Buying or Selling a Business

Transcription

1 TAB 2 Buying or Selling a Business Restrictive Covenants in Commercial and Employment Contexts: Key Cases and Considerations Adrian Ishak, Rubin Thomlinson LLP Parisa Nikfarjam, Rubin Thomlinson LLP March 8, 2017

2 RESTRICTIVE COVENANTS IN COMMERCIAL AND EMPLOYMENT CONTEXTS: Key Cases and Considerations Prepared by: Adrian Ishak and Parisa Nikfarjam Restrictive covenants such as non-competition covenants ( non-compete ) and nonsolicitation covenants ( non-solicit ) are often contentious clauses in contracts but they serve as protective tools for both purchasers of a business and employers. A non-compete prevents a party who has the knowledge of, and experience with, a business from using such knowledge and experience to compete with the purchaser of a business or a previous employer. A non-solicit prevents the direct or indirect solicitation of customers or employees by the party subject to the covenant. By imposing such restrictions, these covenants are a restraint of trade for the person who is subject to the covenant, and are, as a result, resisted by the courts to varying degrees. In this paper, we will explore the manner in which restrictive covenants have been scrutinized, depending on the circumstance (commercial versus employment relationship), to highlight the framework in which they may successfully imposed. A. Restrictive Covenants in the Commercial Context Restrictive covenants such as non-competes and non-solicits largely serve to protect a purchaser in the context of a sale of business by preventing a seller from competing with the purchaser, particularly in the critical period of time following the business sale. While often negotiated during the sale transaction, the covenants restrictions may apply for months, if not years, after the sale has been completed. Therefore, in order to prevent restrictive covenants from constituting an unenforceable restraint on trade, certain factors must be carefully considered when drafting these clauses. Leading Case: Payette v. Guay Inc. ( Payette ) 1 The Supreme Court of Canada ( SCC ) most recently provided guidance on the validity of restrictive covenants in a sale of a business in Payette. In Payette, Guay Inc. acquired assets belonging to corporations owned by Payette. The agreement between the parties contained the following restrictive covenants: 10.1 Non-competition - In consideration of the sale that is the subject of this offer, each of the Vendors and the Interveners covenants and agrees, for a period of five (5) years from the Closing date or, in the case of the Interveners, for a period of five (5) years from the date on which an Intervener ceases to be employed, directly or indirectly, by the Purchaser, not to hold, operate or own, in whole or in part, directly or indirectly and in any capacity or role whatsoever, or in any other manner, any business operating in whole or in part in the crane rental industry, and not to be or become involved in, participate SCC

3 in, hold shares in, be related to or have an interest in, advise, lend money to or secure the debts or obligations of any such business or permit any such business to use the Vendor's or the Intervener's name in whole or in part. The territory to which this non-competition clause applies for the above-mentioned period of time is the province of Quebec Non solicitation - Moreover, each of the Vendors and the Interveners covenants and agrees, for a period of five (5) years from the Closing date or, in the case of the Interveners, for a period of five (5) years from the date on which an Intervener ceases to be employed, directly or indirectly, by the Purchaser, not to solicit on behalf of the Vendor or the Intervener, or on behalf of others, and not to do business or attempt to do business, in any place whatsoever, in whole or in part, directly or indirectly and in any manner whatsoever, with any of the customers of the Business and the Purchaser on behalf of a crane rental business. In addition, the Vendors and the Interveners shall not solicit or hire (unless an employee is dismissed or resigns without any solicitation by the Vendors or the Interveners), in any way whatsoever, directly or indirectly, as an employee or a consultant, or in any other capacity whatsoever, any of the employees, officers, executives or other persons (hereinafter collectively referred to as the Employees for the purposes of this article) working for the Business or the Purchaser on the date this offer to purchase is presented or on the Closing date, and shall not attempt in any way whatsoever, directly or indirectly, to encourage any of the said employees to leave their employment with the Business or the Purchaser. For greater certainty, the parties agree that steps taken by the Vendors to collect accounts receivable shall not be interpreted as a breach of the non competition and non solicitation provisions of this offer to purchase. In addition to the covenants above, the parties also agreed that Payette would work full time for Guay as a consultant for six months following the sale in order to ensure a smooth transition, with the option of entering into an employment relationship thereafter. Ultimately, following the sale, Payette and Guay exercised this option and Payette became an employee of Guay under a separate employment contract. Several years later but within five years of the closing date of the sale, Guay dismissed Payette, and Payette secured alternate employment with Mammoet Canada Eastern Ltd. ( Mammoet ), a competitor of Guay. Guay sought an injunction against Mr. Payette working for Mammoet, and relied on the terms of its restrictive covenants. While the trial court refused to impose the non-compete, the Quebec Court of Appeal did not and ordered Payette and Mammoet to comply with the non-compete. They instead sought an appeal to the SCC. The SCC first distinguished between restrictive covenants in the context of a commercial and employment relationships. The SCC held that the resistance to restrictive covenants in a commercial context is less severe because in a commercial context, the parties often negotiate on equal terms and are advised by competent of professionals. In other words, these contracts do no create an imbalance between the parties. 2 Given the lack of imbalance in commercial contracts, restrictive covenants are often interpreted in the manner consistent with the intention 2 Ibid. at para

4 of the parties. In other words, in a commercial context, the onus is on the seller to prove that the restrictive covenant is unreasonable. 3 The SCC then determined whether the restrictive covenants at play in the case were in relation to a commercial (i.e. sale) contract. The SCC found that, given the context, the covenants were part of the commercial sale as they (1) appeared in the sales agreement; and (2) the consideration for the covenants was stated to be the sale, not the employment relationship. 4 Having determined that the covenants were related to a commercial transaction, the SCC then moved to deciding whether each covenant was reasonable. In the case of the non-compete, the SCC considered the following factors: The term: the SCC held that non-competes in a commercial contract must be limited as to time, having consideration to the nature of the business. The SCC held that the highly specialized nature of the business activities in this case weighed in favour of finding a longer restriction period reasonable. The SCC found that the five-year term was similar to terms in clauses upheld by courts and reasonable in the circumstances. 5 Territorial Scope: the SCC stated that the territory to which a non-compete applies is limited to that which the business being sold carries on its trade or activities as of the date of the transaction. The SCC then took a contextual approach to find that given the unique and mobile nature of the business in this case, the territory set out in the noncompete was reasonable. 6 In the case of the non-solicit covenant, the SCC stated that such covenants are narrower in their restriction and therefore more liberally interpreted when determining their reasonableness. In fact, the identification of a territory was not required for the non-solicit in this case to be held to be reasonable. In sum, the SCC held that both the non-compete and the non-solicit covenants were reasonable and lawful in the circumstances of this case, and Payette s conduct was in violation of the restrictions of the covenants. Legacy of Payette Subsequent decisions have followed the principles and analysis of Payette. For example, in: Brand Solutions by Promotion Solutions Inc. v. Elsey 7, a five year non-compete covenant in the context of a shareholder s agreement was upheld, as the parties agreed to the terms after extensive negotiations and had the benefit of legal advice throughout. Moreover, both parties to the agreement were business owners and sophisticated. In this circumstance, the Ontario court, applying Payette, gave deference to the non-compete covenant, also holding its time frame of five years to be reasonable. 3 Ibid. at para Ibid. at para Ibid. at para Ibid. at para ONSC

5 Imperial Parking Canada Corp. v. Anderson 8, restrictive covenants in an asset purchase agreement and subsequent consulting agreement were all upheld given that they arose in a commercial context. In this case, the parties had entered into an asset purchase agreement which contained a non-compete covenant of four-year duration. The seller also entered into a consulting arrangement with the buyer, which contained a six-year non-compete covenant, which was extended for a further two years (for a total of eight years) to correspond with the extensions to the consulting arrangement. The British Columbia court held that all of the non-compete covenants arose as a result of the commercial transaction, and were therefore presumed enforceable unless proved otherwise. The British Columbia court found that the non-compete covenants were reasonable as (1) the parties were sophisticated; (2) the parties had the benefit of legal counsel throughout the transaction; (3) the geographical scope was not overly broad given the nature of the business; and (4) the length of the term was extended for additional consideration. Since Payette, a few cases have also added to the factors to consider when scrutinizing the enforceability of a restrictive covenant. For instance, simply proving that a restrictive covenant is reasonable with respect to time and geographical location may not be enough if the covenant does not actually protect a legitimate proprietary interest, as recently highlighted in MEDIchair LP v. DME Medequip Inc. 9 In this case, DME Medequip Inc. had purchased a franchise of MEDIchair LP, which included a non-compete covenant preventing DME Medequip from operating a similar store within a 30- mile radius for 18 months after the termination of the agreement. After seven years, DME Medequip did not renew the agreement but continued to operate the same premises but without the MEDIchair LP signage. MEDIchair LP, which did not have any plans to open a store in that area, sought to uphold its non-compete covenant. While the trial judge upheld the non-compete covenant, the Ontario Court of Appeal did not. The Court of Appeal found that the non-compete covenant was not enforceable given that it was not necessary to protect the actual, legitimate and proprietary interests of MEDIchair LP, which had no plans of doing business in the area. Notwithstanding this decision, the jurisprudence suggests that restrictive covenants in a commercial context are presumed to be enforceable based on the perception that sophisticated parties agree to these restrictions after negotiations and with the aid of legal representatives. The presumption is only rebutted if the covenant in unreasonable in scope or term, or does not relate to a legitimate proprietary interest. The analysis of these factors is, naturally, case specific. For instance, courts have upheld terms exceeding five years with respect to non-competes when the nature of the relationship justifies it and adequate consideration is provided. This deference to restrictive covenants in a commercial context does not exist, however, when the restrictions relate to an employment relationship. B. Non-Competes in the Employment Context Restrictive covenants in an employment relationship serve to protect the employer, often at the end of the employment relationship, from an employee who may use their knowledge of the BCSC ONCA 168 [ MEDIchair ]

6 employer s business and resources to either compete with the employer or solicit the employer s clients or employees. While the covenants aim to protect the post-employment conduct of an employee, they are negotiated and agreed to at the outset of or during the employment relationship. As such, there is an imbalance of power between the parties when the restrictive covenants are entered into. For this reason, restrictive covenants in an employment relationship are prima facie unenforceable. That said, a number of cases have historically found non-compete covenants enforceable where the circumstances make the restrictions reasonable. Leading Case: J.G. Collins Insurance Agencies v. Elsley 10 ( Elsley ) In Elsley, Elsley managed the agency s insurance business for seventeen years after selling the business to J.G. Collins. Elsley s contract of employment contained the following non-compete covenant: 3. ( ) the Manager shall not, while in the employ of the Company ( ) or during the period of five years next after ( ) and whether as principal, agent, director of a company ( ) carry on ( ) or take part in the business of a general insurance agent within the corporate limits of the City of Niagara Falls, the Township of Stamford and the Village of Chippawa, all in the County of Welland ( ). During his years of service, Elsley exclusively served the customers of the business and to them he was the face of the business. When Elsley s employment was terminated, he began his own insurance business, and soon employed two insurance salesmen and an insurance clerk formerly employed by J.G. Collins. Soon after, approximately 200 clients took their business to Elsley, which represented 50% of J.G. Collins business. J.G. Collins sought to enforce the non-compete covenant in Elsley s contract and at issue was whether the non-compete covenant was enforceable. The SCC first confirmed that restrictive covenants are prima facie unenforceable unless proved reasonable by the employer. The SCC then outlined a three-step inquiry for assessing the reasonableness of a non-compete covenant: 1) Does the employer have a proprietary interest entitled to protection? 2) Are the temporal and spatial features of the covenant too broad? 3) Is the covenant unenforceable as being against competition generally and not limited to proscribing solicitation of clients? The SCC held that J.G. Collins had a proprietary interest in its clients and employees. Next, it noted that while a five-year non-compete would normally be abusive in a typical employment contract, it was reasonable in this case as J.G. Collins was uniquely vulnerable given that Elsley was essentially the business. Finally, the SCC held that the non-compete was necessary because a non-solicit would not have adequately protected J.G. Collins business. Elsley was, therefore, held to have breached the non-compete covenant and liable for damages. 10 [1978] 2 S.C.R

7 Legacy of Elsley Since Elsley, courts have continued to deem non-compete covenants unenforceable in an employment context unless reasonable under the circumstances. Courts have noted that a noncompete covenant is a more drastic weapon in an employer s arsenal. The focus of a noncompete clause is much broader than an attempt to protect the employer s clients or customer base; it extends to an attempt to keep the former employee out of the business. Generally speaking, courts have not enforced a non-compete covenant if a non-solicit covenant would adequately protect an employer s interests.11 That said, the court will continue to engage in a contextual analysis in determining the enforceability of a non-compete covenant. Take for example, Renfrew Insurance Ltd. V. Cortese,12 which involved an insurance brokerage business. Both defendants were shareholders of Renfrew and received shares in Renfrew in exchange for the non-solicit and non-compete covenants in a Unanimous Shareholder s Agreement ( USA ). The USA specifically prohibited the defendants from competing in the insurance business within a 60 kilometer radius of Renfrew s office in Calgary and for a period of six months following termination. In addition, both defendants agreed not to solicit Renfrew s customers or employees for a period of 18 months. The defendants resigned from their positions at Renfrew and joined a competitor, located within the defined geographical area outlined in the restrictive covenants. In addition, two former customer service representatives who previously worked with the defendants at Renfrew joined the competitor business and two former clients switched their business from Renfrew to the competitor. The trial judge found that the non-competition clause comprising a 60-kilometer radius of a specific location in Calgary for a period of six months was quite reasonable. The judge stated that a book of business in the insurance industry is an invaluable asset making restrictions to an employee s use of it reasonable. Moreover, as both defendants had the benefit of independent legal advice with respect to the restrictive covenants contained in the USA, voluntarily accepted the offer to become owners of Renfrew, and did not fear that the continuation of their employment was dependent on the signing of the agreement, there was an absence of inequality of bargaining power between the parties, further justifying the reasonableness of the covenants. As a result, the trial judge concluded that the non-compete and non-solicit covenants were both reasonable. The trial judge s decision was also upheld by the Alberta Court of Appeal.13 As can be seen above, the contextual analysis of restrictive covenants remains the key method in determining whether a covenant is reasonable. In some situations, a lengthier restriction period (i.e. five to eight years) have been upheld14 As such, the limitations of scope and term will depend on the specific nature of the relationship and business at play. 11 Lyons v. Multari, (2000), 50 OR (3d), 3 CCEL (3d) 34, 2000 CarswellOnt CarswellAlta Renfrew Insurance Ltd. V. Cortese, 2014 CarswellAlta 958, 2014 ABCA See: Dale & Co v Land (1987), 56 Alta LR (2d) 107, 84 AR 52, 1987 CarswellAlta 249, where the Alberta Court of Appeal upheld a five-year non-compete clause stating that the covenant must be measured against what appears to be the unique ability of the [company] to retain the loyalty of clientele ; Dyform Engineering Ltd v Ittup Hollowcore International Ltd, [1985] BCWLD 1699, 19 BLR 1, 1982 CarswellBC 2-6 6

8 C. Key Considerations When Drafting Restrictive Covenants There are, however, situations where a restrictive covenant may exist in a situation that involves both a commercial and employment relationship, creating a hybrid contract. These situations occur, for example, in situations where sale of a business also involves the employment of (or undertaking to employ) the seller of a business by the purchaser following the sale. In such situations, the decision of Payette provides helpful guidance as to the enforceability test to be applied. The SCC stated that where the sales agreement is a hybrid contract: To determine whether a restrictive covenant is linked to a contract for the sale of assets to or a contract of employment, it is important to clearly identify the reason why the covenant was entered into. The '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 noncompetition and non-solicitation were assumed. 15 This is a process of contractual interpretation whereby the terms of the contract as well as the circumstances surrounding the contract are used to ascertain why the restrictions were put into place. Where the restrictions cannot be dissociated from commercial agreement, the less robust analysis of the reasonability of the covenants will take place. However, to avoid any risk of restrictive covenants being analyzed through the more narrow employment relationship lens, parties to a sale of a business may be well served by clearly separating the employment arrangements from the commercial sale transaction and having stand-alone documents with their own respective restrictive covenants and consideration. Notwithstanding whether the employment and commercial relationship can be separated, the leading and recent jurisprudence show that decision-makers will pay careful attention to the following factors when determining whether a restrictive covenant specifically as a noncompete covenant - is reasonable and enforceable: 1. The extent to which there is equal bargaining power between the parties. Careful attention will be paid to whether the parties are both sophisticated; were provided time to negotiate the terms of the restrictive covenant; and had the benefit of independent legal advice. The more equal the bargaining power, the better the chance that the restrictive covenant will be honoured. 2. The term, scope, and interests covered in the restrictive covenant will be key in determining whether the restrictions are reasonable. There is no bright line rule with 473, where the British Columbia Court of Appeal found that an eight-year non-compete clause was reasonable given the nature of the business, investment of capital and the clear intentions of the parties. 15 Supra note 1 at para

9 respect to terms and scope. Careful attention will be paid to the nature of the business at play to determine if the restrictions are practically needed in the specific circumstance. 3. The restrictive covenant must be clear and non-ambiguous in terms of its restrictions and to the party (or parties) and locations to which the restrictions will apply. Given the enforcement requirements at play, corporate entities and their counsel should carefully draft restrictive covenants that are appropriate in the context in which they will be applied, in order to fully enjoy the benefits of these restrictions and protections, both in the commercial and employment relationship