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Court of Appeal Decision Provides Guidance on Restrictive Covenants

March-1-2013

Lawyer Susan Garvie, Kari MacKay
Area Corporate Finance and Securities

Summary

The recent Ontario Court of Appeal decision in Martin v. ConCreate USL Limited Partnership provides important guidance on the enforceability (and the limits of enforceability) of non-competition agreements and other restrictive covenants.

The Martin case confirmed the appropriateness and efficacy of restrictive covenants negotiated in the context of a sale of a business, but highlights the fact that unless such covenants have clear and reasonable limits they will be unenforceable.

Background

Martin was employed by ConCreate USL Ltd. for 20 years, eventually acquiring a minority interest in it and a related business, Steel Design & Fabricators (SDF) Ltd. In connection with the sale of the businesses, Martin retained a minority interest in both companies and entered into agreements containing non-competition and non-solicitation covenants.

Among other things, the terms of the restrictive covenants:

  • had a Canada-wide geographic scope,
  • prohibited Martin from engaging in a range of activities that included activities in which ConCreate and SDF did not engage at the time of the sale transaction, and
  • were effective for a period of 24 months from the time that Martin disposed of his partnership interests

Under the agreements Martin could not sell his partnership interests without first obtaining the consent of each of the general partner and any respective lenders and bonding companies engaged by the companies from time to time. 

Martin’s employment was terminated six months after the sale transaction. Eight days later, he established a company that competed with SDF and employed former ConCreate employees. ConCreate and SDF argued successfully at trial that Martin had breached his agreements; Martin appealed to the Court of Appeal.

The Decision

General Perspective on the Enforceability of Sale of Business Non-Competes

The Court of Appeal, in large part, allowed Martin’s appeal. In so doing, the Court of Appeal confirmed that although restrictive covenants are prima facie unenforceable because they interfere with individual liberty and the exercise of trade, when used in connection with the sale of a business, they may be necessary to protect goodwill and legitimate business interests. The Court of Appeal stated that restrictive covenants given in connection with the sale of a business should receive less scrutiny than those between an employer and employee, particularly where the transaction involves two knowledgeable parties of equal bargaining power. Ultimately the question of enforceability depends on the reasonableness of the restrictions.

Factors in Assessing Enforceability – the Reasonableness Analysis

In considering the reasonableness of the restrictive covenants, the Court of Appeal considered four factors:

  • whether the covenants were ambiguous; and
  • the reasonableness of:

         the geographic scope of the covenants,
         the duration of the covenants, and
         the extent of the prohibited activity.

The Court of Appeal found that the covenants were not ambiguous and that the geographic scope of the covenants was reasonable given the scope of the companies’ business and their legitimate business interests.

However, the Court of Appeal determined that the duration of the covenants was unreasonable, because it was dependant on a future disposition of Martin’s partnership interests, which itself was conditional on the consent of unascertainable third parties who owed no duty to Martin to act promptly or reasonably.  In fact, such parties may have had an interest in withholding consent in order to limit Martin’s competitive activities. Because the covenants had no fixed, outside limit they were found to be entirely unreasonable by the Court of Appeal.

While not determinative of the appeal, the Court of Appeal also found that the scope of the prohibited activities was overly broad, going beyond what was required to protect the companies’ goodwill.

Implications of the Martin Decision

The Martin decision confirms that:

  • non-competition covenants entered into in connection with the sale of a business are subject to a lower degree of scrutiny than restrictive covenants entered into as part of an employment agreement; and
  • in assessing enforceability, courts will consider the reasonableness of restrictive covenants.

What is notable in Martin is that the restrictive covenants were found to be unenforceable in circumstances where the alleged competitive activity commenced eight days after termination of employment. This all-or-nothing approach to enforceability highlights the importance of drafting clear and reasonable limits on restrictive covenants because the failure to do so entirely undermines the effectiveness of an  agreement, even when there is competitive activity that seems clearly within the intended scope of the restrictive covenants.

For more information on the implications of the Martin decision, please contact any member of our Corporate Securities Group or our Employment and Labour Group.