Restrictive covenants are often a key mechanism by way of which the buyer of a business is able to protect the value of their purchase. Indeed, in a 2017 review of legal trends in Canadian private M&A, Thomson Reuters has reported that non-competition covenants were found in 52% of the closing conditions of share acquisition transactions.
While such covenants are common, their enforcement has remained an ongoing concern due to the strict reasonableness requirements imposed by the Supreme Court of Canada in JG Collins Insurance Agencies Ltd. v Elsley, [1978] 2 SCR 916 in order to balance the parties' right to contract with the public interest in discouraging restraints on trade. In light of reliance on restrictive covenants and ongoing concerns with their enforcement, it is useful to provide an overview of the considerations that go into determining their lawfulness.
Restrictive covenants in the commercial versus employment contexts
The first major factor in the analysis of the validity of a restrictive covenant is the context in which it is negotiated. Specifically, the Supreme Court in JG Collins noted a distinction between restrictive covenants in an agreement for the sale of a business and ones contained in a contract of employment, as the former often requires the operation of a restrictive covenant in order for the business to remain a saleable commodity. Accordingly, as later confirmed by the Supreme Court in Guay inc. c Payette, 2013 SCC 45, the criteria for analyzing restrictive covenants in a commercial context will be less demanding than in the employment context, and the basis for finding such covenants to be reasonable will be much broader in the former as opposed to the latter.
In determining whether a restrictive covenant is linked to a commercial contract or to a contract of employment, courts will look to:
- the nature of the principal obligations under the contract; and
- why and for what purpose the accessory obligations of non-competition and/or non-solicitation were assumed.
Reasonableness of a restrictive covenant in a commercial context
Once it is established that a restrictive covenant resides in the commercial context, the covenant will be found to be lawful provided that it is limited to what is reasonably necessary for the protection of the legitimate interests of the party in whose favour it was granted.
To determine the reasonableness of a restrictive covenant in this context, courts may look to circumstances in which the contract containing it was entered into, including:
- the sale price;
- the nature of the business' activities;
- the parties' experience and expertise;
- the parties' access to legal counsel and other professionals.
Having regard to the circumstances in which the contract was entered into, a court will then specifically consider the territorial and temporal scope for which the restrictions are prescribed.
(i) Territorial Scope
The territorial scope of a restrictive covenant must be considered carefully because, as noted by the Supreme Court in Guay, "[a] non-competition clause that applies outside the territory in which the business operates is contrary to public order." The reasonableness of a territorial scope may depend on how mobile, or dispersed, the business is that is being purchased.
(ii) Temporal Scope
The temporal scope of a restrictive covenant is similarly assessed on the basis of the specific circumstances, including the nature of the activities to which it applies. The scope will generally be found to be reasonable, however, when negotiated by well-informed parties who are represented by competent counsel.
The author would like to thank Alex Kokach, Articling Student, for his assistance in preparing this legal update.
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