Supreme Court Favours Enforcing Commercial Non-Compete Covenants

Background

In the business or commercial context, restrictive covenants are most often used in buy-sell agreements and shareholder agreements.  In buy-sell agreements, they are used to restrain the seller of a business from competing with the buyer or the business.  In shareholder agreements, non-compete covenants are used to prevent the shareholder who is leaving the company from competing with it.

Parties to covenants not to compete often call on their lawyers to interpret and advise them on the enforceability of such clauses or the so-called “legality” of non-compete agreements.  The answer to this question is not always easy or straightforward given the broad, contextual, analysis that is required.

The Supreme Court’s recent decision in Payette is in line with its two earlier decisions in the past four decades relating to the enforceability of non-compete agreements in the sale of a business.  [See J.G. Collins Insurance Agencies v. Elsley, and Doerner v. Bliss & Laughlin Industries Inc.]  It is also in line with the court’s stricter approach in the enforceability of non-compete agreements in an employment context, which the court revisited several years ago.  [See Shafron v. KRG Insurance Brokers (Western) Inc.]

These Supreme Court of Canada decisions have applied consistent principles in the past four decades, balancing between the conflicting general public policy against restraints of trade and those in favour of freedom of contract.  In the commercial context, the court has used legal principles that placed a low threshold on the enforceability of non-compete clauses.  In the employment cases, the court has used significantly stricter rules on the enforceability of these clauses because of the imbalance of power in the employment relationship.

This article focuses mostly on principles involved in commercial cases.  In this context, the restrictive covenant has to be generally reasonable as between the parties but also with reference to the public order.

The Wide Latitude in Commercial Non-Compete Clauses

When trying to determine whether a particularly challenging non-compete clause would be enforceable or declared “illegal” or invalid, until Payette, there were no hard and fast rules that lawyers could use to easily assess whether a non-compete clause is reasonable between the parties and with reference to the public interest.

The basic principle underlying the analysis was laid down by the court in J.G. Collins, above, where it held that “the question of reasonableness must be considered in the context of the covenant itself, the agreement in which it is found, and all of the surrounding circumstances”.  In other words, the legal analysis is pragmatic and has to take into account the wording of the non-compete covenant, as well as the broader terms of the agreement that contains the non-compete clause, and all the surrounding circumstances.  That is a fairly broad test.

The court had developed additional guidelines to put the analysis within some framework.  In order for a non-compete clause to successfully withstand a court challenge in Canada, it generally needs to contain unambiguous terms regarding the following: (i) the geographic territory of the restriction, (ii) the period of time during which it was effective, and (iii) the extent of the activity that was prohibited.

However, in Payette, the court went further, more fundamentally shifting the balance in commercial cases away from the general public policy against restraints of trade and in favour of freedom of contract.  Writing for the court, Justice Wagner stated that in interpreting restrictive covenants in commercial cases, as opposed to employment ones, “much more flexibility and latitude is required … in order to protect freedom of trade and promote the stability of commercial agreements”.  [Para. 3]

The court in fact went on to create a presumption in favour of the enforceability of restrictive covenants in the commercial context, unless proven that the scope of the clause is otherwise unreasonable:

[58] Whether non‑competition and non‑solicitation clauses in a contract for the sale of assets are reasonable must be determined on the basis of the rules that govern freedom of trade so as to favour the application of such restrictive covenants.  [Citations omitted] This means that the criteria for analyzing restrictive covenants in a contract for the sale of assets will be less demanding and that the basis for finding such covenants to be reasonable will be much broader in the commercial context than in the context of a contract of employment.  I am therefore of the opinion that, in the commercial context, a restrictive covenant is lawful unless it can be established on a balance of probabilities that its scope is unreasonable.

The factors that may be taken into account in this analysis relate to the circumstances of entering into the contract.  Each case, the court held, must be individually considered given its own unique circumstances.  Factors that may be considered include the sale price, nature of the business activities, the parties’ experience and expertise, access to professional advice, and even the parties’ negotiations and the resources they had at the time.  For example, in the particulars circumstances of the case in Payette, the business was highly specializing and mobile.  This supported both a longer restrictive period and a larger restrictive area.

Other Issues and Applications

The Payette decision also stressed that the signing of an employment agreement in the context of the sale of a business, where the buyer of the business continues to employ the seller’s principal, does not give rise to the much stricter employment test.  Simply because the seller’s principal continues employment with the buyer after the sale of the business does not change the more relaxed analysis used in the commercial context that favours enforcing the terms of the contract.  The decisive factor is whether the non-compete covenant is made in the context of the sale of a business, or an unrelated contract of employment where there is an imbalance of power in the employer-employee relationship.

With respect to non-solicitation restrictive covenants, the court in Payette held that these clauses, which often accompany non-compete covenants, are not subject to the same territorial restrictions as do non-compete covenants.  The court held that territorial restrictions in non-solicitation clauses have generally become obsolete in the modern economy, given new technologies and since customers are not limited geographically, and are therefore not necessary elements in order to be enforceable.

In franchise agreements, non-compete covenants are used to restrain a franchisee from competing with the franchise system after the termination of the franchise relationship.   The clear principles and analysis set out in Payette and the other Supreme Court cases may not easily fit the context of a franchise relationship, given the legal characteristics of a franchise agreement and a franchise relationship, as the courts have defined it over the years.  Where restrictive covenants in the franchise context fall within the spectrum between commercial arrangements on the one hand and employment relationships on the other have not been fully explored in Canadian appellate decisions.  The factors that the Supreme Court discussed in Payette may shed light on the analysis.  Future articles in the Franchise Justice Blog will explore this issue.

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