PROTECTING YOUR BUSINESS INTERESTS

In Brief:

Confidentiality agreements and restraint of trade clauses are commonly used to prevent former employees or franchisees from engaging in activities that compete with businesses, including franchises. However, recent Supreme Court decisions across Australia have indicated that inadequate confidentiality agreements and unreasonable restraint of trade clauses in employment contracts or franchise agreements, may fail to adequately protect legitimate business interests.

1) Confidentiality Agreements and Fiduciary Duties: GlaxoSmithKline Australia Pty Ltd v Ritchie [1]

The Victorian Supreme Court in GlaxoSmithKliene Pty Ltd v Ritchie , addressed issues relating to prohibiting former employees from establishing competing businesses by utilising confidential company information.

GlaxoSmithKline (GSK) was one of two main manufacturers and suppliers of legal opiate extracts from Tasmanian poppies. Mr Ritchie, a former manager at GSK, left the company to set up a competing company involved in the production of the same product. GSK claimed that its production processes were confidential and Ritchie's utilisation of this information in establishing a rival company was unlawful misuse. GSK also alleged that Ritchie breached his duty of good faith and fidelity that he owed to his employer. GSK's case failed on both accounts.

Confidentiality Agreements in Employment Contracts

The decision indicates that it is essential that businesses properly identify and classify what information is confidential. Harper J held that the onus rested with GSK to identify and establish that the information it sought to protect was confidential. [2] Ritchie had signed a confidentiality agreement in the course of his employment, however His Honour held that the agreement did not create a post-employment obligation of confidence, due to insufficient drafting. [3]

Furthermore, Ritchie was entitled to use any information which had become a part of his "general stock of knowledge", so long as the information was not a trade secret. Harper J re-stated the general principle that "the law will not…seek to prevent those who wish to practice their profession or trade from doing so simply because their work for someone other than their former employer may put that former employer at a financial or competitive disadvantage". [4]

As the confidentiality agreement did not extend past his employment, the court found that Ritchie was entitled to use his skill and knowledge to design a process for the benefit of his own company. [5] GSK also faced evidentiary issues, as they could not provide sufficient evidence to establish that Ritchie had misued the information. [6]

Fiduciary Duty

As an employee of GSK, Ritchie owed a duty of good faith and fidelity to his employer. Whilst still employed with GSK, Ritchie worked on an outside project, which helped him to establish his own company after he had left GSK. However, His Honour was not satisfied that Ritchie's activities had "subverted GSK's business". [7] Although Ritchie had exchanged emails relating to his personal project during working hours, this was held to only constitute a "trivial proportion of the time Ritchie devoted to his GSK duties" and did not constitute a conflict of interest. [8] In general, an employee will not breach their fiduciary duty if they evince "an intention…to set up [a company], after their employment has ceased, in competition with his or her employer". [9]

2) Restraint of Trade Clauses

Restraint of trade clauses can successfully operate to protect business interests, if they are reasonable and necessary.

The decision in Workpac Pty Ltd v Steel Cap Recruitment Pty Ltd , [10] is the most recent application of restraint of trade principles; the Supreme Court of Western Australia considered the reasonableness of a temporal and geographical post-termination restraint clause in an employment contract.

The function of restraint clauses in franchise agreements was also examined in a 2006 decision from the Supreme Court of New South Wales, Raine & Horne Pty Ltd v Adacol Pty Ltd . [11]

Employment Contracts: Workpac Pty Ltd v Steel Cap Recruitment Pty Ltd

The plaintiff, Workpac, sought an injunction to restrain former employees from competing with it and making use of its confidential information. The plaintiff was an Australia-wide recruitment agency. The defendants, Steel Cap Recruitment, were former employees who established a rival recruitment agency.

The employment contract contained various "restraint areas" [12] and "restraint periods" [13] : the restraint clause was intended to comprise of any of the various combinations of these areas and periods, with any combination also capable of being severed. The plaintiff sought to restrain the defendants for a period of 12 months after the termination of their employment, from being involved in the business of a recruitment agency within a radius of 500 km from the offices where they had worked. [14]

Templeman J applied existing authorities to hold that in determining the reasonableness of a restraint clause, courts will balance the interests the business seeks to protect and the effect of the restraint on the former employees. [15] Whilst His Honour accepted that the plaintiff's objective to protect its client connection was legitimate, upon examination of the circumstances of each defendants employment and their potential to create relationships with clients, Templeman J deemed the 12 month temporal restriction excessive and unreasonable. [16]

His Honour also indicated that the multiple combinations of temporal and geographic restraints in the employment contract did not reflect a genuine attempt to define an area of protection. It was suggested that courts may look favourably upon cases in which the potential for severance is very limited; for example: two restraints - one would be valid and the other invalid. [17]

Franchise Agreements: Raine & Horne Pty Ltd v Adacol Pty Ltd

The defendants, through the first defendant (Adacol) ran a real estate franchises pursuant to franchise agreements made with the plaintiff, Raine & Horne, in mid 2005. After the franchise agreement was terminated, Raine & Horne sought interlocutory relief to enforce the restraint clause of the franchise agreement. The restraint clause prohibited the defendants from being involved in any real estate agency business for 12 months after termination of the franchise agreement, within 5km of the former franchise premises.

McDougall J applied the general principles that the party seeking to enforce a restraint of trade must show that the restraint is no wider than is reasonably necessary to protects its legitimate interests. [18] In assessing the reasonableness of the restraint clause, it was relevant that the clause only prevented the defendants from establishing a new business within the area and did not prevent the restrained party from carrying on its business at all. [19] The court found that a franchisor is entitled to protect the goodwill of its business built up over many years. [20] In the present case, McDougall held that the restraint clause legitimately protected the franchisor's interests in its local customers. [21]

Protecting Your Business - Considerations for Businesses

Confidentiality Agreements - Protecting Confidential Information & Trade Secrets

Employers and franchisors can safeguard their confidential information and trade secrets by ensuring that the information they seek to protect is covered by a properly drafted confidentiality agreement.

It is important that a confidentiality agreement specifically identifies what information is confidential, specifies how the employee or franchisee (' the recipient' ) is allowed to use the confidential information, addresses disclosure issues during and post termination and ensures that the confidential information is handled securely.

To be legally confidential, the information cannot be of public knowledge and must be sufficiently specific; courts will be reluctant to enforce confidentiality agreements where the confidential information sought to be protected is not adequately defined. Recognised types of confidential information include manufacturing processes, financial and business records, business proposals and plans, customer and price lists, personal information, marketing strategies and plans and product designs and formulations. [22]

Employment Contracts - Avoiding Unenforceable Post-Employment Restraints

Employers can minimize the risk of invalid contractual post-employment restraints and avoid unlawful interference with their business by former employees by the use of employment contracts with tailored post-employment restraints.

Employers need to consider the employee's role within the business, his or her interaction with the client base and what post-termination restriction on the employee's activities are necessary to protect the business. Whether a Court will enforce the post-employment restraint will depend on all the circumstances of the case and the application of the following principles:

• An unreasonable restraint of trade clause is contrary to the public interest and unenforceable;
• A person should not be unreasonably prevented from earning a lawful living and that the public should not be deprived of the services of a person prepared to engage in employment. [23]
• The restraint of trade clauses including:
  • the extent of the restraint on an employee's activities;
  • the geographic area within which such activities are restricted; and
  • the duration of such a restraint,

must be reasonable having regard to the employer's need to protect its legitimate business interests.

• If the activities in the restraint of trade clause are described too vaguely or broadly or do not specifically relate to the duties and responsibilities undertaken by the individual who is being restrained, then the clause may be unenforceable.
• The relative bargaining power between the parties and the amount paid to the employee in consideration for the restraint on their activities.

Restraint of trade clauses are only one way by which an employer may seek to prevent a former employee from interfering with or competing with its business. The employer may, depending on the circumstances of the case, have equitable rights preventing an employee from using customer lists or other confidential information/ trade secrets obtained in the course of his or her employment.

Franchise Agreements - Protecting Legitimate Business Interests

Franchisors can protect their legitimate business interests by ensuring that franchise agreements include reasonable and enforceable post-termination restraint clauses.

The principles that the courts have applied in relation to restraint of trade clauses in franchise agreements, are similar to the approach taken to restraint clauses in employment contracts:

• Geographic restraints , used to prevent a party, post-termination, from establishing a competing business within a certain distance from their former franchisor, must be reasonable. Courts are unlikely to enforce wide restraints, like "anywhere in Australia";
• Restraints on activities must only go so far as to protect the legitimate business interests of the franchise.

In the context of franchising, courts are likely to recognise a restraint clause if it seeks to protect the 'business carried on under the franchise banner within a particular locality'. [24] A franchisor could also claim a legitimate interest in:

• Protecting the patronage built up through the operation of the franchise, which may be lost if the franchisee is permitted to compete without restriction;
• Preserving the confidentiality of confidential information provided to the franchisee, which could be used by the franchisee to compete with the franchisor without restraint; [25]

In assessing the reasonableness of the restraint on activities, the franchisors interests will be balanced against those of the franchisee. Whether a restraint clause is too wide, will depend on the facts of each case.

Sale of Business Agreements - Protecting your Investment

Purchasers of businesses, including franchises, can protect their investment by ensuring that the Sale of Business Agreement includes enforceable restraints which prohibit the vendors setting up a competitive business.

In negotiating a Sale of Business Agreement, purchasers need to:

• ensure that the restraint of trade clause is unambiguous and appropriate for the circumstances;
• consider the scope of restraint (geographic area, duration and activities) that is reasonably necessary to:
  • sever the relationship between the vendor and the customers of the business;
  • protect the legitimate business interests of the purchaser;
• specify that part of the purchase price for the business is in consideration for the restraint on the vendor's activities.

Non-compete clauses in Sale of Business Agreements should be legally reviewed before signing as their enforceability is subject to ongoing review by the Courts.

Stephens Lawyers & Consultants advise on all aspects of business asset protection including confidential information, post-employment restraint and non-compete clauses in Employment Contracts, Franchise Agreements and Sale of Business Agreements and their enforcement.

Researched and written by Colette Downie, edited by Katarina Klaric.

Disclaimer: This article is not intended to be a substitute for obtaining legal advice.

© Stephens Lawyers & Consultants, December 2008.

For further information contact:

Stephens Lawyers & Consultants

Level 3, 530 Lonsdale Street

Melbourne VIC 3000

Phone: (03) 8636 9100

Fax: (03) 8636 9199

Email: stephens@stephens.com.au

Website: www.stephens.com.au

All Correspondence to:

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Melbourne Law Courts

Melbourne VIC 8010