On 4 February, the Court of Appeal handed down judgment in Guest Services Worldwide Limited v Shelmerdine [2020] EWCA Civ 85, an important case on the enforceability of restrictive covenants in shareholders’ agreements.
This is a rare example of the Court looking at covenants in the specific context of shareholders’ agreements and doing so in light of their interaction with compulsory transfer provisions.
This is also the first Court of Appeal decision which addresses what could be called the Hotel California problem.
This problem arises because, despite the existence of compulsory transfer provisions, it is often possible in theory at least that a shareholder’s shares might not fall to be transferred upon their departure as an employee or director. Hence, they could remain subject to the covenants despite no longer being actively involved in the business: – as the Eagles sang, “you can check out any time you like, but you can never leave”. In such cases, the departing shareholder may seek to argue that the covenant is unenforceable because it is unreasonably long.
Background
The Defendant was a consultant in a senior role within the Claimant company. The consultancy came to an end in February 2019.
The consultant was also a shareholder in the company and party to a shareholders’ agreement.
As some shareholders were actively involved in the business whereas others were mere investors, the shareholders’ agreement defined two categories of shareholders with additional restrictions on those who were characterised as Employee Shareholders. An Employee Shareholder was defined as a person who is an employee, agent or director of the company.
The restrictions on Employee Shareholders prevented competition with the company’s business, dealings with its customers or solicitation of its customers, employees or suppliers. The restrictions applied whilst the relevant person was a shareholder and for 12 months after they ceased so to be.
As a shareholder, the consultant was also bound by the Articles which contained fairly standard compulsory transfer provisions.
These provided that a shareholder who was but ceased to be an agent was deemed to have served a transfer notice unless a majority of the other shareholders determined otherwise.
Upon service of a deemed transfer notice the price to be paid for that individual’s shares would be determined (including as necessary on an independent valuation), with that price depending on whether the individual was a good or bad leaver.
Following determination of the price, the other shareholders would have the option (but not obligation) to purchase the leaver’s shares. If they declined, the shareholder could sell the shares to a third party (assuming a willing purchaser could be found) unless the Board reasonably considered that the proposed transferee was a competitor of the company. The third party would also have to agree to sign up to a deed of adherence to the terms of the shareholders’ agreement.
Following the consultant ceasing to be an agent, the company brought High Court proceedings alleging that he had acted in breach of the restrictive covenants in the shareholders’ agreement.
At trial, the consultant argued that as soon as he ceased to be an agent, he ceased to be an Employee Shareholder as that term was defined by reference to those who occupy the relevant positions (i.e. in the present tense) and he no longer occupied it. He therefore contended that the restrictions simply ceased to apply to him.
The High Court accepted the consultant’s argument.
The consultant also argued that in any event the restrictions were unreasonably wide and therefore unenforceable in restraint of trade. He argued that it was possible in theory for him to remain a shareholder and bound by the restrictions indefinitely as he might never be bought ought.
Again, the High Court agreed with the consultant. The company had a legitimate interest in confidentiality and goodwill which merited protection by way of restrictive covenants (in the usual way a pre-requisite to their enforceability). The restrictions would have been reasonable if they had simply applied whilst the shareholder was a consultant and for 12 months thereafter. As they could last much longer than this and possibly indefinitely, however, the restrictions were longer in duration than necessary to protect the company’s legitimate business interest. The Hotel California argument prevailed. The covenants were unenforceable.
The Court of Appeal’s decision
The Court of Appeal swiftly dismissed the argument that the covenants ceased to apply as soon as the consultancy ended. A key part of the purpose of the covenants was to protect the company for 12 months after a person ceased to be a shareholder which (due to the compulsory transfer provisions) would likely happen swiftly upon them ceasing to be a consultant. If the consultant’s argument was correct it would have rendered the 12-month post-termination restrictions effectively pointless. The judge had therefore erred and his judgment on this aspect was set aside.
The Court of Appeal then tuned to the question of enforceability of the covenants.
It held that whilst all covenants in restraint of trade are prima facie unenforceable at common-law, unless reasonable, the Courts should be less vigilant in relation to covenants contained within a shareholders’ agreement or agreement akin to it than with covenants contained within an employment contract.
At the same time, the Court stressed that it is not a simple matter of characterisation with non-compete provisions in employment contracts on one side and non-competes in shareholders’ agreements on the other.
Rather it will be necessary to consider the particular circumstances. At one end of the spectrum there may be non-compete provisions entered into as part of a wider commercial transaction involving the sale of a partnership share or shares in a business. At the other there may be an ordinary employee who has been granted a small shareholding as part of a share participation scheme.
On the facts of this case, the Court held that the 12-month restrictions were plainly enforceable.
First, the company had a legitimate interest in seeking to prevent Employee Shareholders from competing with the business and soliciting clients, given the particular nature of the business and the knowledge such individuals were likely to have obtained. Secondly, the clause appeared in a shareholders’ agreement made between experienced commercial parties. Thirdly, a period of restraint lasting 12 months was entirely reasonable to protect that interest.
In relation to this last point, the Court made clear that 12 months was reasonable even though it ran from when the individual ceased to be a shareholder rather than the cessation of the consultancy. There was likely to be little time elapsing between the two events given the compulsory transfer provisions.
Further, although significant delay was possible (including where, as in the instant case, there was a dispute which led to the individual remaining a shareholder) it was relatively unlikely. In the context of a relatively small private company, the Court also viewed it as very unlikely that a shareholder would be kept locked in indefinitely. Rather what would most likely happen was that the shareholder would be bought out in relatively short order. The Court was not prepared to find the clause unreasonable merely because of such possible, but unlikely, scenarios.
Comment
This case demonstrates the willingness of the Court to uphold restrictive covenants in a shareholders’ agreement where the shareholder has played an active and important role in the business, even where those covenants run from the date the individual ceases to be a shareholder.
The way leaver provisions and covenants are often structured in shareholders’ agreements and articles frequently give rise to the potential for Hotel California arguments. This decision will make such arguments much more difficult to advance in future.
It is therefore a decision which should be welcomed by companies with restrictive covenants in their shareholders’ agreements.
This article was written by David Lascelles. David frequently acts in cases arising from shareholders’ agreements and articles of association including where compulsory transfer provisions and restrictive covenants are at issue. He is particularly well-placed to advise in relation to such matters given his significant experience in commercial and company law matters including in relation to senior executives.
David has been recognised for many years by both Chambers & Partners and Legal 500 independent guides to the legal professions as one of the UK’s leading barristers in both commercial and company law litigation. He is 1 of only 6 juniors barristers in the UK to be recommended in both fields in the 2020 edition of both independent guides.
