Restraint of Trade Provision can be effective
Nov 2011 |Introduction
In the recent decision of Hunter v Koulouris1 the New South Wales Supreme Court was required to consider whether a restraint of trade clause in a business dissolution deed was reasonable, when determining a breach of contract claim. This is an issue that has given rise to a series of cases and insurance notifications in recent years.
Relevant facts
In 1999, James Hunter (the Plaintiff) and Alex Koulouris (the Defendant) went into business together, exclusively importing and distributing solar film products in accordance with a distributor agreement between Johnson Professional Window Films Pty Ltd (the Plaintiff) and Johnson Laminating & Coating Inc, a company which manufactured the solar film products in the United States.
The business created a Sign Division which sourced and supplied decorative glass films and vinyls. In 2006, the First Defendant operated the Sign Division as a separate entity through GTS Films Pty Ltd (the Defendant).
In 2008, the partnership ceased. The parties executed a deed which enabled the First Plaintiff to purchase the First Defendant's share of the Second Plaintiff. The deed contained a restraint of trade clause which prevented the First Defendant from competing with the First Plaintiff's business for a period of five years. The restraint clause also stated "the prohibitions and restrictions contained in this clause are reasonable and necessary to protect the business of [the First Plaintiff]."
From November 2010, the Plaintiffs discovered that the First Defendant had recommenced business in the solar film industry through the Second Defendant (the First Defendant's wife had become the sole shareholder, director and secretary of the Second Defendant).
The Plaintiffs instituted proceedings against the Defendants, claiming the First Defendant had competed with the Plaintiffs before the restraint period had expired, by selling similar products. The Defendants disputed the claim on the basis that a five year period was too long to restrain trade in Australia and the restraint of trade clause was a "non-negotiable term".
Decision
His Honour Judge Davies found there was a prima facie breach of the restraint of trade clause in respect of the Defendants competing with the First Plaintiff, during the currency of the restraint of trade clause.2 Davies J then turned to the predominant issue in the proceedings which was whether the five year restraint of trade clause was reasonable.
His Honour referred to section 4 of the Restraints of Trade Act 1976 (NSW). Section 4(1) states, "a restraint of trade is valid to the extent to which it is not against pubic policy, whether it is in severable terms or not."3 The onus of proof, in relation to the public policy element of section 4, was not an issue in the proceedings.
After reviewing a number of previous decisions relevant to restraint provisions, Davies J observed the following principles as being relevant to the question before the Court:
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Whether a restraint is reasonable should be assessed at the point the contract is entered into;
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When selling a business and its goodwill, a restraint can be considered reasonable, to preserve the goodwill of the business;
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There is not a specific test which determines whether the employer's restraint on an employee is reasonable;
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The negotiations between the parties and the subsequent contractual terms are relevant, and a contractual term expressing the reasonableness of the term or contract is not conclusive; and
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If a restraint clause is breached, it must be determined whether the restraint is "against public policy". A restraint can be narrowed if the restraint clause is "against public policy".
The test ultimately considered by His Honour was, "the time required for severing the relationship between [the First Defendant] and those clients who would patronise the business after its sale".4
Davies J also made reference to Koops Martin v Dean Reeves5 and Brereton J's concept of "customer connection". In the context of employees, Brereton J stated:
"…the establishment of a customer connection is not merely incidental to the employment, but its purpose. In that context, a covenant is considered reasonable, first, to remove the temptation that by cultivation of the target market during employment, the employee may prepare the ground for its exploitation by himself after the employment ends, rather than for his employer during the employment; and, secondly, to prevent exploitation after termination of the employment by the employee of a connection with the customer which the employer has paid the employee to establish for the employer's benefit."6
In applying this test, His Honour found the five year period for the restraint of trade clause in the present matter was reasonable, for the following reasons:
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The business and its goodwill should be protected because it had an exclusive distributorship agreement with the US company. The business was growing and prosperous, and its products in the Australian market were limited to 10 wholesalers and 1200 retailers;
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Based on the distributor agreement between the Second Plaintiff and the US company, the First Defendant knew the US company had a large amount of control over the Second Plaintiff, and would enforce a five year restraint clause upon the ceasing of the partnership;
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The five year restraint of trade clause was agreed to and considered reasonable by the First Defendant;
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The First Defendant received $675,000 and a release from his guarantor obligations to the Second Plaintiff;
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When negotiating the terms of the deed, solicitors were engaged to act on behalf of both the First Plaintiff and First Defendant. Davies J inferred that the First Defendant received "appropriate advice" from his solicitor before executing the deed; and
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Davies J rejected the Defendants' submissions that the restraint clause commenced on 1 July 2006 and had therefore almost expired, because the First Defendant continued to carry on business with the Second Plaintiff's clients after 1 July 2006.
Impact
Restraint provisions can be a useful tool for protecting the interests of one (or both) parties when business relationships come to an end, provided the restraint is effective. This case serves as a reminder of the Court's attitude towards what might be considered reasonable (and therefore effective) when it comes to restraint provisions.
Disputes over restraint provisions have been a significant source of recent litigation, and can commonly result in claims being notified under management liability and professional liability policies.
It is important restraints are carefully considered before they are agreed to, and that they are subject to further analysis before litigation is embarked upon.
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(1) Hunter v Koulouris [2011] NSWSC 887.
(2) His Honour reached this conclusion with regard to the First Defendant's wife being the director of the Second Defendant.
(3) Section 4 of the Restraints of Trade Act 1976 (NSW) is similar to the common law test which provides that restraints "are enforceable only if they are reasonable with reference to the interests of the parties concerned and of the public": Andreas I. Koumoulis v Leventis Motors Ltd (1973) 1 All NLR (part 2) 144 at 146. The common law test is applicable in Queensland.
(4) IRAF Pty Ltd v Graham [1982] 1 NSWLR 419 at [429].
(5) Koops Martin v Dean Reeves [2006] NSWSC 449 at [53].
(6) Koops Martin v Dean Reeves [2006] NSWSC 449 at [44] as per Brereton J.
