Upon leaving your company, a former contractor or employee might choose to compete with you; gaining an advantage through exploiting their knowledge of your company’s trade secrets or confidential information (such as client lists, marketing plans or new product designs or concepts. You can protect yourself from this threat through using restrictive covenants such as non-compete and non-solicitation agreements. These agreements restrict the party from engaging in competition with a company within a specified location, for a specified period after their departure.
Restrictive covenants require careful crafting as they are often scrutinized to prevent unfair restrictions on the ability for individuals to work in their field of expertise. The test most often applied for determining whether a restrictive covenant should be voided within a contract, is reasonableness, as determined by the following four factors:
- Geographical Coverage - refers to the area in which competition is restricted by the covenant, and, from our survey of the law, the geographical limit should be justified and not arbitrary - as a way to think about this, the clause must only be as restrictive as necessary to protect an identifiable legitimate interest that cannot be protected by a non-solicitation clause - which, anecdotally, might be a restriction against taking an executive role or investing or starting another business with the business plan in hand from the company that you were working for (if the potential damage caused by competing can be calculated, that process of calculating is useful in thinking about whether the extent of the geographical coverage and other restrictions are truly reasonable);
- Temporal Length - the time period during which competition is prohibited should also be justified and not arbitrary (same thinking as above).
- Extent of Prohibition - refers to the set of acts deemed competition and thus disallowed - for example, the nature of the business that is being protected should be one that was contemplated by the parties to be protected, and not imprecise or overbroad (for example, “anything concerned with/associated with/related to the fashion industry” would be overbroad by a mile as a restriction placed on a fashion business sales representative or shareholder); and
- Clarity of the Terms (Non-Ambiguity) - refers to whether the former three factors are understood, carefully considered or completely missed in conversations with the restricted party (employees who are handed a pile of standard form contracts could easily miss these restrictions, so a requirement or payment by the employer of the employee’s independent legal advice is one way to ensure they have had a chance to read these materials - and that they have carefully considered the restrictions).
In contrast with agreements that are made with employees or contractors, non-competition agreements in the context of a shareholders’ agreement are afforded greater leniency for reasons including that (1) the commercial counterparties, especially when represented by a lawyer, are expected to have read the agreement and made decisions on each clause carefully and thoughtfully, and (2) shareholders presumably have a greater potential benefit from the business success is greater than an employee or contractor, and therefore the potential power imbalance between the parties is reduced. However, this next case will show that even in the shareholder-company context, non-compete agreements may be void if they are found unreasonable.
Case Study: Martin v. ConCreate USL Partnership (ONCA, 2013)
In this case, Derek Martin acquired a minority interest in ConCreate, and subsequently signed a non-compete and non-solicit agreement with the limited partnership. The language of the non-compete and non-solicit agreements stated that the restrictive covenants would run for a period ending twenty-four months after his disposition of his direct or indirect ownership interest in the company Six months after he was relieved of his minority interest, Martin started a business allegedly competing with ConCreate. ConCreate sued for breach of the non-compete agreement, and Martin asked the court to declare the non-compete void.
The Non-Compete and Non-Solicit Agreement
The non-compete agreement restricted Martin from using any non-public information concerning ConCreate at the time of sale or afterwards, with respect to any products or services that competed with products or services of ConCreate, whether or not offered or planned to be offered by ConCreate at the time of the sale. The non-solicit agreement restricted Martin from soliciting employees, customers, dealers, agents or distributors of ConCreate and from using any non-public information concerning the limited partnership.
The parties to the agreement: Derek Martin, an “accomplished and successful businessman”; and ConCreate, the limited partnership, were likely at equal footing in negotiating the sale of a minority interest in ConCreate and the related non-compete clause. The non-competition agreement spanned all of Canada. It was effective throughout the time Martin held the minority interest and 24 months thereafter. Martin required the consent of ConCreate and their related lenders and bonding companies, whoever they may be “from time to time” to sell the shares or put them back to ConCreate.
Equal footing sometimes is found to be the case where the parties have consulted with independent legal advice. Within the agreement were provisions for which Martin expressly agreed that the restrictions were reasonable, that he received independent legal advice, and that he had negotiated the terms on equal footing.
What was found to be reasonable in this restrictive covenant?
The agreement was reached between two parties, each with independent legal advice and bargaining power. This, along with the provisions in which Martin had agreed to, strengthened the reasonableness of the restrictive covenants.
Moreover, the geographical reach of the non-compete agreement was found to be reasonable despite ConCreate only operating in small areas sporadically across the provinces, because the parties envisioned that the scope of the business would be national at the time of contract formation.
What was found to be UNREASONABLE in this restrictive covenant?
The consents Martin had to obtain to release himself of the minority interest were found to be the glaring unreasonable features of the agreement. Firstly, the people from whom Martin required consents (required from ConCreate and their related lenders and bonding companies in order to divest himself of minority interest) were unascertainable as they changed “from time to time”. Secondly, their consents could have been withheld arbitrarily and indefinitely. It was not just that Martin had to acquire consent from a third party, but that there was no guarantee that such consent would be forthcoming, especially since these third parties owed no duty to Martin, and, in fact, had a commercial interest in withholding their consent.
For the requirement of consent to be valid, it has to be proven that the consenting party will not be influenced by any outside factors. For example, in this particular case, the consenting third party did not want to relieve Martin from his minority interest, as the restrictive obligations set out under the non-compete and non-solicitation agreements could continue to stay in effect as long as Martin had minority interest in ConCreate. It is not unusual practice to require your employees to sign restrictive covenants, but the date of expiry should not be dependent on the date the company gives its consent.
It is recommended to have the restrictive covenants expire at a specific period of time from the date of termination. If the employee has a minority interest in the company, include share buyback language that would automatically have the employee sell back any interest in the company at the time of termination to prevent any loose ends. Martin could have effectively been subjected to the non-compete and non solicit forever, and it was within ConCreate’s interest to do so. This feature was the main reason the non-compete and non-solicit were void.
The temporal length was also found to be unreasonable. It is industry practice that the non-compete time period starts once the sale of the interest begins as the party no longer has a direct interest in the company. In this case, the time period only began after the sale had been completed. Subjecting Martin to the non compete and non-solicit agreement while he only had an indirect interest in the company was unreasonable.
Lastly, the extent of prohibition was found to be unreasonable. Restricting Martin from using anything with respect to any products or services that competed with products or services of ConCreate, whether or not offered or planned to be offered by ConCreate went far beyond what was required to protect the goodwill of the company. In Martin v. ConCreate, the Canada-wide geographical restriction was reasonable despite the company only operating in sparse areas across the country because the parties envisioned that the company would become a Canada-wide operation at the time they formed the contract.
- If you are considering placing non-compete or non-solicit clauses in your shareholder’s agreements to protect your business’ goodwill, Martin v. ConCreate demonstrates that these clauses must be carefully drafted to ensure they are reasonable and thus enforceable.
- Clauses that overly restrict the party with respect to undetermined business activities, or the time and location where the party can compete with your company time can be void even though the strict scrutiny found in the employment context may not apply. Non-compete and non-solicit clauses must be drafted such that there is an unambiguous beginning and end to the time period during which the restrictions are active.
- A clause that potentiates infinite subjugation to a restrictive covenant (for example by making it impossible to obtain consent to be released) makes the covenant void.
- Likewise, a set of prohibitions too broad may void the clause for public policy reasons (such as the unreasonable restraint of trade).
- Restrictions should be limited to only those necessary to protect the goodwill of the company
- Both the corporation and shareholder should seek legal advice prior to entering non-compete or non-solicitation agreements. The express acknowledgement of the reasonableness of the clauses, equivalent negotiation power and legal advice can fortify your clause against voidance. Nevertheless, this does not immunize the clause from being found void by the Court as demonstrated by this case.
Written by: Shawn Lallman
Edited by: Rajah Lehal