Canada: Common Restrictive Covenants In Corporate Transactions Successfully Challenged In The Ontario Court Of Appeal

Martin v. ConCreate USL Limited Partnership

Companies involved in M&A transactions should be aware of the Ontario Court of Appeal's recent decision in Martin v. ConCreate USL Limited Partnership,1 which casts significant doubt on the validity of certain types of restrictive covenants commonly used in these types of transactions. The appeal was from the decision of Justice Perell of the Ontario Superior Court.2

Corporate transactions are often structured to keep the sellers of a business involved after closing. There are often compelling objectives for retaining the sellers for some period of time after closing, such as ensuring a smooth transition or to leverage the sellers' knowledge and connections to grow the business.

As part of the transaction, individual sellers often enter into employment agreements and may also receive equity-based incentives tied to the performance of the business. In some cases, the sellers retain a minority ownership interest in the business.

Buyers will often seek protection against unfair competition from the sellers by insisting on non-solicitation and non-competition agreements ("restrictive covenants").

Many businesses are carried on through one or more privately-held entities, the securities of which are usually subject to various restrictions on transfer. Therefore, the sellers' minority equity interest in the business will generally be illiquid, unless the sellers negotiate some form of future buy-out arrangement at the time of the initial transaction.    

It is not unusual to tie the length of the restrictive covenant to the length of time that the sellers retain an ownership interest in the business or are employed by the business. The Ontario Court of Appeal's decision in Martin v. ConCreate USL Limited Partnership specifically focused on the ability of buyers and sellers to link the duration of a restrictive covenant in an employment agreement to the period of time that the employee/seller retains an interest in the business.

The case involved the purchase and sale of a business that supplied construction, concrete and structural steel for new and old bridges, predominately for publicly-tendered contracts from government bodies or government general contractors. The business was carried on through two separate corporations, ConCreate USL Ltd. ("Old ConCreate") and Steel and Design Fabricators (SDF) Ltd. ("SDF").

The buyer, TriWest Capital Partner III (2007) Inc., directly and indirectly through 7721099 Canada Ltd., ConCreate USL Limited Partnership ("ConCreate LP"), TriWest Construction Holdings Limited Partnership and TriWest Construction Limited Partnership ("TriWest LP") acquired the assets of Old ConCreate and the shares of SDF from two sellers. Specifically, the shares of Old ConCreate were sold to ConCreate LP and the shares of SDF were sold to 7721099 Canada Ltd.

As part of the transaction, Martin effectively received $1.29 million in cash and was repaid loans made to Old ConCreate and SDF in the amount of $3.81 million. In addition, Martin indirectly received a 25% limited partnership interest in TriWest LP (the "TriWest Units") with an unappraised book value of $6.5 million.

Martin's holding corporation (the "Martin HoldCo") held the TriWest Units, which in turn held the units in ConCreate LP.

Mr. Martin executed employment agreements with ConCreate LP and SDF, each of which contained non-competition and non-solicitation agreements. The non-competition and non-solicitation period would end 24 months after Martin HoldCo disposed of the TriWest Units.

The TriWest Units were subject to a limited partnership agreement (the "TriWest LPA"). The TriWest LPA required that any transfer of the TriWest Units required the consent of the board of the general partner and from any lenders (including any future lenders) to TriWest LP. The requirement for the consent of the lenders in connection with such transfers is typical in a leveraged M & A transaction.

Additionally, TriWest LP had a right to repurchase the TriWest Units, and conversely Martin had the right to compel the repurchase of the TriWest Units after his employment ended. The TriWest LPA also contained a non-competition agreement between the partners of TriWest LP.   

Mr. Martin began his employment with ConCreate LP and SDF as President. He was also appointed to the board of SDF as well as the boards of the corporate general partners of ConCreate LP and TriWest LP.

Four months after Mr. Martin began his employment, he went on to incorporate a business that allegedly competed with the business of ConCreate LP and SDF.

Mr. Martin brought an application before the Superior Court to declare the restrictive covenants unenforceable. 

After a thorough examination of the law, the Superior Court dismissed Mr. Martin's application and held the covenants to be enforceable.

The Ontario Court of Appeal disagreed with certain aspects of the Superior Court's reasoning. The Court of Appeal focussed on the fact that the transfer of the TriWest Units required the consent of third party lenders at the time of the transfer whose identity could not be ascertained at the time the deal was executed. Therefore, the covenants in the employment agreements had no outside time limit, since the time period depended on the consent of unknown third parties, which consent might never be obtained.

The Ontario Court of Appeal also found the scope of activity restricted by the covenants to be overly broad.

The Court of Appeal did comment favourably on time limits that ran either from the date of the transaction or the end of the employment relationship.

Buyers involved in an M & A transaction should review the Court of Appeal's decision when structuring restrictive covenants in order to carefully determine whether such covenants will be enforced.

1 2013 ONCA 72

2 2012 ONSC 1840

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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