Walk the line when implementing a restraint of trade

Before the risks that are currently associated with the energy crisis increased in nature, mismanagement was often the most common root cause of a company’s financial distress. This can be put down to poor decision-making or gross financial misconduct on the level that we have seen with several recent high-profile cases in South Africa.

The ancient proverb that the fish rots from the head down is true. To salvage any value, cutting the head from the fish is often necessary. The same principle applies in business. When trying to preserve value in a distressed company, in most cases, top management has to go. Often, these executives sign a restraint of trade because they have skills and insights into the business that will be very welcomed by competitors. I recently read an article by Fluxmans which points out that companies need to be sure they are on the right side of the law when drawing up these agreements.

Useful tools

The Fluxmans article points out that restraints of trade are useful tools that enable a business owner to ensure that the valuable intangible assets of its business, such as the business model, trade secrets and customer and employee information, are protected from unfair exploitation. Typically, a restraint of trade will prevent the person subject to it from competing with the party in whose favour it is given, within a certain territory, for a certain amount of time

Restraints are frequently found in sale of shares agreements, sale of business agreements and employment contracts.

The article adds that, in a sale of shares agreement, a shareholder who is selling his/her shares in a company will undertake that he/she will not become a shareholder in, or be employed by, another entity conducting business in competition with the company. In the case of a sale of business (i.e. agreements where a company disposes of its business along with all of its associated assets and goodwill, as a going concern, to another entity, but the shares in the company itself are not sold) the selling company will give a restraint of trade undertaking in favour of the purchaser, as will the shareholder/s and key employees of the selling company. In both cases, the purpose of this undertaking is to prevent the seller from undermining the goodwill of the company, which is an integral part of the value for which the purchaser has paid.

In an employment contract, an employee may be prohibited from becoming employed by a competing entity. In these circumstances, the purpose of a restraint of trade is to protect the employer’s assets on which its competitive edge is based (such as its trade secrets, confidential information and client base), which a competitor could use to the employer’s detriment.

Key difficulties

The article points out that difficulties can arise in circumstances where the party in whose favour the restraint has been given (Party A) decides to dispose of its business as a going concern to a third party (Party B). This may occur as an outright, arm’s length sale, or as a result of a restructure or reorganisation in which a business division may be transferred between companies in a group. 

If the party who gave the restraint (Party C) breaches the restraint by competing with the business, it is B, as the new owner of the business, that would be affected by this breach and not A, who has disposed of the business and therefore no longer has an interest in it. In Absa Insurance and Financial Advisors Pty Ltd v Jonker and Another (C741/19, C742/17) 2017 ZALCCT 57 (17 November 2017), the court held that for a restraint of trade to be enforceable, the party seeking to enforce it must have an interest in the transaction or agreement, which interest must be capable or worthy of being protected in law.

The article adds that, when considering that it is A, and not B, in whose favour the restraint was given, B would not have the right to enforce it. Therefore, a catch-22 situation arises in which neither A nor B can enforce the restraint.

When drafting an agreement that includes a restraint of trade clause, as well as when drafting sale of business agreements, drafters need to be aware of this potential problem, which is often not foreseen at the time the agreement is signed. In order to ensure that a restraint of trade clause will protect a business and will be enforceable should the business change hands, the drafter should ensure, firstly, that the restraint itself contains a provision in terms of which the party giving the restraint agrees that in the event that the business is sold, the restraint will be enforceable by the purchaser. Secondly, if and when a sale does occur, the sale of business agreement should include a clause in terms of which the seller must cedes its rights in terms of the restraint of trade, to the buyer.

The debate continues

Is it ethical to impose a restraint of trade on an employee? This is how they provide for their family and sometimes even whole communities.

Depending on their involvement in the distress of a company, not many companies would welcome an executive involved in mismanagement with open arms. But what happens to those who are casualties of war? Executives that were unwilling participants in the mismanagement but were shown the door nonetheless? Perhaps this is another area of business rescue that needs to be looked at with a critical eye, as innovative thinking can benefit the industry as a whole. When elephants fight, it is the grass that gets trampled. Can we avoid this entirely?

Phahlani Mkhombo is the MD of Genesis Corporate Solutions and is a Senior Business Rescue Practitioner.