Introduction
A restrictive covenant is a provision in a contract to restrict,
limit or prevent certain actions by one or more parties to that
contract. Also referred to as a “negative” covenant,
restrictive covenants serve to mitigate risk and conflicts (real or
perceived) by placing constraints on the conduct of one or all of
the contractual parties (as opposed to a “positive”
covenant, which is a provision pursuant to which a party agrees to
perform a certain action).
In our experience, mergers and acquisitions
(“M&A“) practice around restrictive
covenants, particularly around the inclusion of blue-pencil
provisions, is an area where Canadian M&A transactions and U.S.
and international M&A transactions notably differ.1
Accordingly, this article may be of particular interest to aid U.S.
and international purchasers and their advisers in how restrictive
covenants in the Canadian M&A context may differ from their own
M&A practices.
This article also provides an overview to U.S. and international
purchasers and their advisers of Canadian restrictive covenants in
the Canadian employment law context. The focus of this article is
the treatment of restrictive covenants under the laws of the
Province of Ontario. There are differences between the treatment of
restrictive covenants under the laws of the other provinces of
Canada, though the principles are generally applicable.
Restrictive covenants take numerous forms and are incorporated
into contracts for various purposes. In M&A and employment law
contexts, two prevalent forms of restrictive covenants are
non-competition and non-solicitation clauses,2 with such
clauses frequently integrated into agreements to safeguard the
economic interests of the non-restricted party.
In this article, we describe what non-competition and
non-solicitation provisions are, provide an overview of the nuances
between such restrictions in these two separate contexts, and
discuss “reasonableness” and drafting guidance, as
dependent on the context of the restrictive covenant.
Non-Competition and Non-Solicitation Clauses – What Are
They?
Non-competition clauses restrict an individual or entity’s
ability to engage in certain competitive activities, typically
after the termination of their employment or upon the completion of
the sale of a business. For example, a party may be restricted from
engaging in a similar profession or trade within a specific
geographic area for a certain amount of time, and/or may be
restricted from investing in a certain percentage of a competing
enterprise.
Non-solicitation clauses restrict, during a defined period of
time, certain individuals or entities from soliciting or inducing
persons, including, for example, clients, customers, vendors,
employees or independent contractors that have some contractually
defined affiliation with the party imposing the restrictions. For
example, subject to certain exceptions, such as for non-targeted
general solicitations, this could include restrictions on actively
enticing clients away from a business, soliciting employees or
independent contractors, or persuading vendors, customers or
suppliers to sever their ties with the party protected by the
clause.
Generally, in M&A agreements, non-competition and
non-solicitation clauses protect the purchaser. Having made a
substantial investment in the business on the basis that part of
what is being acquired is the “goodwill” of the business,
Ontario courts recognize that, for a specified time, the purchaser
should be free to establish relationships with the business’
existing customers without being concerned the vendor may establish
or otherwise work in a competing business. On the other hand, in
employment agreements, these covenants, in tandem with
confidentiality and intellectual property protections, protect the
employer’s interests. As detailed below, the enforceability and
treatment of these clauses (and non-competition clauses in
particular) differs greatly in the context of M&A transactions
versus employment relationships.
Non-Competition and Non-Solicitation Clauses – M&A
Context
Courts typically afford deference to restrictive covenants when
scrutinizing them within the context of M&A
transactions.3 Courts generally consider parties engaged
in such transactions to possess equal bargaining power, expertise
and access to resources, with the parties themselves recognized as
best positioned to determine what is reasonable for the purposes of
the restrictive covenants. Moreover, such transactions often
involve an explicit or inherent payment to the vendor for goodwill.
Sales of goodwill impose certain obligations on the vendor.
Notably, in the context of M&As, the Supreme Court of Canada
(“Supreme Court“) has recognized that
the sale of goodwill can only be protected by restrictive
covenants.4 In Elsey, the Supreme Court
observed that a business could be considered an “unsaleable
commodity” if a purchaser is unable to bar the vendor from
competing.5 Similarly, in Shafron, the Supreme
Court referenced an 1894 House of Lords case which held that the
restrictive covenant “must be taken as entered into in
connection with” the protection of the sale of
goodwill.6
What Makes a Restrictive Covenant
“Reasonable”?
Courts will enforce restrictive covenants in M&A
transactions, so long as they are “reasonable.” This
reasonableness standard has been reaffirmed in recent case law to
be “no more than adequate for its intended purpose”
– a relatively low bar to meet.7 Courts have
emphasized that they should intervene only in extraordinary cases
where parties with equal bargaining power have made unreasonable
judgments. Various factors, including but not limited to the sale
price, nature of business activities and the parties’
experience, can play a role in determining what is considered
“reasonable” in the specific circumstances of a given
transaction.
Drafting Guidance
Given the favourable judicial interpretation of reasonableness
in the context of M&A transactions, restrictive covenants can
be drafted to be relatively broad. However, when drafting such
covenants, parties should still be mindful of the following three
factors: (1) the breadth of activity that is restricted; (2) the
breadth of the geographical area of the restriction; and (3) the
length of time where the applicable activity is prohibited. These
factors should be clearly defined and justifiable in relation to
the context of the transaction. For example, an acquisition of
several dental clinics containing a non-compete agreement that
prohibited the vendor from practising at any dental clinic within a
10-kilometre radius of the clinics he had sold was held to be
enforceable and reasonable.8 While there was no
challenge to the breadth of restricted activity or the 10-kilometre
radius, the court held that a five- to six-year time limit for this
prohibition was a reasonable length of time for the buyers to take
advantage of the restrictive covenant. Generally speaking, time
frames of three to five years are common for restrictive covenants,
depending on the size and nature of the transaction, including the
degree of competitiveness in the target’s industry and
market.
Despite the general enforceability of broad restrictive
covenants, the reasonableness of restrictive covenants in M&A
transactions can still be unenforceable in Canadian courts. In
2021, the Supreme Court denied leave to appeal a decision by the Alberta Court of Appeal to
apply the doctrine of notional (or “blue-pencil”)
severance (the judicial doctrine of reading down a covenant by, for
example, decreasing the geographic scope or time limit in order to
render it reasonable and enforceable). While this leave to appeal
opened the doors for other Canadian courts to adopt similar
reasoning to permit blue-penciling, there has been no case law in
Ontario since 2021 that addresses this matter. Where restrictive
covenants are determined to be unreasonable, the court will find
the entirety of the restrictive covenant unenforceable.9
It remains to be seen whether courts in other provinces and
territories outside of Alberta will blue pencil a restrictive
covenant that may be challenged by a party to an M&A
transaction. Accordingly, generally speaking, our recommendation is
to draft restrictive covenants in these contexts to be no more
broad than necessary, avoiding the inclusion of a blue-pencil
provision.10
Non-Competition and Non-Solicitation Clauses – Employment
Context
The Supreme Court has long recognized a power imbalance between
employers and employees.11 As such, restrictive
covenants and, in particular, non-competition provisions have long
been scrutinized by Canadian courts for interfering with individual
liberty and restraining the ability for individuals to earn a
living based on their skills, ruling them as presumptively
non-enforceable.12
What Makes a Restrictive Covenant
“Reasonable”?
In employment contracts, restrictive covenants not prohibited by
the ESA amendments will be held to a much higher standard of
reasonableness than in the M&A context. In employment
relationships, if a restrictive covenant is challenged, the
employer will be required to demonstrate that the clause is
justified and sufficiently narrow for the legitimate protection of
their business interests. This is particularly the case where an
employer will have to demonstrate that non-solicitation provisions,
intellectual property and confidentiality protections, as well as
non-disclosure agreements, which remain broadly permissible and do
not attract nearly the same level of scrutiny, are insufficient to
protect legitimate business interests. Nonetheless, as with any
restrictive covenant, the courts will assess whether the
non-solicit provision is necessary to protect the legitimate
business interests of the parties. Employers should also take note
of separate and important Competition Act restrictions on
entering into agreements with each other not to solicit or
hire each other’s employees, per our prior guidance.
Drafting Guidance
Where non-compete clauses are permitted in the employment
context,13 we recommend using the narrowest and most
specific language possible to capture the breadth of the
geographical area of the restriction, the length of time, the
breadth of activity that is restricted and a detailed description
of the business. Any ambiguity in a covenant is likely to render it
unreasonable and unenforceable. For example, in a 2021 case heard
by the Ontario Superior Court of Justice, a non-compete clause
prohibited a financial advisor from engaging in almost any work
involved in the securities industry across Ontario for two years
after he left his position. The court found this breadth of
activity to be unreasonably broad as it prohibited the financial
advisor from earning a living anywhere in Ontario.14
Generally speaking, it is rare to see a non-compete clause
exceeding six months in the employment context enforced by a court,
subject to rare exceptions with corresponding lengthy periods of
severance (despite this being an equitable concept, and not being
part of any legal test to establish “reasonableness”).
Like in the M&A context, geographical limits and descriptions
of business activities will be context-specific but need to be
demonstrably justifiable in respect of a company’s actual and
legitimate business interests, and corresponding necessarily
protections. References to “global” or even continental
restrictions are, in most cases, considered too broad by Canadian
courts.
Employers should be precise when formulating restrictive
covenants in employment contracts and when updating existing
employment agreements that pre-date the ESA amendments.
Conclusion
While restrictive covenants serve to safeguard economic
interests in both M&A transactions and employment
relationships, their treatment varies significantly across the two
contexts. The nuances must be understood to ensure such covenants
are both enforceable and reasonable in each specific situation.
One additional and natural question that readers may ask
themselves is: What happens in the context of an M&A
transaction by virtue of which some or all of the seller parties
become employees of the purchaser and thereby have restrictive
covenants both under the purchase agreement (or an ancillary
restrictive covenant agreement) and an employment
agreement with its own restrictive covenants? In practice, it is
entirely possible that the covenants arising from the transaction
may run their course while the seller parties remain employed,
leaving the purchaser/employer wanting the protections associated
with a termination of employment at a later date. Most often, the
“longer of” concept will come into play, meaning that the
longer of the two periods will prevail. Drafters are wise to
address the duality or “longer of” concept in writing,
such that the purchase agreement (or related restrictive covenant
agreement) and employment agreement and its covenants do not, on
their face, conflict with each other or create ambiguity
post-closing since, as outlined above, post-closing ambiguity will
be resolved in favour of the party that is seeking to undertake
certain activities rather than the party seeking to restrict those
activities.
Footnotes
1. Please see our article, Important Canadian Legal Considerations and Market
Practices for U.S. and International Purchasers in Cross-Border
Private M&A Transactions (airdberlis.com), for additional
differences between Canadian M&A transactions and non-Canadian
M&A transactions.
2. Other types of restrictive covenants include
non-disparagement and non-hire covenants, which have been omitted
from this article for the sake of brevity.
3. For example, in UAP Inc. v. Yako, 2021 ONSC 5065 at
para 31, the Ontario Superior Court of Justice implied that
deference is afforded to contracting parties in such situations
when it held that a party who imposed the restrictive covenant for
its own benefit “must live by its terms.” In Dentalcorp Health Services v. Poorsina,
2023 ONSC 3531 [DentalCorp], the same court provided
that only in exceptional cases should the court overrule the
judgment of parties regarding restrictive covenants where the
parties entered into a business agreement, were advised by counsel,
and had equal bargaining power.
4. See Shafron v. KRG Insurance Brokers (Western) Inc.,
2009 SCC 6 [Shafron] and Elsey v. J.G. Collins Ins. Agencies,
[1978] 2 SCR 916 [Elsey].
5. Elsey, supra note 4 at para
15.
6. Shafron, supra note 4 at para 21;
Nordenfelt v. Maxim Nordenfelt Guns and Ammunition Co.
Ltd., [1894] A.C. 535 at page 555.
7. See Tank Lining Corp. v. Dunlop Industrial Ltd., 1982
CarswellOnt 780, and DentalCorp, supra note 3 at para
23.
8. See DentalCorp, supra note
3.
9. See Martin v. ConCreate USL Limited
Partnership, 2012 ONSC 1840 at para 25.
10. While in M&A agreements, we typically would
include a severability provision which provides that if any
provision of the agreement is held invalid by a court decision,
statute or rule, or shall be otherwise rendered invalid, the
remainder of the agreement will remain unaffected, we typically do
not include blue-pencil provisions in such agreements.
11. See Shafron, supra note 4 at para
23.
12. As reported in a previous newsletter, Bill 27, the Working
for Workers Act, 2021, amended the Employment Standards
Act, 2000 (the “ESA“) to
prohibit employers in Ontario from including non-competition
clauses that restrict competition following termination of
employment in employment contracts, or any other type of agreement.
Non-competition agreements entered into before October 25, 2021,
are not automatically void under the ESA amendments; however, they
will still be heavily scrutinized using a similar three-part test
to assess their “reasonableness” as articulated above.
The ESA now articulates two exceptions to the strict
non-permittance of non-competition provisions. In recognition of
the unique M&A context summarized above, one exception applies
in the context of a sale of a business where, if immediately
following the sale, the vendor becomes the purchaser’s
employee, and as part of the sale, the purchaser and vendor enter
into a non-compete agreement, it will not be automatically void by
the ESA. The second exception applies when an employee holds an
executive position such as chief executive officer, president,
chief financial officer, or any other chief executive role. It
should be noted that even for such senior roles, the provision will
still be tested for “reasonableness.”
13. As previously advised, the Government of Ontario’s guide to the ESA provides further
clarification on Bill 27’s prohibition of non-compete clauses
and agreements: any agreement may be considered a non-competition
agreement, regardless of whether or not it contains a time-limit or
geographic restriction. Further, other than relationships exempt
from the ESA amendments as noted above, parties are prohibited from
entering into non-compete clauses or agreements at any time
(before, during and after the employment relationship ends), which
should not to be confused with the ability to require
non-competition by an employee while they are actively
employed.
14. See Mandeville Holdings Inc. v. Santucci,
2021 ONSC 4321.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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