Post-Employment Restraints – Changes Internationally and Possibly in Australia

19/06/24

The United States Federal Trade Commission (FTC) has announced a new rule which, once effective, will prohibit the ability of employers to rely on and enforce key post-employment restraints such as non-compete restrictive covenants.  In Australia, the law governing personal restraints of trade is relatively complex and there are growing calls for reform.  Australia might adopt a similar approach to the impending American changes.  In the context of a very tight labour market, where inflation is outpacing wage growth, and government policy is squarely focused on retaining and even importing (via immigration) skilled labour – restraints, while viewed by employers as a key part of protecting their business, may impose artificial constraints to labour mobility and wage growth.

Post-Employment Restraints

Generally, post-employment related restraint of trade will exist as a contractual obligation (typically contained in an employment contract).  Post-employment restraints are also governed by the common law restraint of trade doctrine.

Typically, an agreement will contain provisions which include at least one, and perhaps all three, of the following post-employment restraints:

  • non-compete clause: to limit a former employee’s ability to work for a competitor of the former employer within a specified area for a specified period of time, in order to protect former employer’s confidential information and goodwill;
  • non-solicit clause: to prohibit a former employee from soliciting or interfering with the customers, clients or suppliers of the former employer, in order protect the former employer’s relationships; and
  • non-poach clause: to prohibit a former employee from hiring the employees of the former employer, in order to protect the former employer’s investment in staff.

The common law doctrine states post-employment restraints are presumed unenforceable unless the employer can justify the existence of the restraint by demonstrating it is reasonably necessary to protect a legitimate business interest, or the employee can show it is otherwise against the public interest.

In some jurisdictions, for example New South Wales, which enacted the Restraint of Trade Act 1976 (NSW), a restraint of trade is valid to the extent to which it is not against public policy, whether it is in severable terms or not.  On application by a person who is subject to a restraint, the Supreme Court may, having regard to the circumstances in which the restraint was created, order that it is invalid or valid to such extent only (not exceeding the extent to which the restraint is not against public policy) as the Court thinks fit.

Cascading Restraint Clauses

Cascading restraint clauses in a contract will typically set up the ability for a restraint to be read down by a Court.

These clauses have emerged as a contractual response to the common law doctrine and the statutory position.  They allow elements of a restraint to be severed (read down), with only those elements of the restraint that are seen as being unreasonable and against public policy removed from the contract.

The clauses layer post-employment restraint alternatives, especially when it comes to geographical restrictions and time restrictions.  They are generally combined with an appropriate severability clause that includes mechanical language which allows the Court to read down the scope of the restraint.  In practice, these clauses allow for a contractual (agreed) procedure for a Court to find a “reasonable” combination of options to avoid a situation where a restraint is deemed to be void and completely struck out of the contract.

By layering alternatives, the Court can strike out only the unreasonable part, leaving the next available alternative.  For example, time restrictions may start at a period of 3 years, and then offer alternatives of 2 years, 1 year, and six months.  Similarly, geographic restrictions may start at an area which includes all of Australia, and then offer alternatives such as New South Wales, a region and then a city.  The severability clause will allow for any covenants or restrictions (which would be valid or enforceable if the area or time were reduced), to be read down by reducing the area or period to the minimum required to achieve that enforceable result.

What a Court finds as reasonably necessary to protect the business interests of the employer may not align with what the employer’s views or the employee’s views, and so the result is that these types of clauses do not provide certainty to either of the contracting parties.  Unsurprisingly, cascading restraints are not commonly used throughout the world.

Former Business Owner Restraints

Employment contracts are not the only agreements which can give effect to a restraint of trade.   Often, a Share Purchase Agreement (or Business Sale Agreement depending on the circumstance), Shareholders’ Agreement or employee equity incentive plan will contain provisions to restrain a party or parties to the agreement.

The intention of a former business owner restraint is similar to a post-employment restraint – to prevent a former owner of a business from using their knowledge of the business’ confidential information to compete with the business they sold or poach key employees from the business they sold.  However, the crucial difference is that a purchaser has compensated the former owner for the goodwill of the acquired business and, in exchange, the new owner should be entitled to ensure the protection of that goodwill and take advantage of the full value of the acquired business.

The courts are more willing to enforce these types of goodwill-related restraints because the former owner has been compensated in relation to the restraint.

Activity within Australian Courts

It is very common for there to be an overlap between a post-employment restraint (for example, contained in an Executive Services Agreement) and restraints that apply to a former business owner.

In a business sale context, or where an executive is also a shareholder in a business, a Share Purchase Agreement or a Shareholders Agreement will usually include a restraint that purports to bind the same executive.  The executive may also be personally restrained pursuant to an Executive Services Agreement.  Post-employment restraints and former business owner restraints can overlap and potentially contradict.  If the language in the different restraints is not precisely and carefully drafted, the restraint may be struck out by a Court.

In a recent case decided in October 2023, 2nd Chapter Pty Ltd v Sealey [2023] VSC 599, the Victorian Supreme Court highlighted how employers may face closer scrutiny in attempting to enforce restraints against former employees, where there has also been a M&A transaction and a shareholder agreement restraint also has application.

In the 2nd Chapter case, the respondent, a financial advisory and wealth management company, applied for an interlocutory injunction restraining two former employees, who were also former shareholders, from engaging in any business in the wealth management industry, soliciting its clients, or interfering in its relationship with its customers.  The former employees, both financial advisers, had resigned from employment and later were employed by a competitor.  In the months following their new employment, a number of the respondent’s clients requested to transfer their business to the competitor.

Four relevant agreements contained varying but similar covenants in restraint of trade, including a Share Purchase Agreement, a Shareholders’ Agreement, a Management Deed, and Employment Agreements, which the respondent sought to enforce as part of the application for the interlocutory injunction.

Decision in the 2nd Chapter Case

The decision in the 2nd Chapter Case is interesting because the court necessarily had to closely examine the scope and nature of the different types of contractual restraints of trade.  The restraints were drawn as cascading restraints and included read down provisions.  The Court found that the restraints contained in all four agreements were not reasonable as between the parties, even if the least restrictive geographical area were adopted.

The Court picked apart the post-employment restraints which:

  • failed to nominate a commencement date for the restraint period;
  • applied to any current client of the respondent, regardless of whether that client had any prior dealings with the former employees; and
  • applied to any former client of the respondent, regardless of how much time had passed since that client had ceased using the respondent’s services.

Further, the Court found that the restraints were not reasonable in the public interest as they would have the effect of preventing clients or former clients of the respondent from taking their business to the business now associated with the former employees for any reason.

Notwithstanding those deficiencies, the employment agreements failed to include a provision that the restraints would continue to apply if the agreement was terminated on notice, and the Court considered it “doubtful” that the restraints survived termination of the agreements.

The interlocutory application was dismissed and the substantive proceedings were adjourned.  The respondent has since appealed the decision.

The Court’s decision demonstrates the difficulty in enforcing post-employment restraints in the context of an M&A transaction where the former employee was also a former shareholder and key manager.  In this context, as shown in the case, several agreements were applicable and each agreement focused on restraining an individual in a certain capacity, creating multiple layered restraints.

The layered restraints were ultimately designed to limit the trade of a particular individual who wore the different hats of an employee, manager and shareholder.  Unusually, the Court gathered the restraints and held them all to be unreasonable in the circumstances.  The decision also highlights the importance of having well-drafted restraint clauses that are effective only in so far as is reasonably necessary to protect the employer’s legitimate business interests.

Australian Competition Review Taskforce

The increased scrutiny of the courts surrounding post-employment restraints coincides with an Issues Paper, released by the Australian Government’s Competition Review Taskforce in April 2024, which explores reform options related to the use of post-employment restraints to improve labour mobility and wage growth.

The Issues Paper relies on Australian Bureau of Statistics (ABS) statistics concerning the proliferation of post-employment restraints by Australian businesses.  The Issues Paper suggests that the use of post-employment restraints favours employers and has a “chilling effect” on labour mobility and wage growth because:

  • employers may utilise cascading restraint periods and areas, which fail to provide certainty to employees regarding their enforcement;
  • restraints are not negotiated by employees because of an imbalance in the relative bargaining position of the employer and the employee; and
  • restraints are used indiscriminately by employers across all their employees.

The Issues Paper does not address the use of restraints of trade in a business sale context.

Key Changes in the United States

In April 2024, the United States Federal Trade Commission (FTC) announced that non-compete clauses in employment contracts would be prohibited.  Once effective in September 2024, the rule will supersede various differing laws put into effect by individual US states to the extent the state law is inconsistent with the new rule.

The new rule prohibits employment agreements (including retroactively) that create post-employment prohibitions or penalties, or otherwise function to prevent an employee from seeking or accepting other employment.  While the new rule targets traditional non-competition clauses, it also encompasses other provisions that create a “de facto” non-compete clause.

Notably, the new rule extends beyond traditional employees to independent contractors, consultants, unpaid employees, volunteers, apprentices, and labour hire/staffing arrangements.

The new rule contains a few key exclusions:

  • employers maintaining existing non-compete agreements with “senior executives” (i.e., employees making over US$151,164 annual compensation and in a policy making position for the business), and
  • non-competes entered into by a person pursuant to a bona fide sale of a business entity.

Importantly, the new rule does not seek to invalidate the enforceability of non-solicit clauses and non-poach clauses.

Takeaway

The sentiment in Australia regarding post-employment restraints appears to be shifting to a more pro-employee stance.  Recent case law has shown that courts may be more closely scrutinising the enforceability of post-employment restraints, and the release of an Issues Paper indicates that the Australian Government appears likely to introduce some level of reform to post-employment restraints, possibly even before the end of the calendar year.

How significant those reforms may be will depend on several factors, including the response submissions received by the Competition Review Taskforce, election results (i.e., how receptive the government will be to implementing reforms), Australia’s trade policy and perhaps how the new rule is received in the United States.

Employers may wish to consider alternative protections to safeguard their commercially sensitive confidential information.  Some progressive steps may include:

  • reviewing the current applicability of post-employment restraint clauses in agreements across the workforce to identify key risks and mitigation strategies;
  • considering how cascading restraints might be tailored should cascading restraints be prohibited;
  • developing alternative employment incentives focused on employee retention in lieu of post-employment restraints; and
  • investigating options such as extended notice periods and garden leave provisions in lieu of post-employment restraints.

If you or your business are concerned about the impact of potential reforms with respect to post-employment restraints, please contact SWS Lawyers at 02 4040 9650 or on info@swslawyers.com.au.

 

This article was written by Reid Farrell, Associate, who is admitted to practice law in NSW and licensed to practice law in California and Texas.

This article is not legal advice.  It is intended to provide commentary and general information only.  Access to this article does not entitle you to rely on it as legal advice.  You should obtain formal legal advice specific to your own situation.  Please contact us if you require advice on matters covered by this article.