Blue pencils at the ready - Supreme Court saves restrictive covenant in employment contract

The role that restrictive covenants in employment contracts play in protecting against post-employment competition from ex-employees can often be quickly dismissed. There is still a perception that this type of clause cannot be enforced when push comes to shove.

The Supreme Court judgment in Tillman v Egon Zehnder Ltd is a useful reminder that this is wrong and that the courts will not hesitate to enforce a reasonably drawn covenant.

Restriction on shares renders covenant unreasonable

Tillman involved the application of a six month non-competition covenant in the employment contract of a highly remunerated financial services professional.

Ms Tillman challenged the enforceability of the restrictive covenant on the basis that, as drafted, it went beyond preventing her employment or engagement by a competitor for six months. It also prevented her from holding any shares in a competing business.

As is common, Ms Tillman’s contract had permitted her to hold an investment of up to 5% of the shares in any listed company during her employment. Given that the non-competition covenant did not have a similar caveat to clarify she was still able to hold a minority shareholding in a competitor, Ms Tillman argued it was too wide.

The Supreme Court agreed that any restrictions on shareholdings post-employment are subject to the doctrine of restraint of trade, such that these should go no further than is necessary. As the non-compete covenant in Ms Tillman’s contract prevented any shareholding, whether large or small, it rendered the covenant unreasonable.

Blue pencil test to the rescue

The story did not end there. Ms Tillman’s former employer Egon Zehnder had included a blue pencil clause in her employment contract. A blue pencil clause permits the removal of the unenforceable part of the covenant in order to leave the remainder enforceable.

The Supreme Court set out a three-step test for a blue pencil clause to “save” a covenant:

  • The unenforceable part must be capable of being deleted without the need to add any new words or make any other change for the remainder of the covenant to still make sense.
  • The remaining terms must be supported by consideration.
  • The removal of the unenforceable part should not generate any major change in the overall extent of the covenant.

Applying this, the Supreme Court held that, if it removed the restriction on Ms Tillman holding shares in a competing business, it left a clear, reasonable non-compete covenant she was required to abide by.

The sting in the tail for the employer was in respect of costs. While the successful party usually benefits from the loser paying its costs (in full or as assessed), it was suggested Egon Zehnder may have to foot the costs. The reason for the dispute stemmed from a defect in the way the employer had drafted the non-compete covenant.

Getting covenants right

Decisions like Tillman show the importance of well-drafted covenants for employers concerned about post-termination competition from ex-employees.

There are two key lessons;

  • These provisions are complex and it is important that you have legal advice on them, particularly any restrictions on shareholdings.
  • Enforcing covenants is expensive and time consuming. This means that if you would never be prepared to spend this time or money to enforce the covenant, there is little merit in including this type of provision in your employment contracts. Once your bluff is called, there will be little deterrent.

Employers need a range of tools at their disposal to counter post-employment competition to avoid any over-reliance on covenants. This means not only sound confidentiality and IP clauses, but also giving thought to what is necessary beyond terms in an employment contract. If your business is IP or information driven, what is your overall strategy on protecting this? If it is people driven, how do you guard against over-reliance on key individuals?

Our content explained

Every piece of content we create is correct on the date it’s published but please don’t rely on it as legal advice. If you’d like to speak to us about your own legal requirements, please contact one of our expert lawyers.

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