Canada: Ontario Court Of Appeal Signals Greater Scrutiny Of Restrictive Covenants

Employers will need to take greater care in drafting non-competition and non-solicitation covenants in the context of commercial transactions following a recent Ontario Court of Appeal decision. In the recent decision for Martin v. ConCreate USL Limited Partnership, the court struck down non-competition and non-solicitation covenants as unreasonable and unenforceable, even though they had been freely negotiated during a commercial transaction in which all parties had received independent legal advice.

Background

Derek Martin (Martin) worked for ConCreate USL Limited Partnership (ConCreate), a company engaged in concrete forming work for bridge construction, for approximately 20 years. During that time, he acquired a minority interest in ConCreate and a related company (SDF).

When ConCreate and SDF were sold to a third party (TriWest), Martin cooperated in the commercial transaction. In addition to certain cash payments and debt forgiveness, Martin was granted a number of "limited partnership units" of the purchaser, TriWest. Martin was also hired as president of ConCreate and SDF. In this context, Martin agreed to covenants that restricted him from competing with ConCreate or SDF, or from soliciting their employees, customers, dealers, agents or distributors across Canada for a period of two years after disposing of his units of TriWest.

Shortly after the transaction, the relationship between Martin and TriWest soured and Martin's employment was terminated. Martin then founded a new company that competed with ConCreate and SDF, and he hired several former ConCreate employees to join him. ConCreate, SDF and TriWest brought a claim against Martin alleging violations of the non-competition and non-solicitation covenants. Martin responded with an application of his own to declare the covenants unenforceable.

Martin's application was denied by the Ontario Superior Court of Justice. On appeal from that decision, the Ontario Court of Appeal overturned the Superior Court's judgment and declared the covenants unreasonable and unenforceable.

The Ontario Court of Appeal's decision

The Ontario Court of Appeal recognized and affirmed a number of general principles that employers have long recognized in drafting restrictive covenants. In order to be enforceable, the covenants must not be ambiguous and must be reasonable in terms of their geographic scope, their duration, and the scope of the activities being restricted.

The court also recognized that covenants negotiated during commercial transactions should not be scrutinized as closely as covenants contained in employment contracts on the basis that the potential power imbalance between employers and employees is unlikely to exist in commercial transactions. Nonetheless, the court found that even in the commercial context, restrictive covenants must still be analyzed to ensure they are reasonable. There is an important public interest in promoting competition and avoiding unreasonable restraints on trade.

The court found that the geographic scope of the covenants was reasonable. Even though ConCreate and SDF worked primarily in Ontario and Alberta, it was appropriate for the covenants to restrict competition and solicitation throughout Canada, because the parties clearly expected the business to be national in scope going forward.

However, the covenants were found to be unenforceable because there was no "fixed, outside limit" to their duration. The covenants would expire two years after Martin disposed of his units of TriWest, but disposal of the units was subject to approval by TriWest's board of directors and unspecified lenders. Since it was unknown whether the lenders would approve, or even who the lenders would be at the relevant time, the covenants might continue indefinitely. That would be unreasonable.

The court also criticized the scope of the activities that the non-solicitation covenant sought to restrict. It found that there was no need to restrict Martin from soliciting customers, employees, dealers, etc., for lines of business ConCreate and SDF did not expect to engage in at the time the covenants were signed. Similarly, there was no need to restrict Martin from soliciting individuals who were not involved with ConCreate and SDF at the time Martin worked there.

The court considered that the covenants were negotiated as part of a commercial transaction, that all parties had independent legal advice, and that they expressly agreed in the relevant contracts that the covenants were reasonable. However, the court concluded that ". . . while these are important factors, they do not entirely immunize the clause from scrutiny. Safeguarding the public interest in free and open competition . . . requires that the court conduct a greater level of independent analysis."

Finally, the court was influenced by the fact Martin held his interest in ConCreate and SDF through a limited partnership and had specifically agreed not to take part in the control or management of the companies. The court contrasted this interest to that of a shareholder in a private company, who can take an active role in the management of the corporation and may be able to assume the functions of the directors pursuant to a unanimous shareholders agreement. Keeping these differences in mind, the court held that the reasonableness of restrictive covenants may be more closely scrutinized when negotiated in commercial transactions that provide the party being bound with more limited rights in the management of the company.

Conclusion

The decision is a helpful reminder of the principles that will affect the analysis the courts will undertake when determining whether a covenant is reasonable; specifically, restrictive covenants must not be ambiguous and must be reasonable with respect to geographic scope, duration, and the activities being restricted.

The court also signals a willingness to more closely scrutinize restrictive covenants that are contained in commercial transactions. In particular, the decision reminds employers to ensure there is a "fixed, outside limit" in respect of the duration of the restrictive covenant. A covenant whose expiry is conditional on future events may not be enforced on the basis that it does not have a fixed, outside limit, unless it is very clear that those events must occur within a specified, reasonable period of time and are defined by clearly ascertainable parameters.

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