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News

Restrictive covenants in shareholders’ agreements

11th June 2020

The recent Court of Appeal case of Guest Services Worldwide Limited v David Shelmerdine [2020] EWCA Civ 85 has highlighted the considerations made by the Courts in determining the enforceability of a restrictive covenant in a shareholder’s agreement.  It has provided a stark reminder of the importance of ensuring restrictive covenants are clearly drafted.

Before reviewing the case in further detail, it is worth recapping restrictive covenants in general.

What is a restrictive covenant?

A restrictive covenant requires the person signing the agreement, to refrain from doing something.  Covenants of this kind are perhaps most commonly seen in deeds or contracts relating to property transactions, placing strict limitations on the actions of a party.

Such covenants are also found in employment contracts or share purchase agreements however, and are intended to stop exiting employees or shareholders competing with the business of the company or poaching employees or customers of the company they are leaving or selling.

Restrictive covenants are also often incorporated into shareholders agreements to ensure that shareholders both during the time they hold shares and for a period of time after they are no longer shareholders are prevented from competing with the business of the company.

For such restrictive covenants to be enforceable, those imposing the covenant should have a legitimate interest for which they have a right to protect.  The covenant should also be reasonable in nature, which, in practical terms, often means that it should be limited in certain ways such as time and geographic scope.

The problem with “reasonable”- GSW v Shelmerdine considered             

Restrictive covenants were at the heart of the case of GSW v Shelmerdine.

GSW was founded in 2011 by Mr David Shelmerdine, and produces maps for guests staying at luxury hotels.  Mr Shelmerdine sold the GSW in 2011 and was retained as an employee, tasked with visiting luxury hotels around the world and organising their maps.

In 2015, it was agreed that Mr Shelmerdine’s role should switch from an employee to a consultant.  When Mr Shelmerdine’s formal consultancy agreement expired in 2017, he continued to provide consultancy services on an ad-hoc basis.

Mr Shelmerdine continued to own shares in GSW following the 2011 sale, and in 2016 a shareholders’ agreement was drawn up between GSW and all shareholders.

In February 2019, Mr Shelmerdine’s consultancy arrangement was formally terminated and soon afterwards GSW alleged Mr Shelmerdine had tried to solicit business from the Ritz Carlton in Budapest and the Metropole in Monaco using a map produced for GSW.

This led to claims from GSW that Mr Shelmerdine had breached the restrictive covenants in both the original consultancy agreement and the later shareholders’ agreement.

The High Court found in favour of Mr Shelmerdine.  The decision stated the consultancy agreement had expired in 2017 and was therefore not in place when the consultancy arrangements ended, so the restrictive covenants could not impact Mr Shelmerdine’s activities.

At the same time, the court ruled the additional restrictive covenants in the shareholders’ agreement could not be enforced due to the fact that they were unreasonably wide.

GSW then launched an appeal, focussing on the covenants in the shareholders’ agreement, with the Court of Appeal having to decide whether Mr Shelmerdine was one of the shareholders covered by the restrictive covenants and if they were ‘reasonable’.

Matters were complicated by the parties to the shareholders’ agreement being divided into two groups, Shareholders and Employee Shareholders.  Only the latter, including direct employees, directors and agents of GSW, were subject to the restrictive covenants.

The covenants sought to prevent Employee Shareholders from poaching employees, starting a competing business or attempting to solicit existing customers and suppliers.

Although labelled as ‘Employee Shareholders’, those covered by the covenant were restricted on the basis of their shareholder status rather than their employment status, with the restrictions applying over the following periods:

  • Any time when the party in question was a shareholder
  • For 12 months after the party ceases to be a shareholder

The High Court decided a shareholder ceased to be an Employee Shareholder after they were no longer an employee, agent or director of GSW and therefore Mr Shelmerdine was no longer subject to the restrictive covenants.

The Court of Appeal however questioned the commercial sense of the original decision, feeling no reasonable person would accept the covenants would end when an individual left the company.  The Court of Appeal also noted that a period of restraint lasting 12 months was “entirely reasonable to protect that interest”.

Since Mr Shelmerdine retained his shares, the Court of Appeal felt he was still an Employee Shareholder when he left GSW in 2019 and was therefore subject to the restrictive covenants.

Clarity in covenants is key

The ruling, and in particular the fact two courts interpreted the law differently, underlines how important it is to seek expert legal advice when seeking to include restrictive covenants in a shareholders’ agreement, or when considering to sign up to a covenant as a shareholder.

Courts will view any commercial agreement, such as a shareholders’ agreement, with less scrutiny than say an employment contract, believing both parties are business people negotiating on equal terms rather than within the uneven power dynamic present in an employee/employer relationship.

It is therefore critical that the wording of any agreement is clearly drafted, with proper consideration given to the length of time the covenant will remain in place, and the circumstances in which they are enforced.  For the individual, an unfair restrictive covenant could have a huge impact on their career; for a business, an ineffective restrictive covenant could jeopardise its future.

If you have an issue with a shareholders’ agreement or would like advice on setting one up, please speak to Emma Benniston, Associate Solicitor in the Corporate and Commercial team, on 0121 716 3701 or email ebenniston@ansonssolicitors.com.

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