Canada: The Second Opinion: Restrictive Covenants And The Sale Of A Business

Since the seminal judgment in Elsley v. J.G. Collins Insurance Agencies Ltd., [1978] 2 S.C.R. 916, Canadian courts have applied the rules for determining the validity of a restrictive covenant more strictly in the employment context than where the covenant accompanies the sale of a business. However, it can frequently be difficult to identify which category a covenant falls into where a business is sold as part of a hybrid agreement that contemplates the vendor will also become the purchaser's employee. In Payette v. Guay inc., 2013 SCC 45, the Supreme Court of Canada weighed in on this issue, and held that the answer depends upon the nature of the principal obligations assumed under the master agreement, together with the rationale for the restrictive covenant itself. Along the way, the Court also clarified the test for the validity of restrictive covenants in the commercial context, and drew an important distinction between non-competition and non-solicitation covenants.

Background

As my colleague Angela Juba discussed in a previous post, the facts in Payette involved a transaction by which the appellant, who co-owned several companies in the crane rental business, agreed to sell the assets of those companies to the respondent, the crane rental leader in Quebec. The agreement of sale contained a provision requiring the appellant and his partner to work as the respondent's full-time employees for a six month transitional period, after which the parties would have the option to negotiate a new employment contract. The agreement of sale also contained two restrictive covenants:

  1. a non-competition covenant, which prohibited the appellant from acquiring an interest or otherwise participating in any business involved in the crane rental industry for 5 years from the end of his employment period in the province of Quebec; and
  2. a non-solicitation covenant, which prohibited the appellant from, inter alia, soliciting or doing business with any of the respondent's customers for a period of 5 years from the end of his employment, whether in Quebec or elsewhere.

The parties proceeded to enter into a new employment contract at the end of the six month period, which was separate from the agreement of sale, but several years later the respondent dismissed the appellant without a serious reason. A few months later, the appellant accepted employment with the respondent's competitor in Montréal, and the respondent sought a permanent injunction to compel the appellant to observe the restrictive covenants. The injunction was initially denied by the Quebec Superior Court, but later granted by the Quebec Court of Appeal.

The Decision

The Supreme Court of Canada unanimously upheld the injunction and dismissed the appeal. Wagner J., who delivered the judgment of the Court, framed his reasons around two issues.

First, the appellant argued that the restrictive covenants were unenforceable based on art. 2095 of the Civil Code of Québec. This provision stipulates that an employer may not rely upon a restrictive covenant if it has resiliated the employment contract without a serious reason. A similar rule exists at common law where an employer wrongfully dismisses an employee: see General Billposting Co Ltd v Atkinson, [1909] A.C. 118 (H.L.); and Globex Foreign Exchange Corporation v. Kelcher, 2011 ABCA 240.

According to Wagner J., art. 2095 only applies to a restrictive covenant that is "linked" to a contract of employment, not a contract for the sale of a business. (para. 42) In determining which contract the covenant is linked to in this sense, Wagner J. set forth the following test:

To determine whether a restrictive covenant is linked to a contract for the sale of assets or to a contract of employment, it is, in my view, important to clearly identify the reason why the covenant was entered into. The [translation] "bargain" negotiated by the parties must be considered in light of the wording of the obligations and the circumstances in which they were agreed upon. The goal of the analysis is to identify the nature of the principal obligations under the master agreement and to determine why and for what purpose the accessory obligations of non competition and non solicitation were assumed. (para. 45)

Applying this test to the facts of the appeal, Wagner J. held that the reason why the appellant entered into the restrictive covenants was the sale of his business to the respondent, not his post-sale services as the respondent's employee. As such, the restrictive covenants could not "be dissociated from the contract for the sale of assets", and art. 2095 C.C.Q. was therefore inapplicable. (para. 46) In arriving at this conclusion, Wagner J. emphasized the following factors:

  1. the text of the restrictive covenants stated that they were provided "[i]n consideration of the sale that is the subject of this offer", and this was also supported by other provisions in the agreement of sale;
  2. in the context of the agreement of sale, the purpose of the restrictive covenants was to protect the assets acquired by the respondent, and the main point of the sale transaction was for the respondent to acquire the appellant's goodwill, employees and customers;
  3. the employment contract under which the appellant was dismissed was separate from the agreement of sale, and did not contain the restrictive covenants; and
  4. although the restrictive covenants themselves made reference to the termination of the appellant's employment, this was only done to make them determinable, enforceable and final by stipulating the start of the period within which they would be in effect. (paras. 47, 49 and 51-52)

The second issue addressed by Wagner J. was whether the restrictive covenants were reasonable. As a preliminary point, Wagner J. rejected the appellant's argument that this issue was governed by art. 2089 C.C.Q., which imposes the burden of proving the reasonableness of the covenant upon an employer. Because the restrictive covenants related to an agreement for the sale of a business rather than an employment contract, their reasonableness was to be assessed "on the basis of the criteria applicable in commercial law". (para. 57) These less demanding criteria held that a restrictive covenant in the commercial context would be lawful unless it could be established on a balance of probabilities that its scope was unreasonable. In an interesting aside, Wagner J. noted that a provision in the agreement of sale, by which the appellant acknowledged the reasonableness of the covenants, was an important albeit non-determinative factor in this analysis:

It is important to note at the outset that the appellant Payette acknowledged that his covenants were reasonable in clause 10.4 of the agreement at issue. This Court is not bound by his acknowledgment, however, since it has to determine whether the covenants in question are valid. The acknowledgment is nevertheless an additional factor, and an indicator that is both relevant to and useful for the assessment of whether the covenants are reasonable, and hence valid. ... (para. 60)

With respect to the non-competition covenant in the agreement of sale, Wagner J. observed that "[i]n a commercial context, a non competition covenant will be found to be reasonable and lawful provided that it is limited, as to its term and to the territory and activities to which it applies, to whatever is necessary for the protection of the legitimate interests of the party in whose favour it was granted". (para. 61) Importantly, he then went on to suggest that even within the commercial context, there could be different degrees of rigour in applying this test, depending upon the comparative bargaining power of the parties:

...[T]he common law rules for restrictive covenants relating to employment do not apply with the same rigour or intensity where the obligations are assumed in the context of a commercial contract. This is especially true where the evidence shows that the parties negotiated on equal terms and were advised by competent professionals, and that the contract does not create an imbalance between them.
...
To properly assess the scope of the obligation of non competition (and that of non solicitation), it is also necessary to consider the circumstances of the parties' negotiations, including their level of expertise and experience and the extent of the resources to which they had access at that time. ... [emphasis added] (paras. 39 and 62)

Upon finding that there was no imbalance of bargaining power between the appellant and respondent, Wagner J. concluded that the non-competition covenant was valid. Its 5-year term was reasonable given the highly specialized nature of the respondent's business activities. As to its territorial scope, Wagner J. noted that the ordinary rule is that a non-competition covenant should be limited to the territory in which the business being sold carries on its activities at the date of the transaction. Nonetheless, although the non-competition covenant in this case extended to all of Quebec, and the vast majority of the appellant's business was only carried on in Montréal, a more expansive territorial scope than usual was merited given the "unique nature of the crane rental industry" in which "[c]ranes are mobile. They go where the construction sites are". (para. 67)

Finally, Wagner J. turned to consider the reasonableness of the non-solicitation covenant. In doing so, he drew an important distinction between it and the non-competition covenant. Although the non-solicitation covenant did not contain any territorial limitation at all, Wagner J. found it was still reasonable on the theory that territorial limitations are generally unnecessary for non-solicitation covenants in the commercial context:

... While it is true that in the case of a non competition clause, the territory to which the clause applies must be identified, a determination that a non solicitation clause is reasonable and lawful does not generally require a territorial limitation.
...
I am of the opinion that a territorial limitation is not absolutely necessary for a non solicitation clause applying to all or some of the vendor's customers to be valid, since such a limitation can easily be identified by analyzing the target customers. In World Wide Chemicals Inc.v. Bolduc, 1991 CarswellQue 1157, L.E.L. Marketing Ltée v. Otis, [1989] Q.J. No. 1229 (QL), and Moore Corp. v. Charette (1987), 19 C.C.E.L. 277, for example, the Superior Court noted that a non solicitation clause does not require a geographic limitation. Finally, in the context of the modern economy, and in particular of new technologies, customers are no longer limited geographically, which means that territorial limitations in non solicitation clauses have generally become obsolete. (paras. 69 and 73)

Significance

The Payette case seems likely to replace Doerner v. Bliss & Laughlin Industries Inc., [1980] 2 S.C.R. 865 as the leading Canadian decision on the validity of restrictive covenants in the commercial context. Although Payette was decided under Quebec law, Wagner J. noted that "the same principles apply in Quebec civil law" as under the common law of restrictive covenants. (para. 40) Accordingly, the approach taken in Payette should be largely applicable in provinces outside Quebec. For a summary of the common law principles, see our prior post on Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72, found here.

The most important feature of Payette is likely to be the purposive test adopted by Wagner J. for assessing whether a restrictive covenant is given in connection with the sale of a business or an employment contract. In addition, however, the Court's suggestion that inequality of bargaining power can influence the reasonableness test even within the commercial context is also significant. As well, the flexible approach the Court took in assessing the territorial scope of the non-competition covenant, and its rejection of any need for a territorial limitation in non-solicitation covenants, should influence the direction of future restrictive covenant jurisprudence. Finally, Wagner J.'s willingness to give some weight to a clause in which the covenantor acknowledged the reasonableness of the covenant suggests that parties should strongly consider including such provisions when negotiating a restrictive covenant on the sale of a business.

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