Negotiating Effective Non-compete Clauses In Shareholders’ Agreement

A shareholders’ agreement is a contract amongst the shareholders of the company that establishes their relationship amongst themselves and with the company. The shareholders’ agreement provides for the rights and entitlement of shareholders and outlines the shareholders’ duties and responsibilities, in a bid to establish fairness and equality among the members while guiding the running and management of the company. It therefore becomes a very useful document even for dispute resolution.

Non-compete, Non Solicitation and Confidentiality Provisions in Shareholder’s Agreements

In order to protect the individual shareholders’ and the company’s interest, a properly drafted shareholders’ agreement may include provisions for non-solicitation, confidentiality and non-compete. Below is a brief description of what these provisions entail:

• Non Compete; This provision prohibits shareholders from engaging in a similar trade practice as the company, and from engaging in future competitive business activities, for a given period, after exiting from the company
• Non-Solicitation; This covenant prohibits shareholders from luring key customers, employees or suppliers of the company after exiting as shareholders from the company.
• Confidentiality; This covenant acknowledges the sensitivity of corporate information (such as trade secrets, proprietary information, intellectual property, and information technology), and creates a binding obligation on a shareholder not to divulge this information to third parties to the company’s detriment.

Justification for Restrictive Clauses in Shareholders’ Agreement

Non-compete clauses in shareholders’ agreements protect the remaining shareholders by preventing any of the owners from using insider information to start a rival business or contribute to a direct competitor. Shareholders of a company are assumed to have intimate knowledge of the company’s trade secrets, business strategy and client lists, which if allowed to use in competition with the company, would have an adverse effect on the viability of the company. Non-compete clauses barring the shareholders from directly competing with the company that they are shareholders in or that they previously were shareholders, are a salient feature of shareholders’ agreement. Non-compete clauses therefore are used, to enable the company share crucial information and business strategy with the shareholders freely, to enable the running of the business without the fear that a shareholder will use their current or former proximity to compete unfavorably with the company.

Enforceability of Non-compete Clauses

Kenya has enacted The Contracts in Restraint of Trade Act, Cap 24 of the Laws of Kenya, which legislation allows the use of restrictive trade clauses and agreements in contractual agreements such as shareholders agreements. However, in order to enforce such clauses, the drafting must adhere to the confines provided by the law. The Act provides that agreements in restraint of trade could be avoided in the following circumstances:

1. where the provisions were unreasonable taking into regard the nature of the business, the time and geographical extent of the restriction;
2. where the provisions provide more than adequate limitation provided to protect the Companies interest; and
3. in consideration of public policy.

Shareholders and their lawyers ought to be mindful about the draftsmanship of non-compete clauses, bearing in mind the legislative provisions that will eventually determine the enforceability of such clauses.In order to ensure that a non-compete clause hold up in a Court of Law, it is important that the draftsman ensures the following:

1. The Focus of the Non-compete clause is to protect the legitimate interest of the company.

   The company should determine what interest exactly it would like to protect, and therefore resolve which non-compete clause, or its variations, would appropriately protect that interest. In order to achieve this, the shareholders’ agreement should concisely articulate the nature of the business of the company. For instance, if the company’s nature of the business is such that key client list or its trained personnel are core factor of the operation of the business, then non-solicitation/anti-poaching provisions should be included, to safeguard that interest. Likewise, if the core business interest is its trade secret then the non-compete clause should include confidentiality clauses.

2. Narrow down the Geographical scope of the non-compete clause

   The courts in enforcing non-compete clauses strive to balance the rights of the parties involved and exercises a reasonability test in balancing the two interests. Limiting the application of non-compete clauses in shareholders’ agreement to the geographical location of the company or areas where the Company’s presences is most affected, would endear the contract as reasonable, in the eyes of the Court applying the reasonable test as opposed to a clause that places the restriction on a larger, less defined geographical scope.

3. Reasonable Time restriction

   The scope of the time restriction, just like the geographical scope, is key in determining whether a non-compete clause will be enforced. The time limit should be reasonable and just enough to protect the Company’s legitimate interest. Longer time limits than those defined by the Company’s business legitimate interest will render a non-compete agreement unreasonable and hence unenforceable.

Enforceability of Non-compete Clauses in comparison to Employment contracts

The Court’s attitude towards non-compete clauses in employment contracts is well documented, with most judges apprehensive to enforce non-compete clauses in the wake of the high un-employment rates and in the interest of public-policy. However, the weight of having to balance the will of the parties in a non-compete agreement vis-à-vis public interest, is diminished for shareholders’ agreement compared to employment agreement, and therefore a non-compete clause in a shareholder’s agreement is more likely to be enforced, in comparison. For company officials, especially senior officials, who are employed by the company but also hold shares in the company, best practice would be to have them execute two contracts, a Service Agreement and a Shareholders Agreement, both with non-compete clauses, that survive the termination of the contract.

How can CM Advocates help?

We, at CM Advocates LLP, have excellent and experienced corporate and Commercial  Lawyers  who will help you draft and/or review your shareholders agreements to ensure that you have the appropriate and enforceable non-compete clauses. Contact any of our team today or book an online consultation Related Services: Commercial/ Business Law, Non-Compete, Non-Solicit, and Trade Secrets Practice, Employment, Labour Relations and Immigration Law AdvisoryRelated Template: