By Peter Garry, Cripps Harries Hall, Kent

Enforceability of restrictive covenants following LLP conversion

Following conversion of a partnership to limited liability partnership (LLP) status (by transferring the assets and goodwill), can the restrictive covenants under the old partnership deed still be enforced against partners who retire from the partnership prior to the conversion?

This question arose in the recent case of Prescott v Dunwoody Sports Marketing [2007] EWCA Civ 461. In essence, the facts were:

l A partner was subject to restrictive covenants, requiring him not within two years after his retirement (a) to solicit business from, or interfere with the relationship between the partnership and clients ('prohibited clients') who were receiving goods or services from the partnership at any time during the 12 months prior to his retirement ('the pre-retirement period'), or (b) to solicit or employ any person who had been an employee during the pre-retirement period and remained one at the retirement date ('prohibited employee').

l The partner retired and solicited clients and staff, and recruited a prohibited employee.

l The continuing partners issued a claim against the retired partner and obtained an interim injunction prohibiting further solicitation.

l The continuing partners then transferred the business of the partnership into a limited company. (The same principles apply on a transfer to an LLP.)

l The continuing partners' (and the company's) solicitors wrote to the retired partner, indicating an intention to amend the claim so as to substitute the company for the partnership as claimant, but did not immediately pursue it.

l The retired partner failed to serve a list of documents, in breach of an unless order. As a result, the continuing partners applied for and obtained a permanent injunction and judgment for damages arising out of loss of the employee.

l Both injunctions prohibited the retired partner until the second anniversary of his retirement from soliciting prohibited clients or employees in line with the covenants.

l Part of the period covered by the injunctions, and in respect of which damages were awarded, fell after the date on which the partnership had transferred its business.

l Following the entry of judgment, an application was made, without notice to the retired partner, to substitute the company for the ongoing partners as claimant (entitling

the company to enforce the judgment and injunction), and such an order was duly made. The retired partner did not seek to set it aside.

The retired partner appealed the award of damages and the injunction. He claimed that the restrictive covenants were not enforceable because:

l The partnership ceased to trade and dissolved on the transfer of its business to the company; and

l The transfer did not transfer the partnership's cause of action.

Given that the company was not a party to the partnership agreement which imposed the covenants, the Court of Appeal posed the question of whether it had acquired the right to enforce them by virtue of the transfer, which had transferred to the company 'all... assets and rights of whatever nature employed in the business'. On that wording, the court found that the benefit of the covenants had been transferred to the company. But what losses could it recover, and was it entitled to an injunction for the period after the transfer?

In Townsend v Jarman [1900] 2 Ch 698, a partner had covenanted not to carry on a particular activity within 40 miles of the partnership business. The partners sold the business to a company, in which they became directors. The company was later wound up, and the goodwill sold to Mr Townsend. Applying Jacoby v Whitmore (1883) 49 LT 335 (CA), it was held that, despite the convoluted chain of title, the benefit of the covenant passed to Mr Townsend as part of the goodwill. But the covenants in Prescott were different in nature to that in Townsend.

The wording of the covenant on solicitation of prohibited clients, prohibited interference with the relationship between the partnership and the clients, but there was no such relationship to protect after the transfer of the business. The covenant was not intended to apply after the partnership's relationship with clients had ceased. The injunction in relation to solicitation of clients was accordingly overturned.

The Court of Appeal said that, while by the time of the appeal hearing the period of the injunction had expired, its being overturned might permit the retired partner to seek damages under the cross-undertaking in damages given by the continuing partners in the course of the interim injunction application, in respect of the period after the transfer of the business.

On the question of damages awarded for solicitation and employment of the employee, the court considered the following question. The solicitation and start of employment was alleged to have taken place about two months prior to the transfer of the business, but the damage claimed arose out of that period and the subsequent period of two months. The partnership did not suffer any loss after the transfer. The duty not to solicit was not owed to the company (though it had taken an assignment of the benefit of the covenant). Was the company entitled to the damages claimed for the period after the transfer of the business?

On this question, the Court of Appeal preferred to order a separate enquiry, but noted that it is clear from Offer-Hoar v Larkstore Limited [2006] 1 WLR 2926 that there is no reason why, by virtue of there having been an assignment, a party who has committed a wrong should be able to avoid paying the losses arising which, but for the assignment, he would have

had to pay to the assignor. Otherwise there would be a 'legal black hole'.

Thus, whether a covenant is enforceable post-LLP conversion will depend on whether on a true construction it was intended to survive the cessation of the partnership's business. If so, an assignee LLP will very probably be able to recover losses incurred before and after conversion.