Non-Compete / Non-Solicit Covenants: Ontario Court of Appeal Provides Guidance on Requirements for Enforceability
Feb. 7, 2013
The Ontario Court of Appeal’s February 5, 2013 decision in Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72 analyzes the non-competition and non-solicitation covenants applying to a former company President (Martin). The covenants had been entered into by Martin in connection with a previous sale of the business by Martin and other stakeholders, after which he stayed on as President. Later, Martin’s employment was terminated and he established a competitive business. The enforceability of the restrictive covenants thus became an issue.
While the Court’s decision generally acknowledges the appropriateness of restrictive covenants entered into in connection with a business sale, the Court held that Martin’s particular covenants are not enforceable because they lack a clear, outside limit to the duration of the non-competition and non-solicitation period.
The case is highly relevant for both the drafting of, and litigation surrounding, restrictive covenants, particularly those entered into in connection with a business transaction. The main points emerging from the Court’s decision are:
- Greater deference will be given to restrictive covenants contained in agreements entered into by sophisticated parties with legal representation. This is especially the case in the context of a sale of a business, where it is necessary to protect the goodwill of the purchased business.
- However, the duration of the covenant must be clearly defined. When, as here, a covenant’s end date is conditional on events requiring the consent of third parties, the covenant could be declared unreasonable and thus unenforceable.
Martin worked for ConCreate for 20 years, acquiring a minority interest in it and a related company SDF.
ConCreate eventually sold all of its assets to Target LP, and all shares of SDF were sold to another entity controlled by Target LP’s parent company TriWest LP. As consideration for his interest in ConCreate and SDF, Martin and/or his holding company received millions of dollars in assets, including 25 percent of TriWest LP’s outstanding limited partnership units (the Units).
Martin entered into the restrictive covenants in connection with this transaction, and he continued on as the President of Target LP and SDF.
Six months after the sale transaction, Martin’s employment was terminated. Eight days later, he established a company that competed with Target LP and SDF and employed a number of former ConCreate employees. Target LP and SDF commenced litigation against Martin relying largely on the restrictive covenants entered into at the time of the business sale.
The covenants provided that the non-competition and non-solicitation period would end 24 months after Martin disposed of the Units. However, transfer of the Units needed to be approved by the board of directors of TriWest LP’s general partner, as well as “the Lenders” – defined as Target LP and SDF’s, and their subsidiaries’, senior secured lenders and bonding companies from time to time.
Martin moved to have the restrictive covenants declared unenforceable. Justice Perell of the Ontario Superior Court dismissed his motion. He appealed.
The Ontario Court of Appeal largely allowed Martin's appeal, and found the covenants unenforceable.
The Court noted that covenants in restraint of trade are prima facie unenforceable as they interfere with individual liberty and the exercise of trade. However, the Court noted that Martin, represented by counsel, had agreed to the covenants in the context of a sale of a business, recognizing their reasonableness. The Court accepted that the companies had legitimate business interests that a restrictive covenant could protect. Covenants in the context of sale of a business are scrutinized less rigorously than those between employer and employee. These factors weighed in favour of enforcing the covenants. However, this could not immunize them entirely from judicial scrutiny.
The Court held that the covenants satisfied the first two of four factors for assessing reasonableness. First, they were not ambiguous. Second, their scope was not unreasonable given the scope of the companies’ business.
The covenants ran into trouble on the third factor – duration. The Court held that “the duration is unreasonable because it depends on any required consents of third parties, is therefore for an indeterminate period, and there is no fixed, outside limit.” The Court emphasized that the identity of the Lenders could change and thus Martin could not know whose consent would be necessary to dispose of the Units. These Lenders also had no duty to Martin to act promptly or reasonably – on the contrary, they had an interest in keeping him out of the market.
The decision also indicates that the Court was troubled by the fact that the 24 months had not even begun to run even though Martin had no control over the business but merely held an indirect interest. The Court indicated that a restriction on use of confidential information would amply protect confidential information that could be accessed as a result of such an indirect interest.
The Court did not say that twenty-four months after a sale of business, plus time to divest assets, was an unreasonable duration. Nor did it say that twenty-four months after employment ending, plus time to divest assets, was an unreasonable duration. However, tying the period an event that required the consent of third parties who did not owe Martin any legal duties, and whose identities changed over time, was not reasonable.
The Court also expressed concerns in relation to the fourth factor – the scope of prohibited activities. The Court indicated that the covenants’ prohibition on solicitation was too broad to protect the companies’ goodwill, because Martin was prohibited from communicating or dealing with persons who became customers of the businesses after he left, and for products and services about which he knew nothing.
The Court did uphold confidentiality portions of the restrictive covenants, holding that they were reasonable for the respondents to protect their intellectual property interests.
Another issue to be mindful of when considering restrictive covenants in the context of any commercial transaction (including any non-M&A transaction and, in certain circumstances, even transactions involving non-Canadian parties), are the restrictive covenant rules in sections 56.4 and 68 of the Income Tax Act (Canada). To avoid unexpected tax consequences, any restrictive covenant (very broadly defined for purposes of these rules), whether legally enforceable or not, must be analyzed under these rules. For assistance with these rules, contact any member of the Osler Tax Group.