KAO, LEE & YIP v. JOHN RICHARD EDWARDS

HEADNOTE

Covenant in restraint of trade - "salaried partner" in solicitors' firm - whether wider than necessary to protect firm's goodwill - Bridge v. Deacons [1984] 1 AC 705 distinguished.

IN THE COURT OF APPEAL

1993, No. 97
(Civil)

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J U D G M E N T

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Litton, J.A., (delivering the judgment of the court):

1. What we have before us is a familiar problem: To what extent, if at all, is a restrictive covenant in an employment contract enforceable in law?

2. The plaintiffs are a firm of solicitors who, over a period of years, have built up professional connections with clients, particularly banks. Such "trade connections" constitute the goodwill of the practice; it is an asset which the partners are entitled by legal process to protect. The defendant is likewise a solicitor who, one must assume, is well capable of looking after his own interests when he entered into the employment contract with the plaintiffs. If, by his own contract, he has undertaken to the plaintiffs that upon the termination of employment he would not do work for the firm's clients for a period of time, why should the court recoil from enforcing such undertaking at the suit of the plaintiffs? Sanctity of contract is, after all, an important principle.

3. The matter, however, is not as simple as that. As pointed out in Herbert Morris Ltd. v. Saxelby [1916] AC 688 at 699, there are two principles or views of public policy which, in this area of the law, come into conflict: namely, freedom of trade and freedom of contract. While the community is rightly interested in people being free to contract and being held to their bargains, it is equally interested in trade being free. These conflicting propositions of law boil down to this: all restraints of trade of themselves, if there is nothing more, are contrary to public policy, and therefore void. It is no answer simply to say: but the defendant is a sophisticated contracting party who has, with his eyes open, voluntarily bound himself in this way. If, upon a proper analysis of all the relevant circumstances, the court concludes that the covenant is in restraint of trade, then freedom of contract must give way. The covenant is void ab initio. of course, in the weighing process, the court will have regard to the fact that the defendant is, himself, a professional person and, in contracting the way he did, had found nothing apparently unreasonable in the covenant when he signed the contract. But this factor is not decisive.

Restrictive convenant

4. The covenant which has given rise to this litigation is clause 17 in a contract dated 28 June 1989 entitled "Salaried Partnership Agreement". The plaintiff firm at that time consisted of five "equity partners" of which Mr. Emmanuel C.C. Kao and Mr. Yip Wan Tak were the "founding partners". The defendant was described as a "salaried partner". Clause 1 of the agreement states:

"1. The Equity Partners hereby admit and take the Salaried Partner into partnership with them in the Practice and the Salaried Partner shall become partner in the Practice with the Equity Partners and all other present and future equity or salaried partners upon the terms and subject to the conditions set out in this Agreement with effect from the 1st day of July 1989 until this Agreement is terminated pursuant to the terms and conditions hereof or until the Salaried Partner shall be admitted into full equity partnership with the Equity Partners and all other future equity partners (if any)."

5. If one stopped reading at the end of clause 1, the conclusion is inevitable that the agreement of 28 June 1989 was, in effect, a partnership agreement: the equity partners were taking the defendant "into partnership with them in the Practice". But it is plainly not so if one reads on. Under the agreement, the defendant was entitled to be paid a monthly salary of $83,333. This was his only entitlement. The agreement made provisions for the founding partners "in their sole absolute and unfettered discretion" to pay (or not to pay) bonuses to the defendant as they should from time to time determine. The defendant was not required to contribute any capital to the practice nor was he entitled to a share of profits. Clause 10 of the agreement states:

"10. The Salaried Partner shall not be entitled to any or all of the capital or the assets or property of the partnership of the Equity Partners. Further, the Salaried Partner shall not be entitled to claim the goodwill of the Practice carried on by the Equity Partners."

6. The agreement goes on to provide that the defendant was not to engage the credit of the practice nor to take part in the control or management of the practice except under the direction of the founding partners.

7. The peculiar feature of the arrangement, however, is this. The defendant was held out to the outside world, and apparently to the staff members of the firm itself, as a partner. His name appeared in the firm's letterhead as a partner, and he was introduced to clients of the firm, and attended social functions, as a partner. The result of this contractual arrangement was that, in law, the defendant would have been liable for the firm's debts as a partner by virtue of the holding out, but he enjoyed none of the benefits of partnership except, possibly, the "prestige" which attended his status. Because of the potentially unlimited liability which he would have incurred as a result of the holding out, the agreement of 28 June 1989 provided for a full indemnity against all loss and liability from the equity partners. In so far as it is relevant to place this contract into any particular category, in my judgment, it is plainly an employment contract and the judge was correct in having so described it.

8. Clause 17, which gives rise to the litigation in this case, reads as follows:

"17. Upon the termination of this Deed and unless the Salaried Partner shall immediately upon such termination be admitted into full equity partnership with the Equity Partners, the Salaried Partner shall not for the space of five (5) years from the date of such termination directly or indirectly:-

(a) solicit legal business from, or do any work or act normally done by solicitors for, any person or firm or corporation who or which shall have been a client of the Practice (which expression includes the partnership practice of Kao, Lee & Yip being carried on before the date of this Agreement) at any time within a period of three (3) years immediately preceding the date of such termination PROVIDED ALWAYS THAT the foregoing restrictions shall not apply to anything at any time done by the Salaried Partner professionally for himself or for any member of his family or for the professional representatives or trustees of any such member;

(b) .....".

9. Prior to the defendant entering into the salaried partnership agreement, he was employed by the defendant as an assistant solicitor under the terms of an employment letter dated 22 September 1987 which also contained a restrictive covenant to this effect: upon the termination of the defendant's employment for whatever reason, the defendant undertook for the space of three years from the date of the termination not to do any work normally done by a solicitor for, nor solicit business from, any person firm or corporation which had been a client of the firm for a period of three years preceding the date of the termination.

Background facts

10. The background facts are fully stated in Jones J.'s judgment and they need only be briefly summarised. The plaintiff firm started in Hong Kong in 1981 with three partners and 14 staff members. It enjoyed rapid growth. At the time of the writ, 9 December 1992, there were four equity partners and three salaried partners, 20 assistant solicitors and 170 staff members. The practice occupied the entire 6/F of Swire House in Central. It had departments dealing with litigation, conveyancing, company/commercial matters, finance and banking and town planning/land matters. The defendant was admitted as a solicitor in England in 1981 and in Hong Kong in 1982. When he joined the plaintiff firm as an assistant solicitor in 1987 he was engaged in general litigation work. Upon his appointment as a salaried partner, the defendant was put in charge of the litigation department. As might be expected, the litigation department rendered legal services to the entire client-base of the firm. Much of the work of the firm was generated by its banking clients. There were about 10 to 15 major banks who provided work on a fairly regular basis; these banks themselves, would, of course, have customers of their own who would in turn be referred to the firm for legal services. The effect of this is that if the plaintiff firm should lose one major banking client, this has a severe knock-on effect.

11. As an assistant solicitor, the defendant was well regarded by the partners. Early on, he expressed his aspiration to be a full equity partner in the firm. Although the employment as an assistant solicitor under the letter of 22 September 1987 was for a period of two years, by mutual agreement this was replaced by the salaried partnership agreement of 28 June 1989 which took effect on 1 July 1989. This was, in fact, the first salaried partnership agreement entered into by the firm and, as explained in Mr. Kao's evidence, was regarded as a "half-way house" between the status of an assistant solicitor and a full equity partner; and if the defendant demonstrated the necessary degree of promise there was every chance that he might be elevated to the status of a full equity partner. This was an aspect of the evidence much relied upon by Mr. Andrew Li QC, counsel for the appellant, because it showed that the defendant, whilst having no share of the goodwill of the firm as such, nevertheless had reasonable prospects of sharing in that goodwill in the future: and therefore had himself an interest in that goodwill being preserved. Mr. Li also pointed to the evidence to the effect that, in June 1989, when the defendant was engaged as a salaried partner, the equity partners of the firm had, between themselves, in their own partnership deed, a restraint similar to clause 17. I will revert to this aspect of the evidence later on as it forms a central theme of Mr. Li's case.

12. The defendant, upon his being employed as a salaried partner, enjoyed a substantial increase in status. He had authority to sign professional communications, on a par with the equity partners. Files were opened on his authority in the same way as the files of the equity partners. The firm's stationery listed him as one of the partners. He enjoyed a substantial increase in salary: some 60%. Because of the way he was presented by the equity partners to the outside world, he was able to develop strong professional links with clients of the firm who believed that they were dealing with a partner, with a stake in the firm.

Termination

13. The termination of employment as a salaried partner came when, on 28 March 1991, the defendant gave notice to the firm, expiring on 28 September 1991 or earlier by mutual agreement. How this came about is not relevant to these proceedings. On 2 May 1991 the defendant wrote to Mr. Kao, setting out his achievements in the course of his employment and asked Mr. Kao to consider paying one year's salary ex gratia. In stating his case the defendant said:

"As you know, and as we have discussed, I am now actively looking for a job. I would prefer to stay in Hong Kong, where I have made my home for the past 10 years. However, in view of my seniority and contractual restraints this is proving to be very difficult."

14. The plaintiffs rely upon this as an acknowledgement by the defendant that in May 1991 he considered clause 17 as an effective "contractual restraint", at least as far as Hong Kong was concerned.

15. No ex gratia payment was made. By mutual consent the defendant's employment was terminated on 15 July 1991.

Background to litigation

16. After the defendant left the plaintiff's employment in July 1991 he joined the firm of Messrs Alsop Wilkinson. About a year later the plaintiffs received a letter from Messrs Alsop Wilkinson, dated 18 August 1992, stating that they had been asked by the Bank of America to take over the conduct of a piece of litigation then handled by the plaintiffs: that was an action in the commercial list, commenced in 1989 by a company in liquidation called Zanda Investment Ltd. in which the Bank of America was the defendant. The letter of 18 August 1992 was copied to two officials of the Bank of America. This led eventually to a letter from Mr. Kao to the defendant dated 19 October 1992 in which Mr. Kao, after referring to clause 17 of the agreement, said:

"It has recently come to my notice that you have handled a number of matters as a solicitor for Bank of America.... who has for the relevant three years period been, and is still, a client of the firm. These matters include a High Court action between Zanda Investment Ltd. and the bank".

17. In the letter, Mr. Kao required a full explanation of the defendant's conduct including details of all matters handled by him for the Bank of America since he left the firm.

18. By his reply of 21 October 1992 the defendant said:

"Before commencing my present employment with Alsop Wilkinson I informed them of the convenant which you have quoted in your letter. Their view, like mine, was that the convenant is unenforceable since it is solely directed at restricting competition from a former employee and completely lacks mutuality.... It is true that I am engaged in the current trial of Zanda Investment Ltd. v. Bank of America for the bank. As you know, I had no involvement in that case when your firm was representing the bank."

19. The defendant refused to give any explanation of his conduct.

20. The writ was issued by the plaintiffs on 9 December 1992 in which they sought an injunction to enforce clause 17 of the agreement, and for damages for breach of contract. When the matter went before Jones J. in March 1993, he disposed of it on a preliminary issue, holding that the convenant, as drawn, was unreasonable both as to area (being worldwide) and as to time (for a duration of five years) and was void in law. The action was accordingly dismissed.

Bridge v. Deacons

21. Understandably, Jones J. focussed upon the leading case of Bridge v. Deacons [1984]1 AC 705, a judgment of the Privy Council given in March 1984 upholding a restrictive covenant also of five years' duration in a solicitors' partnership agreement. As the judge found, the restrictive convenant in this case was modelled on the convenant in Bridge v. Deacons except that the convenant in that case was restricted to Hong Kong. Obviously, if the reasoning in Bridge v. Deacons is applicable to this case then, apart from the question of the territorial limit of the convenant, the court must uphold the validity of clause 17. The judge, as I understand his judgment, distinguished Bridge v. Deacons on two points: (i) the defendant did not have equal bargaining power with the firm when he entered into the agreement, unlike the solicitor in Bridge v. Deacons, and (ii) there was, unlike the position in Bridge v. Deacons, no mutuality between the defendant and the plaintiff firm regarding the restrictive convenant.

22. As to point (i), although the concept of "equality of bargaining power" sits rather uncomfortably in the context of contract law, it expresses an attitude of the courts in these cases: for example, Denning LJ's approach in M. & S. Drapers v. Reynolds [1956]3 AER 814 at 820: "During the last forty years the courts have shown a reluctance to enforce covenants of this sort. They realize that a servant has often very little choice in the matter". What the judge plainly had in mind in using the expression "inequality of bargaining power" is his finding that, contrary to the plaintiffs' contention, the relationship between the defendant and the plaintiffs was essentially that of employee and employer. As stated in Chitty on Contracts (26 Ed.) Vol. 1 para. 1203:

"The doctrine of restraint of trade has always been applied to convenants contained in contracts of employment which limit the freedom of the employee to work after the termination of the employment. Such convenants are viewed by the courts much more jealously than the other of the principal traditional categories of convenant to which the doctrine applies, namely, convenants between the vendor and purchaser of a business".

23. In essence, the two situations mentioned in Chitty (supra) are at opposite ends of the same spectrum. When a vendor sells a business, including its goodwill, and immediately competes in the same line with his purchaser, he derogates in effect from his own grant; accordingly, the public interest cannot be injured by the vendor convenanting not to compete. In such a case "public interest cannot be invoked to render such a bargain nugatory: to do so would be to use public interest for the destruction of property": Lord Shaw in Herbert Morris Ltd. v. Saxelby [1916]1 AC 688 at 713. On the other hand, restraints upon the opportunity of a workman to earn his livelihood raises rather different issues. "No actual thing is sold or handed over by a present to a future possessor. The contract is an embargo upon the energy activity and labour of a citizen; and the public interest coincides with his own in preventing him, on the one hand, from being deprived of the opportunity of earning his living, and in preventing the public, on the other, from being deprived of the work and service of a useful member of society": Herbert Morris Ltd. v. Saxelby (supra) at 714. A restrictive convenant given by a vendor is very likely to be upheld by the courts; a similar convenant given by a workman would be more jealously scrutinized; this accords with established principles and common-sense. However, we would not, for our part, have rationalised the proposition in this case in terms of "equality or inequality of bargaining power", for this puts an unnecessary burden upon the court. How unequal must the "inequality" be? If this were a live issue between the parties, can it be the subject of mutual discovery? How far can each party go in the course of mutual discovery to plumb the depth of the opponent's pocket? Such matters can be highly oppressive. However, as we understand the judge's approach, he was not engaged upon such an evaluation. Rather, he regarded the position of the defendant, despite his status of being a "salaried partner", as that of an employee of the firm and, accordingly, public policy leans more heavily in his favour. In this regard, the judge was, in our view, plainly right. For, despite all outward appearances, the defendant was in the position of an employee of the firm and, in the returns made by the firm to the Inland Revenue Department, was so categorised. In a sense, he had the worst of both worlds. He had no share in the profits of the firm and yet, by being held out as a partner, incurred the legal liabilities of a partner.

24. As to point (ii) above, this seems to us to be the key to the decision in Bridge v. Deacons. There, the restrictive convenant was in an agreement which bound all the partners including the appellant, Mr. Bridge. By the agreement, he was admitted to full capital partnership and had a share in all the assets of the partnership including its goodwill. A convenant aimed at protecting clients' connections, an aspect of the goodwill, was as much for his benefit as for that of the other partners. As Lord Fraser said at 716C-E:

"The question is whether [the convenant] was reasonable, as between the parties, for the respondents to obtain protection against appropriation by the appellant of any part of the goodwill, notwithstanding the 'departmentalisation' of the practice.

Their Lordships considered that it was reasonable, provided .... that the protection did not extend beyond the respondent's practice ..... On this question the mutuality of the contract is a most important consideration. The contract applied equally to all the partners. None of them could tell whether he might find himself in a position of being a retiring partner subject to the restriction .... or of a continuing partner with an interest to enforce the restriction. It was at least as favourable to the appellant as to the more senior partners; by clause 22 of the agreement every partner is obliged to retire on 31 December immediately following his 60th year birthday, and the probability therefore was rather that the restriction would apply first against the more senior partners than the more junior ones. Moreover, if any of the senior partners had retired soon after the appellant joined the firm, he might well have been able to take many more of the firm's clients with him than could the defendant....".

25. This aspect of mutuality as between the contracting parties is wholly absent in this case. In Bridge v. Deacons, once the appellant was admitted to the partnership, he shared in the profits and losses of the partnership together with the other partners; each stood to benefit to some extent from the success of the others in attracting clients. Hence, the fact that the firm was "departmentalised", and the appellant's connections with the firm's clients were confined to the work of the industrial property department, was irrelevant: it did not make the restrictive convenant, precluding the appellant from acting as a solicitor in Hong Kong for any client of the firm for five years, whether the client was served by the industrial property department or any other department of the firm, unreasonable.

26. In our judgment, Jones J. had accurately assessed the nature of the defendant's position as a salaried partner; the defendant was, despite the language of clause 1 of the agreement, not being admitted into partnership. He was to head the litigation department with, at the most, a possibility that some time in the future he might have been admitted to full partnership. This possibility, in our judgment, did not affect the nature of the relationship.

Legitimate interest

27. It is common ground in this case that the plaintiffs are entitled to a restrictive convenant for the protection of their legitimate interests, provided that it is reasonable in the circumstances. The onus of showing that the convenant was reasonable fell on the plaintiffs.

28. Here, the only legitimate interest is the partnership goodwill or client connections. The plaintiffs' complaint leading to the litigation is that within five years of the defendant ceasing to be a salaried partner he did work as a solicitor for the Bank of America, a client of the firm, and had been such within three years of the date of termination; hence, the defendant had acted in breach of clause 17.

29. Obviously, a solicitor's goodwill is built up from his professional relationships with clients and, to a lesser extent, social ones. As such, it has a locality. In June 1989, when the salaried partnership agreement was signed, the practice of the firm was Hong Kong - based. The plaintiffs had applied to open a branch in Shanghai and there was a possibility that this might be granted some time in the future. Clause 5 of the agreement provided for the practice to be carried on at the 6/F of Swire House, Central, "and/or at such other place or places as the Founding Partners may from time to time think fit". There was no suggestion that the plaintiffs were contemplating at that time having a branch anywhere else in the world except in Shanghai. Both before and after the date of the agreement, there had been discussions with overseas firms for some form of professional linkage but nothing had materialized. The plaintiffs could in no way be described as an international firm and, plainly, such connections as they had established with clients were local.

30. Looking, then, at the wording of clause 17, what does one see? Plainly, the restriction against doing "any work or act normally done by solicitors" is worldwide. This conclusion is reinforced when one contrasts this convenant with that in Bridge v. Deacons which expressly limited the prohibition to acting "as a solicitor, notary, trade mark or patent agent or in any similar capacity in the Colony of Hong Kong". This view of the plain meaning of the clause is consistent with what Mr. Kao said in evidence namely that he had modelled clause 17 on the convenant in Bridge v. Deacons but made it worldwide. The reason, he said, was that the work undertaken by the firm was often international in nature.

Worldwide restraint

31. The test of the validity of a convenant such as this is simple: is it wider that reasonably necessary to protect the plaintiffs' goodwill? Assume, for instance, that the defendant, upon termination of his employment, had returned to the United Kingdom and was employed by a firm of solicitors there. Assume further that one of the plaintiffs' banking clients was also a regular client of that firm. Does it mean that, for the space of five years, the defendant was precluded from doing work as a solicitor in the United Kingdom for that client? On the plain wording of clause 17, the answer is yes: an impression reinforced by the evidence of the draftsman of clause 17. But the plaintiffs as a firm have not done any work as solicitors for such client in the United Kingdom; as they have cultivated no professional links with clients there, it is difficult to see what legitimate interest they might have to protect by this covenant as extended to the United Kingdom. In our judgment, Jones J. was correct to conclude that clause 17, not being confined in its scope to Hong Kong, was too wide.

Duration of restraint

32. As regards time, five years, the plaintiffs justified the restraint by virtue of the fact that the work of a solicitor is generally intermittent. A worthwhile connection with a client, Mr. Li submits, takes time to build up; professional exposure is seldom on a daily basis. Accordingly, a period of restraint over five years is justified. But, it should be noted, the argument rubs both ways: by clause 17, the defendant is purportedly restrained from doing any work for anyone who had been a client of the practice "at any time within a period of three years immediately preceding the date of [the] termination". One could, therefore, have a situation where in, say, June 1988 a client bought a property through the firm; and this was the only professional contact; yet, nearly 8 years later, in June 1996 (within five years of the date of termination), the defendant would still be prohibited by clause 17 from undertaking litigation work for that client. It is noteworthy that in the earlier agreement of 22 September 1987 the period of restraint was three years from the date of termination: assuming this period to be no longer than necessary to protect the plaintiffs' goodwill, what justification is there to extend the period for a further two years? Simply because the defendant has, under the agreement of 28 June 1989, become a salaried partner? The plaintiffs' answer is that, as a result of the defendant's elevated status, he was given a much wider access to the plaintiffs' "client base". We are not persuaded by this argument. It seems to us that the 5-year restraint is aimed at stifling competition, deterring the defendant from leaving the firm, rather than the protection of the firm's goodwill.

33. The judge approached this matter by following the judgment of Godfrey J. in Ho Wing Cheong v. Graham Margot [1991] 1 HKLR 245 at 249-250, where the test of the reasonableness of the duration was by reference to the time it would take to break the connection of the employee with the employer's clients and for the employee's successor to re-bond the firm's professional relationship with the clients. There, the employer's business was that of a stock-broker who might be expected to have far more frequent dealings with clients than a solicitor. An exact analogy with the case of Ho Wing Cheong v. Graham Margot may be inappropriate and a restraint for a longer period than that held by Godfrey J. to have been reasonable in that case may be justified. One can readily see that, to protect a solicitor's connection with his clients, a rather longer period might be reasonable, for the reasons advanced by Mr. Li. Nevertheless, it is difficult to fault the judge's finding in this case that a restriction for a period of five years after termination is far too long for the protection of the plaintiffs' legitimate interests. We would uphold judge on this point as well.

Construction of clause 17

34. Mr. Andrew Li, Q.C., in putting the plaintiffs' case, urged upon us this approach: in construing clause 17, the court should reject extravagant possibilities and look to what, within the reasonable contemplation of the parties, would be realistic; thus, to construe clause 17 as if it might apply to prevent the defendant from doing any work normally done by solicitors in Peru or Chile would be absurd. The parties could never have so intended. Mr. Li relied on Haynes v. Doman [1899] 2 Ch. 13, Home Counties Dairies v. Skilton [1970] 1 WLR 526 and Littlewords Organization v. Harris [1977]1 WLR 1472 in support of his proposition. By implication, he argues, the scope of clause 17 should be construed as limited to England and Hong Kong: this is because, known to the parties at the time of the agreement, both Mr. Kao and the defendant were admitted to practice in those two jurisdictions, and nowhere else. We cannot accept this submission. At the end of the day, it is purely a matter of the proper construction of clause 17. We find it difficult to draw out of the wording of clause 17 this restricted meaning. We readily accept that in construing a restrictive covenant, the court must put it in its factual matrix. Accordingly, where, as in Home Counties Dairies v. Skilton, the words "dairy produce" in the covenant cannot possibly have meant "butter and cheese sold by a grocer", because the contractual nexus did not accommodate this, the court must give a restricted meaning to the clause. But, as Simon Brown LJ explained in J.A. Mont (UK) Ltd v. Mills [1993] IRLR 172 at 176, if wide covenants were to be construed in this way, so that they would always be cut down to the extent necessary to protect the employer's legitimate interests as found by the court, what incentive would there be for employers to draft their covenants restrictively? And how is the employee, faced with a covenant in wide terms, to know that the courts would ultimately trim the covenant down? The burden is upon the plaintiff to satisfy the court that, by the words used by him the covenantee (who proffered the contract for the employee's signature), the covenant is no wider than necessary to protect his interests. The court should not strain to give an artificial construction to the clause in order to preserve its validity. There is, of course, also this additional impediment to Mr. Li's argument: the plaintiffs here have no goodwill in England to protect. Thus, adopting the restricted meaning urged upon us by Mr. Li, clause 17 is still too wide.

Conclusion

35. For the reasons above, we would dismiss this appeal and make an order nisi that the appellants are to pay the costs of the appeal.