"Business purchasers be wary: the importance of Cream to restraint of trade clauses"

Business sales and restraint of trade clauses

A purchaser of a business will usually want a business sale agreement to include a restraint of trade clause.  The purpose of such a clause is to seek to protect the goodwill of the business by prohibiting the seller from starting up a competing business for a period of time after the sale.  

Standard or poorly drafted clauses are often used in business sale agreements instead of tailoring such a clause to suit the specific circumstances.  The risk is that a court will not enforce any such clause that may be void for uncertainty or unreasonable in being too wide in its application. 

Therefore, it is important to get the wording of the clause right in order to avoid:

• a potentially lengthy and expensive challenge in court as to the enforceability of such a clause; and
•  the possibility of a serious erosion of the goodwill of a business. 

The test for enforceability

There are two tests that must be satisfied in order to justify a restraint of trade clause:

• the restraint must be reasonable in the interest of the parties in that it affords no more than adequate protection to the covenantee, while at the same time it is in no way injurious to the public; and
• the court must form its own judgment in dealing with the question of reasonableness between the parties, bearing in mind issues such as the proprietary interest to be protected, the investment by the parties, duration and geographical area of the restraint.

The case of Cream v Bushcolt Pty Ltd [2004] is a useful example of the commercial approach of courts in determining reasonableness.

In 1998 Mr Cream sold his Western Australia livestock transportation business "Cream Transport" to Bushcolt Pty Ltd. The purchase price was only divided as between land on the one hand and plant and equipment on the other.  The deed of restraint contained a clause prohibiting Cream from competing with his previous business for a period of 10 years in Western Australia.  A further clause acknowledged that the parties agreed that each of the restraint obligations were reasonable having regard to the interests of each party.

However, three years later Cream re-entered the livestock transportation business in the same geographical area.  He contended that he did so primarily as he had close links to the local community and as it was the only job for which he was qualified.

The Full Court of the Supreme Court of Western Australia considered that the effect of the restraint covenant and its operation in practice were decisive elements in determining the unreasonableness of the restraint of trade and held that:

• the fact the parties in Cream had consented to the restraint was not conclusive as to the restraint's validity;
• in the circumstances, the period of 10 years imposed by the restraint was excessive and beyond that required for the reasonable protection of the goodwill, particularly as no part of the consideration had been allocated to goodwill.
• Malcolm CJ noted that the "absence from the agreement of any allocation of any part of the consideration for the sale and purchase of the business to goodwill" was "relevant to the assessment of the reasonableness of the restraints imposed in terms of duration, geographical area and operative scope". However, the amount paid for goodwill could not of itself be considered conclusive in determining the validity of the restraint; and
• in terms of the geographical scope of the restraint the Court held that although the business clients throughout Western Australia it had only a few clients in many regions. Malcolm CJ accepted the evidence that the business sold to Bushcolt operated predominantly within a radius of 200 kilometers of Geralton. It was held that the restraint of trade covering all of the State of Western Australia was unreasonable and not necessary to protect the goodwill in the business purchased by Bushcolt.

Accordingly, the entire restraint covenant was held unreasonable and therefore void.

The approach of the courts in each State varies. Had Western Australia adopted legislation based on the Restraints of Trade Act 1976 (NSW), the purchaser may have succeeded in gaining protection for some shorter period and within a more limited scope, including as to area.  With regard to goodwill, it is not possible to discern from the judgment in Cream whether it would have made any difference if the parties had apportioned a significant part of the purchase price to the goodwill.  However, it will likely be a factor the courts will take into account.

How can Talbot Olivier assist?

Restraint of trade clauses in business sale agreements are not "boilerplate" clauses. They should be legally reviewed or drafted before an agreement is signed. In particular, business purchasers need to:

• ensure that the restraint of trade clause is unambiguous and appropriate for the circumstances;
• properly consider the scope of restraint (geographic area, duration and operational activities) that is reasonably necessary to: (a) sever the relationship between the vendor and the customers of the business; and (b) protect the legitimate business interests of the purchaser; and
• consider allocating some of the purchase price to the goodwill of the business in consideration for the restraint on the vendor's activities.

Talbot Olivier can assist you in reviewing existing or proposed restraint of trade clauses, or by carefully drafting business sale agreements to suit your particular circumstances.

For further information or advice on this topic, please contact Paul Kordic, Principal, by email at pkordic@talbotolivier.com.au or Louis van Aardt, Senior Lawyer, by email at Lvanaardt@talbotolivier.com.au.