers, two of whom were shareholders Escala Partners, a financial advisory and wealth management firm. After the shareholders sold their shares to another group and they all became employees of 2nd Chapter, they all faced legal action from their new employer, after they resigned. 2nd Chapter (and other plaintiffs) sought to enforce various non-compete and non-solicitation of client clauses.
Scope of the restraints
The Court ultimately found all the restraints to be unreasonable and unenforceable.
The Court determined that the restraints extended beyond what was reasonably necessary to protect the employer's legitimate interests. Specifically:
- Non-solicitation of clients: The restraints applied to all clients of Escala Partners, not just those with whom the former employees had direct dealings or personal connections with. It was contended by the Plaintiffs that the former employees had access to client identities and fee structures through company records, client events, and meetings, which could allow them to offer better terms to those clients in their new employment. However, the Court found that the close personal connection between advisor and client did not exist for clients who were not directly served by the former employees. Therefore, there was no relationship of trust or connection to be protected.
- Severability of problematic aspects: The Court considered whether the problematic aspects of the restraints could be severed or read down to make them enforceable. However, it found that it could only use the 'blue pencil' principle to omit words, not to add or alter the drafting. In this case, the principle could not be applied to give the scope of the restraints an acceptable operation, rendering the entirety of the restraints unenforceable.
Duration of the restraints
The Court also found the duration of the restraints to be unreasonable:
- Share Purchase Agreement: The restraint lasted for a maximum of 5 years post-completion, which was deemed unreasonable, especially since the employees held very small shares in 2nd Chapter. The Court noted that no attempt was made to differentiate the duration of the restraint based on the size of each seller's stake. While such a restraint might be reasonable for employees with larger equity, it was excessive in this context.
- Management Deed: The restraint was tied to the termination of another document, which could occur at any time at Plaintiffs' election, rather than being linked to when the former employees ceased their employment. This lack of a clear endpoint made the restraint unreasonable.
- Shareholders Agreement: The restraint had the potential to last up to four years post-resignation, with no reasonable justification for such a lengthy period. The receipt of dividends by the shareholders as partial consideration for the restraint was not determinative.
- Employment Agreements: The cascading non-solicitation of client restraint was not considered in detail due to the finding of unenforceability on other grounds. However, the court noted that a 6 month or 3 month period post-employment would be reasonable, rather than the 9 or 12 months stipulated.
Other considerations
The Court also criticised:
- the cascading clause in the employment agreements because it was not drafted in way that made it clear how it operated, indicating it unreasonableness
- the use of broad definition of "engage in" in non-compete provisions in the Management Deed, which went beyond what was reasonable.
Confidentiality concerns
It was also argued that there was a real risk of the former employees taking clients and confidential information to a competitor, LGT Crestone. These included identities of clients, portfolio sizes, and pricing structures, which could be used to offer similar services at lower costs. While the Court acknowledged the legitimate interest in protecting confidential information, it found that this risk was already mitigated by existing confidentiality obligations within the agreements, statutory obligations, and obligations imposed in equity. Therefore, the restraints were not necessary in order to address this risk.
Implications for employers
The judgment highlights the need for employers to carefully draft restraint of trade clauses to ensure they are no more restrictive than reasonably necessary to protect the interests of the employer.
The judgment highlights several important points in this respect:
- Non-solicitation of client clauses should be drafted to only include clients which the employee had dealings with during their employment
- Definitions of phrases such as "engage in" in non-compete clauses, which seek to restrict the capacities in which an employee can be involved with a competitor, should not be overly broad and be confined to the capacities the employer wants to prohibit most
- Cascading clauses must be drafted very clearly to explain how they operate
- The time limit for which non-solicit and non-compete clauses operate should be crystal clear and not excessive.
Federal Government's reforms
The Federal Government is currently consulting on modernising the National Competition Policy. The Treasury's Employment White Paper Roadmap suggests that non-compete clauses may hinder job mobility and innovation. Proposed regulations with respect to non-compete clauses include:
- Complete bans: Similar to the United States framework; a complete ban on non-compete clauses.
- Thresholds and limits: The use of high-income thresholds to determine applicability, the imposition of compensation requirements and duration limits.
At this stage, it appears non-solicitation of client clauses will not be affected by these reforms.
Conclusion
The decision in 2nd Chapter applies a more critical approach to the enforceability of post-employment restraints than previous case law. However, it remains to be seen if the approach taken by the Court in this case becomes a trend in subsequent cases. In any event, if the Federal Government reforms in this area become law, the use of non-compete clauses may be significantly restricted in the future.
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.