Putting off the competition
Drafting effective restrictive covenants in a law firm's partnership deed is vital to protect the firm against team moves which can be catastrophic, says Jennifer Haywood
Most English legal services firms who are limited liability partnerships (LLPs) include in their agreement one or more covenants which restrict what the partners can do once they leave the firm.
Often, however, they have not been updated to reflect changes to the firm’s business. Fifty years ago, it would have been common to see the scope of covenants defined by geographical area.
A covenant restricting someone from operating within a distance of a few miles is now rare. Non-solicitation, non-acting and non-poaching covenants are much more common today.
However, these can be difficult to enforce, particularly in an age of social media; and there has been much interest in recent years in drafting covenants that can effectively protect client relationships and prevent team moves.
The main challenge lies in ensuring the covenants are enforceable. A restrictive covenant that is a restraint on a person’s ability to trade is unenforceable unless it goes no further than is reasonably necessary to protect a legitimate interest of the covenantee.
In the employment context, the courts are particularly alive to the issues raised by the probable inequality in bargaining power between employer and employee.
The courts have been more generous towards enforcing covenants in a partnership context, despite the fact that in practice it is probably even harder to persuade a firm to modify the covenants in a partnership agreement than it is to negotiate an employment contract.
The court’s approach towards partnership agreement covenants is partly based on the premise that a departing partner may be selling their share of the goodwill.
It also reflects the fact that at the point at which a partner is signing up to a covenant, they do so as someone who may seek to rely on it as against another departing partner. Indeed, they may even have benefited previously from a departing partner complying with the covenants before they themselves leave.
In Bridge v Deacons [1984] AC 805, the Privy Council took the view that the partners were those best able to collectively judge what was necessary for the protection of their business.
In that case, there was a non-dealing restrictive covenant in the partnership agreement which prevented a partner from acting as a solicitor in Hong Kong for five years for any client of the firm or anyone who had been a client within the three years before he left. This was held not to be unreasonable.
In recent years, the courts have enforced non-compete covenants where the covenantor has sold goodwill (Kynixa v Hynes [2008] EWHC 1); and where the court is persuaded such covenants are necessary to protect client contacts.
In Tradition Financial Services Ltd v Gamberoni [2017] IRLR 698, for example, the court upheld a six-month non-compete covenant on top of a three-month garden leave covenant in an inter-dealer broker’s employment contract.
The court relied on the practical difficulties involved in policing non-solicitation or non-acting covenants and in establishing breach of confidence; industry standards; and the benefits the covenantee had received in return for a contract which included restrictive covenants.
The courts would not necessarily enforce a non-compete covenant in every situation – each case turns on its own facts.
But these decisions reflect the discomfort felt by many about allowing individuals to take the benefits of lucrative contracts while ignoring the burdens; and appropriating to themselves the return on the investment in business relationships and employee teams made by their employers.
Non-compete covenants remain rare in professional services firms, probably because enforceability is not the only issue.
Ultimately, firms have to make partnership attractive to their junior lawyers and, increasingly importantly, to lateral hires.
Lateral hires may well be put off by non-compete covenants which restrain partners who do nothing particularly egregious – and effectively prevent them from working at all.
In any event, keeping someone out of the market for a few months may not even be that effective at protecting the business in the long term.
The downsides of noncompete covenants may well, therefore, exceed the potential benefit to many businesses.
Less off-putting and potentially much more effective are covenants targeted against team moves. Team moves can be catastrophic to the firm.
They can eviscerate a firm’s business, stripping it of a substantial income stream and staff resources and leaving the firm struggling to fulfil commitments to clients while still holding lease and other liabilities.
The time, effort and expense spent on retaining existing lawyers and recruiting new lawyers can be hugely distracting. Well-drafted covenants which prevent more than one partner or employee leaving to join another firm can therefore be helpful.
It can be tempting for a firm to think clients will object to interference in their freedom to instruct whom they wish to instruct, so there is little point in the firm seeking an injunction and in spending time and effort updating its covenants.
However, clients may be more understanding and accepting of covenants that restrict team moves which are intended to protect team stability, than nonacting covenants which bite more directly on the client relationship.
Even if a firm decides not to seek injunctive relief it may be possible to claim damages against the covenantor, or from their new firm if that firm has induced a breach of the covenants.
However, proving loss is not as straightforward as it was before last year because of the ruling in Morris Garner v One Step (Support) Ltd [2018] UKSC 20.
In this case, the majority decision of the Supreme Court was that negotiating damages is not generally available for breach of a non-compete covenant – ie one can no longer usually claim damages for breach of a covenant calculated by reference to the fee a reasonable covenantor would have paid a reasonable covenantee for release from it.
It is therefore necessary to prove any loss of profits or reduction in the value of goodwill. However, while identifying and proving the appropriate counterfactual can be a challenge, it’s not necessarily impossible.
One way of avoiding having to prove loss is to agree in advance on an amount that should be paid in the event of breach and set out such agreement in the partnership or LLP deed. In other words, include a liquidated damages clause in the deed.
Although it may be difficult to identify in advance a sum which would closely reflect the potential losses that might flow from a particular breach, any imprecision in estimation is unlikely to render the clause invalid as a penalty following the decision in Makdessi v Cavendish Square Holdings BV [2015] UKSC 67.
The Supreme Court decided that the test for whether a contractual provision is penal is whether it imposes a detriment out of all proportion to the innocent party’s legitimate interest in enforcing the covenant.
Even in the absence of a liquidated damages clause, covenants are likely to assist negotiations over the transfer of liabilities or some form of profit split or compensation in the event of a diversion of clients or team members.
Headhunting competitor firms may even decide to pick off other competitors who do not have similar covenants and whose members do not therefore carry the risk of injunctions or damages claims.
It is, at the very least, worth digging out your deed and reviewing the post termination arrangements to see if they are fit for purpose. What are the main partner departure risks to your business, and are your post termination restrictive covenants effectively tailored towards protecting against those risks without putting off lateral hires?
If not, would it be worth starting a conversation within your firm about amending your deed to ditch outdated covenants – and introduce effective ones?
Jennifer Haywood is a barrister at Serle Court Chambers serlecourt.co.uk
