What is a Breach of Covenant? Understanding Legal Obligations in share purchase agreements

When acquiring a business, certain information and assurances are usually sought by the buyer about the state of the business, which can often be in the form of warranties or indemnities given by the seller.

Buyers of a business may also seek reassurance that the sellers aren’t going to take certain actions which may impact the value of the business, such as setting up a competing business or soliciting employees – this will usually be in the form of covenants in the share purchase agreement.

What is a covenant?

In very simple terms, a covenant is a promise or agreement to do something (positive) or not to do something (negative or restrictive).

A classic example of a restrictive covenant in a share purchase agreement would be an agreement for the seller not to compete with the business of the target company for a period of time (i.e. a ‘non-compete’ clause).

Other examples of a restrictive covenant might include the seller of the business not being permitted to:

• deal with clients of the target company;
• poach employees of the target company;
• trade in the same geographical area; or
• use a similar business name as the target company.

When negotiating a restrictive covenant, the party seeking the benefit of it should be mindful that, for it to be effective, it can’t amount to a ‘restraint of trade’. A covenant which seeks to restrict trade will only be upheld by the court where it has been put in place to protect a legitimate interest of the business in question and goes no further than is reasonably necessary to protect that interest. One of the particular pitfalls to avoid is ensuring the restrictive covenant is not in place for too long, as although freedom of contract exists between buyer and seller, the courts are keen to ensure that restrictive covenants are in the interests of both parties.

Breach of covenant

It may not be straightforward to bring a financial damages claim in breach of contract because, even if it appears that a party is in breach, the court will first need to establish that the covenant itself is enforceable.

In doing so, the court would consider three things:

1. What the covenant means when properly construed;
2. Whether the party relying on the restrictive covenant can show that it has a legitimate business interest which requires the protection of the covenant; and
3. If a legitimate interest has been established, the court would then consider whether the restrictive covenant is no wider than is reasonably required to protect that interest.

The court will adopt a more liberal approach to the assessment of restrictive covenants in the context of a business sale (as opposed an employment context) but will nevertheless assess the reasonableness of the covenant as at the date it was entered into, having regard to the value of goodwill, the relative bargaining power of the parties and other case specific factors.

If the covenant is found to go too far, it would be deemed void and would not be enforced by the court. However, if the court finds that the covenant is fair, this may give rise to a breach of contract claim.

In some circumstances, it may be possible for the innocent party to seek an injunction to prevent a breach of a covenant (or any further breaches), rather than simply taking action for damages after the event of the breach.

It’s important for parties that believe there may have been a breach of a restrictive covenant in a share purchase agreement to take urgent legal advice in order to ensure the protection of their business.