Canada: The Second Opinion: Restrictive Covenants At The Ontario Court Of Appeal

A Commentary On Recent Legal Developments By The Opinions Group Of Mccarthy Tétrault LLP

The Ontario Court of Appeal has released an important new judgment concerning the enforceability of restrictive covenants: Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72.  The decision provides guidance about when a restrictive covenant will be unenforceable owing to its duration and the scope of its prohibited activities, and suggests that a different test for unenforceability will apply where the existence of the covenant is linked to the covenantor's interest in a limited partnership as opposed to a corporation.

The facts in Martin were as follows.  The plaintiff/appellant Martin acquired  minority interests in the two defendant/respondent companies – Concreate and SDF – through his holding company MartinCo.  MartinCo sold those interests to two entities controlled by TriWest LP, a limited partnership, and Martin became the president of SDF (which amalgamated with the TriWest LP entity that acquired it) and of the other TriWest LP entity that acquired Concreate ("Target LP").  As well, Martin became a director of SDF and of the general partners of Target LP and TriWest LP.

As part of the purchase agreement, Martin entered into employment agreements with SDF and Target LP that contained three types of restrictive covenants: (1) a general non-competition covenant; (2) a restriction on soliciting employees, customers, dealers or agents of SDF and Target LP; and (3) a prohibition on the use of any non-public information pertaining to the respondents.  In addition, MartinCo received limited partnership units in TriWest LP.  Two aspects of the restrictive covenants were particularly noteworthy.

First, the duration of the covenants was to extend until 24 months after Martin disposed of his direct or indirect interest in the TriWest LP units.  However, pursuant to TriWest LP's limited partnership agreement, MartinCo could not sell those units without the consent of both the board of TriWest LP's general partner , and of various "Lenders" to the TriWest entities.  These "Lenders" were defined to include not only current lenders, but other lenders that might arise "from time to time".

Second, the activities which Martin was prohibited from pursuing by the non-solicitation clause were extremely broad.  They included communicating with any customers, dealers, agents or distributors of SDF or Target LP, for the purpose of promoting products or services that competed with those of SDF or Target LP, even where: (1) the parties so solicited did not begin conducting business with SDF or Target LP until after MartinCo sold its TriWest LP units, and Martin ceased to be a director of SDF and the TriWest LP and Target LP general partners; and (2) the products or services in question were not offered or planned to be offered by Target LP and SDF at the time of the sale transaction.

The Martin litigation was triggered when Target LP and SDF terminated Martin's employment a short time after the transaction closed, allegedly for cause.  Martin then began a new company that competed with Target LP and SDF, and they brought an action which alleged among other things that he breached the restrictive covenants.  Martin responded by seeking a declaration that the restrictive covenants were unenforceable, which was initially dismissed at first instance.

On appeal, the non-competition and non-solicitation covenants were found to be unenforceable, though the confidentiality covenant was upheld.  Hoy J.A., for a unanimous Court, began by observing that because the covenants in question were given in connection with the sale of a business, the test for determining whether they were reasonable as between the parties (and thereby enforceable) should be applied more leniently than in the case of covenants between employers and employees (paras. 52-54, 62 and 76).  Parenthetically, it should be noted here that Martin's covenants, although given in conjunction with the sale of a business, were nonetheless also suggested by the application judge  to be entered into through the employment agreements (see paras. 78-78 and 89 of the application judgment).  As a result, the argument can be made that the Court should have applied the more rigorous "employment" approach in assessing their enforceability.  This issue is currently before the Supreme Court of Canada in the appeal from Guay inc. c. Payette, 2011 QCCA 2282, which we discussed in previous posts here and here.  That said, because the application judge found that the restrictive covenants were not entered into in an "employment context", and this finding was not appealed, the issue did not arise before the Court of Appeal (see para. 34 of the appeal judgment).

In applying the test – which involves asking whether the covenants were reasonable as to geography, time or prohibited activities at the time when they were entered into – Hoy J.A. found that Martin's restrictive covenants were not ambiguous, nor geographically unreasonable merely because they were national in scope. Nonetheless, Hoy J.A. concluded that the non-competition and non-solicitation covenants were unreasonable as to their duration.  In addition, she held that the non-solicitation covenant was unreasonable as to its prohibited activities.  Accordingly, both covenants were unenforceable, since neither could be saved through the "notional" severance or "blue pencil" approaches.

With respect to duration, Hoy J.A. held that the covenants could extend for an indefinite period of time, since it was not possible to know the identity of the future "Lenders" whose consent might be required before MartinCo could dispose of its TriWest LP units and thereby initiate the running of the 24-month covenant expiry period.  Moreover, those lenders did not owe any contractual duties to Martin or MartinCo to provide their consent promptly or reasonably, and they might have a commercial interest in not doing so in order to limit Martin's competition with the respondents.

Hoy J.A. was also "troubled" by the fact that the duration of the covenants was tied to the period during which Martin held his indirect interests in the units.  She would have preferred that the duration was either calculated from the time of the sale transaction, or that it run until a specified time period after Martin ceased to be a director or officer of the respondents.  In this respect, Hoy J.A. rejected the respondents' arguments that it was necessary to link the non-competition and non-solicitation covenants to MartinCo's continued interest in TriWest, merely because Martin would have access to confidential information about them until that interest was sold.  According to Hoy J.A., this concern was already addressed by the remaining non-confidentiality covenant.

Of particular note, Hoy J.A. also held that because covenants arose in the context of a limited partnership agreement, the test for their reasonableness was different than if they had simply been tied to MartinCo's ownership of shares in a corporation:

Significantly, the Units are units in a limited partnership. In the Partnership Agreement, MartinCo and the other limited partners specifically covenant not to take part in the control or management of the business. Indeed, MartinCo risks losing its limited liability if it takes any part in the control or management of the business. In contrast, in a private company, shareholders can take an active role in the management of the corporation, and, pursuant to a unanimous shareholders agreement can even assume the functions of the directors. The reasonability analysis of a non-competition covenant in a limited partnership agreement is therefore different from that applicable to a non-competition covenant in a unanimous shareholders' agreement. (para. 64)

These comments suggest that the reasonableness of a restrictive covenant whose continued duration is tied to the covenantor's interest in a limited partnership will be approached more strictly by the courts than one that is tied to the covenantor's interest in a corporation.  In a limited partnership context, the covenantor (assuming it is a limited rather than general partner) has less of an ability to meaningfully direct or participate in the business to which its interests relate.  Therefore, a restrictive covenant whose existence is predicated upon the covenantor's continued interest in a limited partnership places unique constraints upon the covenantor's liberty of action, and merits a greater level of judicial scrutiny than one that is merely tied to the covenantor's interest in a corporation.

Finally, in holding the non-solicitation clause was also unreasonable as regards the scope of Martin's prohibited activities, Hoy J.A. focused upon the fact that the specific parties, products and services to which it related were not ascertainable nor contemplated by the parties at the time when the sale of the business occurred.  Relying upon the Ontario Court of Appeal's own earlier judgment in Mason v. Chem-Trend Limited Partnership, 2011 ONCA 344 - where a non-competition covenant relating to all of the employer's world-wide customers arising during the employee's 17 period of employment was found unenforceable - she stated:

In my view, while the covenants in this case were entered into in the context of the sale of a business, the analysis in Mason is nonetheless apt. It is not reasonable for a restrictive covenant, given in the context of the sale of a business, to extend to activities neither carried on nor in the parties' contemplation at the time of sale, while the covenantor was involved in the business post-sale, or even while the covenantor had an ownership interest in the business. (para. 76)

In light of Martin, parties drafting restrictive covenants should be careful to ensure that not only the covenant's geographic scope, but also its duration and prohibited activities, are reasonably ascertainable by the covenantor at the time when the covenant is entered into.  Further, the parties should pay particularly close attention to these features of the covenant where its existence is linked to the covenantor's continued interest in a limited partnership, as opposed to a corporation.

My colleague, Earl Phillips, has also written a post on this decision for McCarthy Tétrault's British Columbia Employer Advisor blog which can be found  here.

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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