Navigating Restraint of Trade Clauses in Australian Business Sales | GRM LAW

Navigating Restraint of Trade Clauses in Australian Business Sales

When buying a business, a purchaser invests significantly not just in tangible assets but also in the business's goodwill – its established reputation, customer base, and supplier relationships. To protect this investment, particularly the goodwill, Sale and Purchase Agreements (SPAs) in Australia almost invariably include restraint of trade clauses. These clauses aim to prevent the seller (and sometimes key individuals associated with the seller) from competing with the purchased business for a certain period after the sale. However, navigating these clauses requires careful consideration, as courts scrutinise them closely and will only enforce restraints that are deemed reasonable.

What is a Restraint of Trade Clause?

A restraint of trade clause is a contractual provision that restricts a party's freedom to engage in a particular trade, business, or profession. In the context of a business sale, common restraints include:

• Non-Compete Clauses: Preventing the seller from establishing, operating, or being involved in a business that competes with the one sold.
• Non-Solicitation Clauses: Prohibiting the seller from soliciting or dealing with customers, suppliers, or employees of the business sold.

These restrictions are typically limited by:

• Duration: The length of time the restraint applies (e.g., 1, 3, or 5 years post-completion).
• Geographic Area: The physical area where the restraint applies (e.g., a specific city, state, or the whole of Australia).
• Scope of Activity: The specific types of business activities restricted.

The Legal Principle: Reasonableness is Key

Under Australian common law and specific legislation like the Restraints of Trade Act 1976 (NSW), restraints of trade are prima facie (on the face of it) void and unenforceable because they are contrary to public policy, which favours freedom of commerce and competition.

However, this presumption can be rebutted. A restraint clause will be considered valid and enforceable only if it is proven to be reasonable in the circumstances. Reasonableness is assessed by considering two main factors:

1. Protection of Legitimate Interests: The restraint must do no more than is reasonably necessary to protect the legitimate interests of the party benefiting from the restraint (the purchaser, in a business sale context). The primary legitimate interest protected in a business sale is the goodwill acquired by the purchaser.
2. Public Interest: The restraint must not be unreasonable in the interests of the public (e.g., by unduly stifling competition).

Courts generally allow broader restraints in business sale agreements compared to employment contracts, recognising the purchaser's need to protect the significant value paid for goodwill. However, the onus is still on the purchaser seeking to enforce the restraint to prove its reasonableness.

Factors Determining Reasonableness

When assessing the reasonableness of a restraint clause in a business sale, courts consider:

• Duration: Is the time period of the restraint longer than necessary for the purchaser to establish their own connection with the customers and goodwill of the business? Restraints exceeding 3-5 years often face significant scrutiny, although longer periods might be justified in specific circumstances. As seen in DXC Eclipse Pty Ltd v Wildsmith [2023], a 7-year restraint was deemed unreasonable as the purchaser couldn't justify why such a long period was needed solely to protect goodwill, especially when the seller's contractual obligation to stay post-sale was much shorter.
• Geographic Area: Does the restricted area accurately reflect where the business actually operates and draws its goodwill from? A restraint covering areas where the business has no presence is likely unreasonable. Failing to specify a geographic limit, as in Butt v Long (1953), can render the clause void.
• Scope of Restricted Activities: Does the clause restrict the seller from activities genuinely competitive with the business sold, or does it extend too broadly? Restraints should focus on the specific type of business conducted at the time of sale, not potential future ventures.
• Nature of the Business: The type of business, its market, and customer loyalty patterns influence what is considered reasonable.
• Purchase Price Allocation: Explicitly allocating a portion of the purchase price to goodwill in the SPA can strengthen the argument that the restraint is necessary to protect that specific, paid-for interest. The lack of such allocation was a factor in finding a 10-year restraint excessive in Cream v Bushcolt [2004].
• Bargaining Power: While less critical than in employment contexts, significant inequality in bargaining power could potentially be a factor.

Drafting Effective (and Enforceable) Restraint Clauses

To maximise the chances of a restraint clause being enforceable:

• Be Specific: Clearly define the duration, geographic area, and scope of restricted activities. Avoid ambiguity.
• Tailor the Restraint: Ensure the restrictions directly relate to the specific business being sold and the goodwill being protected. Don't use overly broad, generic clauses.
• Use Cascading Clauses (Carefully): Consider using tiered or cascading clauses (e.g., offering several combinations of duration and area, from broadest to narrowest) allowing a court to sever unreasonable parts and enforce a narrower, reasonable restraint. However, these must be drafted carefully to avoid uncertainty.
• Justify the Restraint: Be prepared to demonstrate why the chosen duration, area, and scope are reasonably necessary to protect the purchased goodwill.
• Allocate Price to Goodwill: Clearly state in the SPA that a specific portion of the purchase price is attributable to goodwill.
• Seek Legal Advice: Engage experienced commercial lawyers to draft or review restraint clauses tailored to the specific transaction.

Conclusion

Restraint of trade clauses are a vital tool for purchasers in business sales to protect their investment in goodwill. However, they are not automatically enforceable. Australian courts require restraints to be reasonable, balancing the purchaser's legitimate interests against the seller's freedom to trade and the public interest in competition. By carefully considering the duration, geographic scope, and nature of the restricted activities, and ensuring the clause is precisely drafted and justifiable, parties can increase the likelihood that the restraint will achieve its intended purpose if challenged.

Disclaimer: This article provides general information only and does not constitute legal advice. You should seek specific legal advice tailored to your circumstances.