The rules of engagement: restrictive covenants, Canadian Employment Law Today (October 30, 2013)

The rules of engagement: restrictive covenants, Canadian Employment Law Today (October 30, 2013)

By Nikolay Y. Chsherbinin

Restrictive covenants relating to employment and competition have been an integral part of our law for many years, typically taking the form of non-competition and non-solicitation clauses. While restrictive covenants can be found in commercial and employment contracts, their interpretation requires the application of different rules. With a presumed imbalance of power in an employer-employee relationship, the interpretation of restrictive covenants is stricter than in a commercial context, where an imbalance of power is not presumed to exist. In its recent decision, Guay Inc. v. Payette, 2013 CarswellQue 8646 (S.C.C.), the Supreme Court of Canada considered important issues relating to the interpretation of restrictive covenants limiting employment and competition in a contract for the sale of assets that resulted in a contract of employment with the vendor’s principal. The top court affirmed that whenever a restrictive covenant is negotiated in connection with the sale of assets, employment law rules do not apply. In addition, it did away with the requirement to limit non-solicitation clauses geographically.

Gauy Inc., a crane rental company, acquired assets belonging to corporations controlled by Yannick Payette. The sale agreement contained non-competition and non-solicitation clauses. To ensure a smooth transition following the sale, the parties also agreed to include a provision in the agreement in which Payette would work full-time as a consultant for six months. At the end of the transition period, they entered into a contract of employment, originally for a fixed term and later an indefinite term. Four years later, Payette was dismissed without cause and went to work for Gauy’s competitor. Gauy brought an injunction in the Superior Court compelling Payette to comply with the restrictive covenants set out in the agreement, which was dismissed. Subsequently, the Court of Appeal overturned the lower court’s decision and ordered a permanent injunction against Payette and his new employer.

Payette appealed to the Supreme Court of Canada to consider the system of rules applicable to the agreement that led to the formation of an incidental employment relationship. The court explained that to determine whether a restrictive covenant is linked to a contract for the sale of assets or to a contract of employment, it must consider wording and context to identify the reason for the covenants. The evidence showed the reason Payette agreed to the restrictive covenants related to the sale of his business and not to his subsequent services as a consultant. Having considered the ordinary meaning of the words in and the circumstances of the agreement, the court was unable to separate Payette’s obligations from the contract for the sale of assets. In its view, the purpose of the non-competition provision was to protect the assets acquired by Gauy in exchange for the $26 million it paid to Payette. The main point of the transaction was to acquire Payette’s goodwill, skilled employees and customers. Consequently, the court found there was a direct causal connection between the restrictive covenants and the sale.

The court pointed out the restrictive covenants were not included in the employment contract and therefore did not form an essential aspect of the negotiations that led to the employment relationship. Ultimately, the Supreme Court concluded that because the restrictive covenants were negotiated in the sale agreement, they must be interpreted on the basis of commercial and not employment law. The court emphasized the factual context in which the covenants were negotiated must be taken into consideration when reviewing such clauses. Reasonableness of restrictive covenants. In a commercial context, a restrictive covenant will be deemed lawful unless it can be established that its scope is unreasonable.

This begs a question of how one determines the reasonableness of a restrictive covenant’s scope?

It must be assessed on the basis of the rules that govern freedom of trade so as to favour the application of the restrictive covenant. The criteria for analyzing the restrictive covenants in a contract of sale of assets will be less demanding and the basis for finding such covenants to be reasonable will be much broader in a commercial contract than an employment contract.

What are then the reasonable limits of restrictive covenants?

In a commercial context, a non-competition covenant will be found to be reasonable and lawful, provided it is limited in “its term and to the territory and activities to which it applies,” to whatever is necessary for the protection of the legitimate interest of the party in whose favour it was granted. The validity of a non-competition clause will depend on the circumstances in which the contract was entered into. In this regard, the court offered a non-exhaustive list of factors, which courts can consider when assessing the scope of restrictive covenants, including: the sale price, the nature of the business activities, the parties’ experience and expertise, whether the parties had access to legal counsel and other professionals, and the extent of the resources to which the parties had access. Geographical limits obsolete Payette argued the restrictive covenants were unlawful because they were overly broad in their term and to the territory to which they applied. The noncompetition covenant contained the restriction of five years from the date Payette ceased to be employed. Considering the “highly specialized nature of the business’ activities,” the court determined the five-year restriction was reasonable. In considering the absence of the geographical limit for the non-solicitation clause, the court found that in the context of the modern economy and new technologies, customers are no longer limited geographically, which means “geographical limitations in non-solicitation clauses have generally become obsolete.”

As a result, the following distinction must be kept in mind: in the case of a non-competition clause, the geographical limit must be identified, while in the case of a non-solicitation clause, it is no longer generally required.

The top court reminded us that despite a contractual party’s written acknowledgment that restrictive covenants are reasonable: “the court is not bound by an acknowledgement, since it has to determine whether the covenants in question are valid.” The acknowledgment is merely a factor, which is both relevant and useful for the assessment of reasonableness.

The Guay decision drew a clear line between the system of rules governing restrictive covenants in the commercial and employment contexts. The Supreme Court made it clear restrictive covenants must be interpreted in a manner consistent with the intention of the parties and the obligations to which the covenants give rise, unless they are contrary to public order. The effect of disregarding such clauses solely because they appear in an agreement that preceded the formation of a separate contract of employment would be to negate the foundations of and the rationale for the obligations of non-competition and non-solicitation provided for in the clauses, while at the same time discounting the intention of the parties.

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