Canada: Post-Termination Restrictions: The Supreme Court Reinvigorates The Blue Pencil Test

On 3 July, the Supreme Court handed down its judgment in Tillman v Egon Zehnder Ltd on whether a restrictive covenant that prevents an ex-employee from being "interested in" a competitor for six months without an express carve-out for minor shareholdings was too wide and therefore unenforceable in its entirety.

The Supreme Court has taken this rare opportunity to consider some fundamental issues on the enforcement of restrictive covenants. In this long awaited decision we are given clarity on what is "an interest" in a competitor and if the current contract raises a problem what can and will the Court do to "blue pencil" the problem.

Enforceability of post-termination restrictions

Restrictive covenants are an unlawful restraint of trade which, when they protect a legitimate interest to a reasonable extent will be enforced. The interest is about confidential information or goodwill (meaning customer or staff connection). What is reasonable depends on the seniority of the individual, the market in which you operate and the extent of the restriction. These clauses will be enforced if they meet these thresholds. The court can and will "blue pencil" - meaning "delete" - terms which are excessive and will enforce what is left. But the court will not reduce or redraft a clause to make it work. For that reason care needs to be taken.

The case of Ms Tillman

Ms Tillman was a senior and very successful executive at Egon Zehnder. She was headhunted by a competitor and gave notice. Egon Zehnder sought to enforce the six month restrictions in her contract to keep her out of the market. The case focussed on specific terms which prevented her being "interested or concerned" in any competing business for a period of six months from termination. Under clause 13.2.3, Ms Tillman agreed that she would not "directly or indirectly engage or be concerned or interested in any business carried on in competition with any of the businesses of [Egon Zehnder]" within a twelve-month period prior to the termination date "and with which [she was] materially concerned during such period." Crucially, clause 13.2.3 did not contain an express limitation allowing her to hold a minor shareholding in a competing business for investment purposes, when she was able to do so, when she had been an employee. Given that the phrase 'interested in' included holding one share in a publicly quoted company, this rendered the restriction impermissibly wide, and therefore void. There was no suggestion that Ms Tillman owned or ever intended to own any shares at all.

The story to this point is that employer lost in the Court of Appeal. Going back to basics, the Court of Appeal concluded that a restriction, which prohibited any "interest" after employment when it had been permitted before termination was unreasonable. Unfortunately for the former employer, it made no difference that Ms Tillman had or ever intended to buy shares. The restriction was too wide rendering the covenant as a whole unenforceable. As for the "blue pencil" test, the Court of Appeal concluded that it could not simply take out the offending word and leave "concerned" on its own. The Court of Appeal observed that it must always be doubtful whether parts of a single covenant can be deleted without the contract becoming "not the sort of contract that the parties entered into at all".

Egon Zehnder has fought on the Supreme Court on two points:

  1. The Court of Appeal got the law wrong on the issue of "interested in" - if it was unreasonable in principle the issue was very limited and should be discounted ("the validity principle"); and
  2. If the Court considered severance then it should take each element of any restriction separately, delete one element and leave the rest rather than the approach taken here and say that it is either the entire obligation or none of it ("the severance issue").

What did the Supreme Court decide?

The validity principle

The validity principle in construing agreements proceeds on the premise that the parties to a contract will have intended it to be valid. The phrase "engaged or concerned or interested in", adopted in clause 13.2.3, has long been included in standard precedents for the drafting of non-competition covenants and treated as including a shareholding prohibition large or small. Subject to the question of possible severance, the Supreme Court agreed that clause 13.2.3 was void as an unreasonable restraint of trade, as it did not have a minor shareholding carve-out

The severance issue

Having agreed that the clause as drafted was void as too wide, the Supreme Court then turned to consider the correct approach to severance in restraint of trade cases.

On the question of severance, the Court was faced with two differing judicial approaches. The Attwood approach being that parts of a single covenant could not be severed (Attwood v Lamont [1920] 3 KB 571). By contrast, the Beckett approach using three criteria for severance (Beckett Investment Management Group Ltd v Hall [2007] ICR 1539).

The Supreme Court has now overruled the Attwood approach and endorse the Beckett approach being:

  • Criterion one: whether the unenforceable provision is capable of being removed without the necessity of adding to or modifying the wording of what remains;
  • Criterion two: that the remaining terms continue to be supported by adequate consideration (this will not usually be in dispute); and
  • Criterion three: that the removal of the unenforceable provision does not so change the character of the contract that it becomes not the sort of contract that the parties entered into at all.

It is the third criterion that is most likely to be crucial and requires consideration as to whether removal of the provision would not generate any major change in the overall effect of all the post-employment restraints in the contract. The focus is on "the legal effect of the restraints, which will remain constant, and not their perhaps changing significance for the parties and in particular the employee".

On the facts of Ms Tillman's case, the words "or interested" are capable of being removed from clause 13.2.3 without the need to add to or modify the wording of the rest of the clause. Furthermore, the removal of the prohibition against her being "interested" would not generate any major change in the overall effect Accordingly, Ms Tillman was bound clause 13.2.3 save that she could have held a minor shareholding for investment purposes if she had wished.

What does this mean for employers?

It remains the case that the general rule is that all contractual restraints on a former employee's freedom to work are void and unenforceable as being in restraint of trade and contrary to public policy unless they can be shown to be no wider than reasonably necessary to protect the employer's legitimate business interests for a reasonable period.

While the Supreme Court's judgment is welcome news for employers, it should be remembered that the "blue pencil" test is still a very limited life-line. A court can sever an unenforceable clause or words from a clause. However, a court will not re-write a clause to make it enforceable if it is too broad. Nor will it construe a wide (and void) restriction as having implied (and valid) limitations.

Restrictive covenants must be carefully thought through and drafted to ensure they achieve the result intended.

Employers should also remember that the reasonableness of a restrictive covenant is judged at the time it was entered into, not at the time when the employer seeks to enforce it. A subsequent change of circumstances, such as a promotion, will not turn an invalid covenant into a valid one. Employers should review restrictive covenants, particularly when an employee is promoted, to see that they are appropriate to the changed circumstances and decide whether they need to be entered into afresh.

A sting in the tail...

In the case of Ms Tillman, Egon Zehnder were ultimately successful in saving their restrictive covenant. While the contractual period of the restraint expired long ago in relation to Ms Tillman, the principle of the matter went in the employer's favour.

A moral victory but at a cost. The final paragraph of the Supreme Court's judgment refers to the costs in this case. It reiterates the words from an earlier case on the "legal litter", a short hand for the unreasonable parts of post-employment restrictions to which employers extract the agreement of prospective employees "cast[ing] an unfair burden on others to clear them up". Lord Wilson in his final sentence concludes his judgment with "In my view the company should win ... but there might be a sting in the tail".

Read the original article on GowlingWLG.com

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