When purchasing a business, it helps to include a restraint of trade clause in the sale of business contracts. This clause aims to protect you (as the purchaser) by preventing the vendor from opening up a competing business nearby after the sale is complete. As a purchaser, it is essential to know what kind of restraint is suitable. This article unpacks:
- drafting a restraint of trade clause;
- the law regarding these provisions; and
- the consequences for breaching a restraint of trade clause.
Drafting a Restraint of Trade Clause
Restraint clauses prevent the vendor from operating a competing business within a specified period and within a specified geographic area. Importantly, it is vital to consider what is meant by 'operating' and a 'competing business'. Your contract can expand these terms to be very broad or apply to specific roles and narrow types of businesses.
Indeed, a broad or narrow approach will best suit you, depending on whether you are buying or selling. As the buyer, you want the restraint to be as broad as possible (while being reasonable). Conversely, as the seller, you want it to be narrow.
In New Zealand, courts generally take the approach that a restraint is unenforceable unless a party can justify that it is reasonable. Hence, it is important to ensure your restraint clause is reasonable and you draft it clearly. In particular, a restraint clause should:
- clearly define what proprietary interests are being protected;
- specify an appropriate or necessary geographic area where the restraint will apply; and
- specify an appropriate or necessary period of time that the restraint will apply for.
Likewise, what is an appropriate or necessary restraint period and area will depend on the particular circumstances of the arrangement.
This is different to the approach taken in Australia, where restraint clauses are drafted as 'cascading clauses'. A cascading clause progressively decreases in restraint period, for example, three years, two years, one year. The restraint area will also decrease in a cascading clause. Essentially, a cascading clause acts as a fallback position if the vendor challenges the initial restraint as being unreasonable in court.
Assessing a Restraint of Trade Clause
For a restraint clause to be enforceable in New Zealand, the restraint must be reasonably necessary to protect a legitimate commercial or proprietary interest. As such, if a restraint of trade is unreasonable, the court may:
- delete the restraint;
- modify the restraint area or period so that the provision would be reasonable; or
- decline to enforce the contract. For example, if deleting or modifying the clause would alter the party's arrangement, it would be unreasonable to allow the contract to stand.
A restraint will be reasonable if it gives the purchaser no more protection than what is 'reasonable.' To assess reasonableness, the first step is to identify the purchaser's legitimate protectable interest(s). A protectable interest is a property right or interest, but it can also include commercial interests. For example, interest in:
- confidential information;
- trade secrets; or
- economies of scale.
When a court determines whether the restraint is reasonable, several interests will be relevant. This includes the:
- relative bargaining power of the parties;
- activities and conduct caught by the restraint;
- benefits the vendor receives;
- the geographical scope of the restraint;
- duration of the restraint; and
- commercial context (including standard practice in the industry).
Consequences for Breaching a Restraint of Trade
Suppose the vendor violates the restraint of trade and the parties cannot agree on a resolution. In that case, the purchaser must go to court to enforce it. A court may order an injunction (i.e. an order that stops a party from doing a particular thing) or damages. The purchaser must prove loss, and the court will generally calculate damages according to the lost income or lost profit by the purchaser.
Importantly, a court will determine whether the purchaser suffered any actual loss based on the facts of the case.
As the purchaser, you must include a restraint that is objectively reasonable or includes a cascading clause that would allow a court to determine what is reasonable. Assessing whether a restraint of trade clause is reasonable is driven by each case's unique facts and what both parties gain from the transaction. All parties in a transaction must protect their interests while allowing some degree of flexibility and compromise.