Tuesday, February 5, 2013

Restrictive covenants

Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72 is an important case upholding strongly the principle that, generally, restrictive covenants are unenforceable:

(1) Framework

[49]       Covenants in restraint of trade are contrary to public policy because they interfere with individual liberty and the exercise of trade: see Elsley v. J.G. Collins Ins. Agencies Ltd., [1978] 2 S.C.R. 916, at p. 923. They are prima facie unenforceable. A covenant will only be upheld if it is reasonable in reference to the interests of the parties concerned and the interests of the public in discouraging restraints on trade: see Elsley, at p. 923.
[50]       The party that seeks to enforce a restrictive covenant has the onus of demonstrating that the covenants are reasonable as between the parties. The party seeking to avoid enforcement of the covenant bears the onus of demonstrating that it is not reasonable with respect to the public interest: see Stephens v. Gulf Oil Canada Ltd.(1975), 11 O.R. (2d) 129 (C.A.), at p. 141.
[51]       If a covenant is ambiguous, in the sense that what is prohibited is not clear as to activity, time, or geography, it is not possible to demonstrate that it is reasonable: seeShafron v. KRG Insurance Brokers (Western) Inc., 2009 SCC 6, [2009] 1 S.C.R. 157, at paras. 27, 43; Mason, at para. 14. It is therefore unreasonable and unenforceable.
[52]        The law distinguishes between a restrictive covenant in connection with the sale of a business, and one between an employer and an employee: see Elsley, at p. 924.  The former may be required to protect the goodwill sold to the purchaser, and does not usually involve the imbalance of power that exists between employer and employee. Accordingly, a less rigorous test is applied in determining the reasonableness of a restrictive covenant given in connection with the sale of a business: seeShafron, at para. 23; Elsley, at p. 924.
[53]       Greater deference is given to the freedom of contract of “knowledgeable persons of equal bargaining power”: Elsley, at p. 923.  Nevertheless, the broader restraints on trade justifiable in the context of a sale of a business must be reasonable within such a context. There is a strong public interest “in discouraging restraints on trade and, maintaining free and open competition unencumbered by the fetters of restrictive covenants”: Elsley, at p. 923; see also H.L. Staebler Co. v. Allan, 2008 ONCA 576, 239 O.A.C. 230, at para. 34.
[54]       The factors relevant in determining whether a restrictive covenant is reasonable are the same in the contexts of the sale of a business and an employment agreement: the geographic coverage of the covenant, the period of time that it is in effect and the extent of the activity prohibited: see Shafron, at para. 43. And, as the application judge noted, reasonableness is determined in light of the circumstances existing at the time that the covenant was made. Those circumstances include the reasonable expectations of the parties about the future activities and marketplace of the business: see Tank Lining Co. v. Dunlop Industrial Ltd. (1982), 40 O.R. (2d) 219 (C.A.), p. 226.

(2) Standard of review

[55]       The parties agree that the standard of review of the application judge’s determination that the covenants are unambiguous and reasonable is one of correctness.

(3) Ambiguity

[56]       I agree with the application judge that the covenants are not ambiguous. As in Mason, the covenants in this case are more appropriately analysed as part of the reasonableness inquiry.

(4) Geographic scope

[57]       Nor, in my view, is there any basis for interfering with the application judge’s finding that the parties envisaged that “the scope of the business was and would be national.” I agree with the application judge’s reasons for concluding that the geographical scope of the restrictive covenants is reasonable. I also agree with the respondents that the “entire agreement” clause in the agreement of purchase and sale did not preclude the application judge from considering other documents connected to the transaction. The Confidential Information Memorandum and slideshow presented to the respondents were relevant in determining the parties’ reasonable expectations of the scope of the purchased business.

(5) Duration: the Prohibited Period

[58]       I part company with the application judge on the key issue on this appeal – the reasonableness of the duration of the restrictions.
[59]       In my view, 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. Notably, the required consents are not limited to third parties whose consent was required at the time that the covenants were entered into. As the definition of “Lenders” in s. 1.1 of the Partnership Agreement, and the definitions incorporated therein, make clear, the duration is potentially tied to the consent of unascertainable future third parties:
“Bank” means the principal banker of the General Partner, from time to time;
“Bonding Company” means collectively all Persons which from time to time have bonding facilities with the Partnership, the General Partner or any of the Subsidiaries including the Guarantee Company of North America;
“Lenders” means the senior secured Lenders to the Partnership and its Subsidiaries from time to time, including the Bank, the Bonding Company, and any senior secured debtholders of the Partnership or any of its Subsidiaries from time to time; [emphasis added]
[60]       Further, the third parties owe no contractual duty to Martin to act promptly or reasonably.  As Martin argues, the Lenders may have a commercial interest in limiting Martin’s competition with the respondents.
[61]       The application judge correctly noted that the respondents bear the onus of establishing that the covenants are reasonable as between the parties. However, in my view he erred when he posited that the “Lenders may not have contracted for the right to consent to any transfer of the shares and... the Lenders might give their consent.”  In so doing, he shifted the onus to Martin to establish that the Lenders would not give their consent. At the time the covenant was made, who the Lenders might be at the relevant time, what consents might be required, and whether those consents would be given, was not ascertainable.  Moreover, there was no guarantee that Martin would be in a position to influence who the Lenders would be and whether they would be entitled to approve the transfer of Units.  Martin could not have proved what the application judge would seemingly have required.
[62]       Martin did agree to this provision in the context of the sale of a business and acknowledged its reasonableness in signing the Agreements. He was also represented by counsel. However, while these are important factors, they do not entirely immunize the clause from scrutiny. Safeguarding the public interest in free and open competition, in my view, requires that the court conduct a greater level of independent analysis.
[63]       While not determinative, unlike the application judge, I am also troubled by the fact that the duration is tied to the period during which Martin has an indirect interest in the Units. Unlike the usual non-competition covenant obtained in a sale transaction, the duration is not calculated from the time of the sale transaction. Nor does it run until a specified time period after Martin ceases to be an officer or director, as is common in an employment context.
[64]        Significantly, the Units are units in a limited partnership. In the Partnership Agreement, MartinCo and the other limited partners specifically covenant not to take part in the control or management of the business. Indeed, MartinCo risks losing its limited liability if it takes any part in the control or management of the business. In contrast, in a private company, shareholders can take an active role in the management of the corporation, and, pursuant to a unanimous shareholders agreement can even assume the functions of the directors. The reasonability analysis of a non-competition covenant in a limited partnership agreement is therefore different from that applicable to a non-competition covenant in a unanimous shareholders’ agreement.
[65]        The respondents argue that tying the duration of the non-compete to the ownership of the Units is reasonable because MartinCo has the right to inspect and audit the limited partnership’s books of accounts and records and registers of the business and affairs of the partnership pursuant to s. 6.1 of the Partnership Agreement. They argue that if MartinCo exercises those rights of inspection and audit, it might obtain confidential information which it could use to compete unfairly with the respondents.
[66]       Section 2.3 of each of the Agreements is a broadly drafted prohibition on the use of non-public information. The prohibition is not limited to the Prohibited Period; it continues in force for so long as the respondents carry on business. Section 2.3 protects the respondents’ proprietary information. Given this, and that divestiture of Martin’s interest in the Units does not necessarily follow when Martin ceases to be actively involved in the businesses, tying the general non-competition provision in s. 2.1 and the non-solicitation covenant in s. 2.2 to the period during which Martin has an indirect interest in the Units is in my view unreasonable.
[67]       The respondents do not appeal the application judge’s determination that if the duration of the covenants was unreasonable, ss. 2.1 and 2.2 could not be saved by either “blue pencil severance” or “notional severance”. It is therefore unnecessary for me to address this issue. Having concluded that the duration of the covenants is unreasonable, and having regard to the application judge’s determination (with which I agree) that ss. 2.1 and 2.2 cannot be saved by the doctrine of severance, ss. 2.1 and 2.2 are therefore unenforceable. This does not affect the enforceability of s. 2.3.

(6) Prohibited activities

[68]       While not determinative of this appeal, I also do not agree that the scope of the prohibited activities is reasonable.
[69]        I do not take issue with the application judge’s finding of fact that the definitions of “Concreate Business” and “SDF Business” particularize and describe business activities “that ConCreate and SDF had already staked out for themselves” or his conclusion that they are therefore reasonable. The application judge was appropriately deferential to the parties’ right to contract in coming to this conclusion.
[70]       My difficulty arises with respect to s. 2.2(a), the non-solicitation clause. That clause, which is reproduced in Appendix A, was not addressed by the application judge in his reasons.
[71]       The restrictions in s. 2.2(a) extend to communicating or dealing with any persons who were customers, dealers, agents, or distributors of SDF or Target LP, at the time of the sale transaction or afterwards. Further, the section is drafted in relation to “any products or services that compete with products or services offered by [SDF or Target LP]”, whether or not offered, or planned to be offered, by ConCreate or SDF at the time at the time of the sale transaction. Moreover, the prohibitions are not limited by reference to the “Concreate Business” or “SDF Business”. The restriction is effectively broader than the general non-competition provision and goes far beyond what was properly required to adequately protect the goodwill of the purchased business.
[72]        Section 2.2(a)’s prohibitions also extend to persons who did not start conducting business with the respondents, and products and services the respondents did not offer, until after Martin ceased to be a director of Target LP’s and  TriWest LP’s respective general partners and SDF, and after MartinCo disposed of the Units. The restrictions go beyond what is reasonable to protect the respondents’ interests.
[73]       Martin would have no basis to know if persons unassociated with the respondents at the time he ceased to have any involvement with SDF and Target LP had since commenced business relations with them. Likewise, Martin cannot be expected to know about every new product or service the respondents offer or plan to offer. This is particularly so given that the section purports to apply to businesses not included in the definitions of “Concreate Business” and “SDF Business”.  
[74]       Given the litigation between the parties, I am not convinced that a prompt response to any queries by Martin would be forthcoming. A potential, permitted customer could be lost while waiting for a response.
[75]       In Mason, a restrictive covenant in an employment contract prohibited the employee from dealing with “any business entity which was a customer of the Company during the period in which [he] was an employee of the Company”. This court held that the covenant was ambiguous in its practical implementation and overly broad, and therefore unenforceable. The employer company had world-wide operations and the covenant was not limited to the customers that the employee had dealt with. The employee did not have a list of all of the company’s customers, and he had no way of knowing whether any particular potential contact he might wish to make was a customer of the company during the 17 years that he was an employee. This court concluded, at para. 29, that it was not workable, or realistic where the parties are in ongoing litigation, for the former employee to contact his former employee and vet potential customers.
[76]       In my view, while the covenants in this case were entered into in the context of the sale of a business, the analysis in Mason is nonetheless apt. It is not reasonable for a restrictive covenant, given in the context of the sale of a business, to extend to activities neither carried on nor in the parties’ contemplation at the time of sale, while the covenantor was involved in the business post-sale, or even while the covenantor had an ownership interest in the business.


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