Restraint clauses: what they are and what to look out for

This article was published in the Hire and Rental News Magazine, February 2023 issue, page 28

Restraint of trade clauses can play a vital role in protecting your business. This is especially important in an industry like the hire and rental industry where employees come and go, and hurdles to entry aren’t particularly high.

But a restraint will only protect your business if it is valid and enforceable.

What are restraint clauses?

In essence, a restraint involves a party promising not to engage in certain activity, such as poaching customers or competing more generally.

Restraints can be found in various contexts, such as in:

• employment contracts

• consultancy agreements

• business sale or share sale agreements

• franchise agreements

• shareholders agreements.

As such, individuals or businesses may be subject to multiple restraints at any one time.

The court’s approach to restraint clauses

While restraint clauses can be a useful tool to protect business interests, they may not be enforceable in certain circumstances. Very generally speaking, the Courts consider restraints to be void as the principle behind restraints is contrary to the public policy position that everybody should have the right to earn a living to feed themselves and their families. 

The Courts do however recognise that restraints are needed in certain circumstances. In determining whether to enforce a restraint, the Courts normally ask two questions:

• Is there a legitimate interest?

• Is the restraint reasonably necessary in order to protect that legitimate interest?

What is a legitimate interest?

For the purposes of interpretation, the Courts need to be able to identify a specific interest that needs protection. Typical examples of legitimate interests include trade secrets, confidential information and the goodwill of a business. A general interest, such as an interest in preventing a former employee from competing or using their knowledge, will not be considered a legitimate interest.

Is the restraint reasonably necessary?

For a restraint to be enforceable, the restraint must be no more than is reasonably necessary to protect a legitimate interest. Whilst there is no true bright-line test for this, the Courts typically look at the surrounding facts and circumstances, including factors such as:

• what is the interest being protected

• who are the parties, and what characteristics do they possess

• what activities is a party prevented from doing

• where geographically is the party prevented from conducting the activities

• how long is the party prevented from conducting the activity

• has any consideration been paid

• what is usual in the current market.

Ultimately, whether a restraint is reasonable depends on the facts and circumstances. As an example, in the recent appeal judgement of McMurchy v Employsure Pty Ltd; Kumaran v Employsure Pty Ltd [2022] NSWCA 201, the Courts considered whether a 9-month restraint against two former sales managers was reasonable. Here, the Courts were willing to enforce against one of the former sales managers on the basis they had access to certain confidential information but were unwilling to enforce that same restraint against the other as they did not appear to have the same access rights.

What happens if a restraint is not reasonable?

Under common law, when the Courts determine that a particular restraint clause is unreasonable, they will try to apply the ‘blue pencil test’. This involves the Courts seeing if they can make a restraint reasonable by simply striking out parts of the clause. As the Courts are not entitled to modify or alter any of the words in conducting the test, it may result in the entire restraint being struck out, even if it means leaving a legitimate interest entirely unprotected.

In NSW however, unlike other States and Territories, restraint clauses that are unreasonable may be ‘read down’ pursuant to the Restraints of Trade Act 1976 (NSW). What this means is that where this Act applies, the Courts aren’t limited to simply striking out words but can modify the provision so that at least some protection is afforded to the legitimate interest.

Practical considerations

Drafting

To ensure a restraint is enforceable, it is important to make sure the clause is properly drafted and tailored to the individual facts and circumstances, noting how the Courts deal with restraints that are considered unreasonable.

As what is considered reasonably necessary does change from time to time, it may be appropriate to include some flexibility and think about what minimum protections are necessary. In doing so, you should be working closely with your lawyers to ensure any restraints you put forward are appropriately designed and drafted.

What action can be taken if a restraint is breached?

If you are concerned that someone has breached their restraint, it is important to ensure that steps are taken to stop any further breach and to ensure you are not seen to be waiving your rights or otherwise accepting the conduct. Typical steps include:

• issuing formal cease and decease letters

• informing other involved parties about the alleged breach of restraint.

Ultimately though, you may need to take formal legal action, which may include seeking an injunction, to enforce the restraint. Sometimes proving that a restraint has been breached can be difficult.

As such, it is important to take formal legal counsel as soon as possible to ensure that you are taking the most appropriate action.

Authors: Eric Kwan and Isabella Krstanovski

Contributing partner: Michael Cossetto