Canada: Doing Business In Ontario: A Quick Summary Of Employment And Labour Considerations In M&A Transactions

The deal is done and closing is two days away. What can (and can't) you do with the new employees you're about to inherit?

Employment law and other HR related issues are likely to arise in virtually all M&A transactions. Unfortunately, the reality is that among the many factors that a buyer considers when structuring the purchase of a target company, these issues are often relegated to a lesser status than issues such as tax structuring. It is important for prospective purchasers and vendors to address employment law considerations as early as possible in order to minimize expense and delay further down the line. This article provides a high level overview of five key points that a prospective purchaser should consider before acquiring a company with operations in Canada, and more specifically, Ontario.

Sale of Shares v. Sale of Assets

In any transaction, a purchaser should consider at an early stage its obligations with respect to the vendor's employees.

In a share purchase, the purchaser inherits the vendor's employees because the legal identity of the employer does not change. In other words, there has only been a change in ownership of the company, not in the identity of the employer. In these circumstances, the employment relationship flows directly from vendor to purchaser without any termination of employment. The purchaser steps into the shoes of the vendor as the new employer. By doing so, the purchaser also inherits all of the employees' past service, terms of employment, employment agreements/contracts, bonus plans, and the liability for any termination costs. It is an integral part of the due diligence process for the purchaser to carefully assess the liabilities it will be inheriting, particularly because terminations in Canada can be costly, as discussed below. 

In an asset purchase, the sale of assets effectively terminates the employees' employment with the vendor on closing and there is no automatic flow-through of employment to the purchaser. In these circumstances, the vendor remains liable for all termination and severance costs. If the purchaser desires to re-hire any of the vendor's employees post-closing, the purchaser will likely be required by the terms of the purchase agreement to make an offer of employment on substantially similar terms of employment, which includes recognizing all of the employees' prior service with the vendor.

The purchaser must also be aware of the fact that in almost all provincial employment standards statutes the purchaser of a "business or part of a business" who retains employees of the vendor will be required to recognize each such employee's entire period of service with the vendor. This applies regardless of the structure or type of transaction, meaning an asset sale can have the same impact as a share sale.

No "at will" employment in Canada

The concept of "at will" employment, prevalent in the United States, does not exist in Canada. Employment in Canada is governed by two concepts: statute and the common law (judge-made law).

By statute, each province has its own employment standards legislation which sets out specific employment standards including the right to notice of termination (or pay in lieu). In Ontario, notice is one week per year of service to a maximum of eight weeks. If the employer has a payroll in Ontario of $2.5 million or more, and the employee has at least 5 years of service, the employee is also entitled to statutory severance pay of one week per year to a maximum of 26 weeks. Statutory notice and termination must be paid by law.

In addition to statute, employment is also governed by the common law which automatically incorporates into every employment relationship (written or not) the concept of "reasonable notice of termination." Unless a termination is for just cause, an employer is required to provide an employee with reasonable notice (or pay in lieu) of termination. In doing so, the employer must take into account the employee's age, years of service, position and salary. Common law notice significantly increases the amount of statutory notice and can be as high as 24 months for long-serving employees.

The best way to cap an employer's termination costs is through the use of a written employment agreement that contains a specific termination provision. So long as the termination provision is properly drafted and includes statutory notice and severance, a court will enforce the precise amount of notice (or pay in lieu) in the agreement, significantly limiting not only liability on termination but also litigation costs.

If a purchaser plans to terminate the employment of any employees it has inherited, its termination and severance costs can be incredibly high, particularly if the vendor has a long serving workforce. It is imperative that the purchaser evaluate these costs during the due diligence process.

No Unilateral Changes to Terms of Employment

Whether an employee has a written employment agreement or not, an employer cannot unilaterally change a fundamental term of an employee's employment without the employee's consent. Without consent, the employer has committed breach of contract and the employee may sue for constructive dismissal. For example, a purchaser might inherit an employee that has a particularly generous change of control provision in an employment agreement, or an executive level employee who is not bound by a non-solicitation obligation post-employment. If the purchaser desires to have that employee enter into new terms of employment, the purchaser must provide the employee with fresh "consideration" such as a raise, signing bonus, or option grant. The purchaser cannot impose changes on the employee unilaterally.

The matter of constructive dismissal should always be considered but particularly where a purchaser has a specific restructuring in mind following the acquisition of a business.  Courts in Canada have found constructive dismissals to occur where an employer unilaterally changes an employee's compensation, reporting lines, and scope of responsibility. In one case, an Ontario court ruled that the employer had constructively dismissed a 30 year employee when, following a corporate reorganization, the employer reduced his compensation and duties and changed his reporting structure. The combination of a 14-17% reduction in compensation and job responsibilities was a breach of contract. Of interest, the court also ruled that neither a corporate reorganization or an employer's financial circumstances justifies a breach of contract.

Restrictive Covenants

In Canada, it can be difficult to enforce a non-competition provision in an employment agreement because courts generally prefer not to completely restrict an individual from working in his or her chosen field. A court is more likely to enforce a non-solicitation provision because it achieves the same outcome: it prevents the former employee from contacting a company's clients or employees for a defined period of time after employment. When a court analyzes restrictive covenants, it is guided by "reasonableness," having regard to the geographic scope (i.e., the area in which the employee cannot work or solicit such as a specific city, or a kilometre radius of a location), the length of time (i.e., one year following termination), and the scope of prohibited activity (i.e., a list of certain clients that cannot be contacted, or competitors that the individual cannot work for). It is unlikely that a court will enforce a restrictive covenant that aims to prevent an employee from working as broadly as "anywhere in the world," or "anywhere the company does business," or for "five years." The key to enforceability is whether the restrictions are reasonable in light of the employee's position and ability to cause damage to the company following termination. This is a case-by case analysis.

An employer has the best chance of enforcing a non-competition provision where it is contained in a shareholder agreement, or in a purchase and sale agreement. In those circumstances, a court will treat the corporate agreements as a commercial contract between equal parties with equal bargaining power (as opposed to an employment contract where courts typically view the employee in a less powerful position), particularly where the employee has received significant consideration in exchange for the agreement not to compete, or where there is a sale of goodwill whose value can best be preserved by a restrictive covenant.

It is important to also note that in Canada, a court will not, as is common in some US states,  "blue pencil" or rewrite an overly broad or unreasonable restrictive covenant. An employer gets one shot at limiting an employee's post-employment activities and has the best chance of doing so where the provision is clear and narrowly tailored to the precise activities, customers, and employees with whom the individual most recently worked.

Incentive Compensation

In addition to an employment agreement, an executive or managerial level employee might also be a signatory to a bonus plan, stock option plan, or commission plan. Depending on the language in these plans, an employer may be obligated to provide the employee with this incentive compensation during the termination notice period, even if the employee was not actively at work during this period.

This is because often, a bonus or commission plan will state that an employee must be "actively employed" on the date the bonus is paid out. Or, an option plan might state that the employee's options will expire 90 days after he or she "ceases to be an employee" or "on the effective date of termination." Courts in Canada have determined similar language to mean that the employee's incentive compensation rights exist until the end of the reasonable notice period, as opposed to ending on the actual date of termination. This is particularly problematic where, in Canada, there is no-at will employment and a notice period could be quite long, where a termination is contentious, or where the potential incentive payment is large. When conducting due diligence, the purchaser should be sure review the language of any employment-related bonus, commission, or stock option plans to determine whether the issue of compensation entitlements on termination of employment has been addressed. If not, the purchaser should consider amending the plans post-closing. One recommended safeguard is to clearly define the phrases "termination date" or "end of employment" in the plans to specifically exclude any notice period.

Tips and Takeaways

  • Do your employment and labour due diligence early to ensure that a purchaser's plan for the business does not violate any of its employment law obligations.
  • Obtain copies of all employment offers, agreements, collective agreements, bonus plans, stock option plans, benefit plans, employee handbooks, and a full list of all employees (including those on leave of absence) with their ages, length of service, positions and salaries to assist in determining what liabilities are being inherited and how to address them post-closing.
  • Negotiate the purchase agreement to contain terms and conditions allowing a purchaser to terminate the deal or at least renegotiate financial terms if labour or employment issues cannot be resolved.
  • Ensure that any representations given by the vendor are as detailed and thorough as possible in the event that the due diligence materials are lacking in substance.
  • Draft your employment agreements, stock option, and incentive compensation plans together and ensure that the language regarding termination dates is consistent.
  • Use employment agreements. A clear and well drafted employment agreement is one of the most effective ways to limit an employer's liability on termination of employment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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