Jul 11, 2014

Court of Appeal for Ontario finds restrictive covenants a bit too tight

Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72 (CanLII)

Today’s decision of the Court of Appeal in Ontario in Martin v. ConCreate USL Limited Partnership, 2013 ONCA 72 (“ConCreate”) confirms that restrictive covenants in commercial agreements without a fixed term are unenforceable.

The tl;dr version: Restrictive covenants of indefinite duration and subject to consent of indeterminate third parties are unenforceable.

In ConCreate, the applicant/appellant Derek Martin worked at ConCreate USL Ltd. where he acquired a minority interest in ConCreate and Steel Designed & Fabricators (SDF) Ltd. (“SDF”), a related business, which were sold to entities controlled by TriWest Construction Limited Partnership (“TriWest LP”). Martin retained an indirect interest in ConCreate and SDL.

Martin signed agreements containing similar restrictive covenants in favour of ConCreate and SDL with a term of two years dealing with general non-competition and non-solicitation provisions. However, these restrictive covenants only terminated after Martin disposed of his indirect interest in ConCreate and SDL and were otherwiswe subject to the approval of the board of TriWest LP’s general partner and any required approvals from the third party lenders from time to time.

Perell J. dismissed Martin’s application for a declaration that the restrictive covenants in the agreements were unenforceable. Martin appealed.

Hoy J.A. (Weiler and Juriansz JJ.A. concurring) allowed the appeal.

Justice Hoy summarizes the law on restrictive covenants as follows:

[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: see Shafron 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: see Shafron, 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.

While agreeing with Perell J.’s view that the restrictive covenants were neither ambiguous nor surfeit in geographical scope, Justice Hoy parts company with the finding that the duration of the prohibited period was reasonable, stating:

[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….the duration is potentially tied to the consent of unascertainable future third parties…

[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.

Hoy J.A. further notes that Perell J. incorrectly shifted the onus on Martin to establish that the Lenders would not give their consent, which meant that “Martin could not have proved what the application judge would seemingly have required.” Furthermore,

[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.

Since the respondents did not appeal the application judge’s finding that “blue pencil severance” or “notional severance” was inappropriate, the Court of Appeal relied on its finding of indeterminacy to conclude that the restrictive covenants were unenforceable in duration. While not dispositive of the appeal, Hoy J.A. also disagreed with Perell J.’s finding that the scope of the prohibited activities was reasonable.

Finally, on the issue of the enforceability of the non-confidentiality clause, the Court of Appeal concludes:

[77] As I understand it, the crux of Martin’s argument on the confidentiality argument is that the prohibition in s. 2.3 of the Agreements on his use of “know-how” prevents him from using the wisdom he accumulated over his 20 some years with ConCreate for an unlimited period of time and is therefore unreasonable. I am not persuaded that this is the effect of s. 2.3. While “know-how” is not specifically defined in the Agreements, it is a type of the respondents’ non-public intellectual property (“all non-public intellectual property including trade secrets, unfiled patents….and know-how…). It is reasonable for the respondents to seek to protect their proprietary interests.