Restraints of trade are commonly used in New Zealand contracts – from mergers and acquisition(M&A) deals, in shareholders’ agreements and employment / contractor arrangements. They help protect business value, but if drafted too broadly or without clear justification, they risk being unenforceable.
In M&A and capital raising transactions, buyers and investors will carefully review restraints on founders or key employees / contractors to ensure there is the necessary protection of IP, customer relationships, and know-how.
This guide outlines the types of interests that can be protected, key factors courts might consider, and how restraints are typically applied in corporate transactions – along with some practical tips.
Restraints presumed invalid unless reasonable
The landmark case of Nordenfelt v Maxim Nordenfelt Guns & Ammunition Co [1894] held that a restraint is prima facie unlawful, but it may be upheld if it is reasonable in the interests of the parties to the contract and with reference to the interests of the public.
To be enforceable, a restraint must:
- protect a legitimate business interest
- go no further than reasonably necessary in terms of duration, geography, and scope.
In short, the restraint must provide adequate protection, but nothing more.
What can be protected?
A restraint cannot simply prevent competition for its own sake. The law will not protect a party from ordinary commercial competition. Instead, the restraint must be connected to a specific interest, such as:
- trade connections (e.g. client or supplier relationships)
- confidential business information
- know-how or intellectual property
- goodwill of a business being sold.
Two common types of restraint clauses
Non-compete
Prevents a person from working for, or establishing, a competing business within a defined area and timeframe.
Non-solicitation
Prevents a person from contacting or poaching former clients, customers, suppliers, or employees. These tend to be narrower and more enforceable, especially in the employment context.
Reasonableness of restraint depends on scope
Restraints must be reasonable and proportionate. Courts will closely examine the scope of the restraint if necessary, considering:
1. The activity being restrained
Is the restriction narrowly targeted (e.g., preventing contact with certain clients) or a broad ban on competing in an entire industry? Narrow restraints are more likely to be enforceable. E.g. in the AANZ template shareholders’ agreement, a competing entity is defined as any business or other undertaking, which is directly competitive with the Business or any material part of the Business. The defined term Business should be reviewed carefully and, in some cases, a narrower defined concept of Restricted Business may be required.
2. The geographical area
A restraint covering a small local area may be reasonable for a small business; a nationwide or international restriction may be justified for a larger company. If the business is likely to expand overseas, consider if the geographical area should include jurisdictions where the business might operate in the future.
3. The duration of the restraint
While no strict limits exist, restraints lasting 3 years are generally seen as the upper bound in the M&Acontext (see below), but employment restraints tend to be much shorter (e.g. 3 -12 months). But each must be justified.
In addition, restraints in employment / contractor agreements could receive closer scrutiny if challenged, especially if the employee or contractor is junior, the restraint is broad in scope, or the employer cannot identify a specific protectable interest.
Uses in corporate transactions
M&A
Restraints are generally included in sale and purchase agreements as part of M&A deals. They apply to the sellers (whether in share or asset sales) with the rationale to protect a business’ core working knowledge, and ultimately the goodwill being transferred. While a buyer is likely to prefer that the restraints to apply to all sellers regardless of their involvement in the business, there are typically exclusions for:
- private equity, venture capital and other institutional investors for whom restraints are simply unworkable; and
- large groups of small sellers.
Buyers typically require non-compete and non-solicitation clauses binding sellers for at least 24-36 months post completion of the sale. Restraints on the sellers of a business in favour of the buyer are upheld more readily than restraints on an employee in favour of their employer. This reflects the substantial value exchanged and more balanced bargaining power in company or business sales (compared to the employer – employee relationship).
Shareholders’ Agreements
Restraints in shareholders’ agreements usually apply to founders and sometimes key employee shareholders due to their knowledge of the business. The restraints aim to:
- prevent restrained shareholders from competing during and after exiting the business
- protect confidential information, trade connections, and goodwill, and
- provide comfort to investors that key people won’t damage the business on exit.
These restraints typically apply while the person is a shareholder, and often for a specified period after exiting the business (e.g. 12–24 months). Restraints in shareholders’ agreements have not been conclusively tested by New Zealand courts, so enforceability remains more uncertain. But the High Court has held that restraints in shareholders’ agreements (as with all restraints) must focus on a legitimate proprietary interest that requires protection. To maximise enforceability, shareholder restraints should be reasonably scoped and connected to a legitimate interest.
One issue companies and founders should consider is when the restraint period runs from – usually from the date they cease to be either (i) a shareholder or (ii) employed, or engaged as a contractor, by the business. In the NZ context, the restraint period often lands on being the earlier of those two events. Investors might argue that a founder who has ceased to work for a company but who retains a shareholding should not compete. On the other hand, a departing founder has no guarantee of any party acquiring their shares on their exit, so the restraints could continue forever. This is not reasonable, nor likely to be upheld by a court.
Legislative developments and global trends
The Employment Relations (Restraint of Trade) Amendment Bill, currently at its second reading, proposes significant changes to restraints in employment agreements, including:
- making non-compete clauses unenforceable against employees earning less than three times the minimum wage
- requiring compensation of at least 50% of the average weekly wage during any restraint period
Notably the Bill does not include specific carve-outs for M&A transactions or shareholder restraints, potentially affecting how restraints are structured in all cases going forward. While the Bill focuses on employment agreements, its impact could ripple into other areas, particularly where employee-like roles overlap with shareholder or contractor positions. This is, of course, all yet to be seen with the Bill some way off becoming law (if at all).
There has also been a shift to try and restrict the use of non-competes in places such as the US, the UK and parts of the EU. But, in most cases, those restrictions are not intended to apply to non-competes imposed in connection with M&A deals.
Final thoughts
Restraints of trade are vital for protecting sensitive business interests but must be considered carefully. You should:
- ensure there is a specific protectable interest
- keep restraints no broader than necessary in activity, geography, and duration
- consider the relationship between the parties and the commercial context to assess reasonableness
- consider the restraint period, and when it runs from
- define the restricted business accurately and fairly in the context of a non-compete.
