Banning non-competes – muddy waters for commercial transactions

The Federal Government has announced it intends to ban non-compete clauses that apply to workers earning less than the high-income threshold in the Fair Work Act 2009 (Cth) (currently $175,000 per annum) and that it will consider and consult on:

• non-competes for workers who earn above the high-income threshold; and

• clauses that restrain the solicitation of clients and co-workers.

However, employment contracts are not the only place where non-competes arise – they are also common features of commercial transactions such as business and share sale agreements, shareholders' agreements and equity incentive plans. The draft bill has not yet been published and it is currently unclear what the proposed reforms may mean for these types of arrangements.

Separately, this is also an issue being considered by the ACCC. The changes signal that the ACCC will be carefully reviewing goodwill protection restraints in sale contracts of all notified mergers, and may take enforcement action where those restraints are too broadly cast.

Current position on non-competes

Non-compete clauses are generally more enforceable in commercial transactions than in employment arrangements due to their differing nature and context.

At law, a goodwill protection provision in the context of a commercial transaction will be enforceable if it affords no more protection than is reasonably necessary to protect the interests of the party in whose favour it is imposed and it is reasonable having regard to the interests of the public.

In commercial transactions, such as the sale of a business or an equity investment, the non-compete is often seen as a necessary component to protect the value (goodwill) of the business (in conjunction with employment non-competes). It is designed to prevent the restrained party from funding (potentially out of the sale proceeds) a business run in competition with the business sold. The compensation that a party typically receives in these transactions for agreeing not to compete is generally viewed as a fair exchange; particularly where parties most usually have the benefit of legal advice.

This contrasts with employment contracts, where non-compete clauses can be seen as restricting an individual's ability to earn a livelihood as an employee and there is an in-balance in bargaining power and legal advice is often not taken. Courts are more likely to scrutinise and limit non-compete clauses in the context of an employment relationship to ensure they are reasonable in scope, duration, and geographic area, and that they do not impose undue hardship on the employee.

Because of these differences, a commercial transaction provides a stronger justification for more substantial (and unregulated) non-compete protection.

If the law is changed so non-competes cannot be enforced or are more challenging to enforce in the context of commercial transactions, this would likely negatively impact the value of target businesses, potentially resulting in lower valuations and make investments into Australia less attractive, and growth capital more expensive and difficult.

The venture capital (VC) sector, where founders or existing management teams are critical to the ongoing success of the business and maintain existing relationships and support ongoing value – will be particularly affected should legislation be introduced which alters the well-established legal position on non-competes. Often in these businesses, involved employees accept lower remuneration for a higher potential slice of the pie through equity ownership or incentives. If restraints can't be given or if enforcing them becomes more challenging, this will likely either be priced into the value of the business or even more damaging, make VC investment unattractive in Australia.

What's happening overseas

The Federal Government announcement follows similar developments in the US and UK.

The US Federal Trade Commission (FTC) has moved to ban most non-compete clauses in employee contracts. Although there are grandfathering provisions for existing senior executive contracts, there is no carve-out or salary threshold for go-forward arrangements. This is subject to an exception allowing non-competes in certain "sale-of-business" agreements, if a genuine sale of goodwill has occurred. This exception includes bona fide sales of a business, of a person's ownership interest in a business, or of all or substantially all of a business's operating assets. It had originally been proposed this would be limited to circumstances where the seller owned at least 25% of the business but the 25% threshold was dropped by the FTC following feedback this was too high and failed to reflect that many owners held smaller equity stakes in businesses with significant value attributed to goodwill. It also rejected a requirement that sellers must sell their entire interest in the business. This means the exemption for business sales now applies regarding of the size of the sellers' interest in the target business.

California has also attracted media attention for its ban on non-compete laws for employees but it also has a narrow carve-out for the sale of a business involving the sale of:

• the goodwill of a business;

• all of a seller's ownership in a business entity; or

• all or substantially all of the assets of a business together with the goodwill of that business.

We note the FTC's rule is already subject to multiple legal challenges (traversing a number of fronts including jurisdiction and constitutional challenges, alongside pushback from the business community). The outcome of those challenges, and the implications for the future of the FTC ban, are as yet unclear.

The UK has proposed limiting non-competes in employment contracts to 3 months, but does not propose to apply these restrictions to wider workplace contracts such as shareholders agreements and, it seems likely, employee share option agreements. The proposed reforms would also not extend to non-solicitations, paid notice periods or confidentiality clauses – for example allowing protection to be sought through long notice periods.