Simon's Megalomaniacal Legal Resources

Contracts - Restraint of Trade

MEDIchair LP v. DME Medequip Inc.

In MEDIchair LP v. DME Medequip Inc. (Ont CA, 2016) the Court of Appeal canvasses the principles applicable to determining whether the court will uphold contractual terms that are in restraint of trade:

[33] The basic principles governing the courts’ approach to the enforceability of covenants in restraint of trade have been set out clearly in two cases from the Supreme Court of Canada, Elsley v. J.G. Collins Ins. Agencies, 1978 CanLII 7 (SCC), [1978] 2 S.C.R. 916, and most recently, Payette v. Guay, 2013 SCC 45 (CanLII), [2013] 3 S.C.R. 95. Both cases also address the difference in approach when the clause is contained in a contract for the sale of a business versus an employment contract. Although the test is essentially the same, courts will give more scrutiny to the reasonableness of a restrictive covenant in the employment context, while applying a presumption of validity to such clauses where they have been negotiated as part of the sale of a business.

[34] The test was described by Dickson J. (as he then was) as follows in the Elsley case, at pp. 923-4:

The principles to be applied in considering restrictive covenants of employment are well‑established. They are found in the cases above-mentioned and in such familiar authorities as the Nordenfelt case, Mason v. Provident Clothing and Supply Co. and Attwood v. Lamont. Of more recent vintage: Scorer v. Seymour-John and Gledhow Autoparts Ltd. v. Delaney. A covenant in restraint of trade is enforceable only if it is reasonable between the parties and with reference to the public interest. As in many of the cases which come before the courts, competing demands must be weighed. There is an important public interest in discouraging restraints on trade, and maintaining free and open competition unencumbered by the fetters of restrictive covenants. On the other hand, the courts have been disinclined to restrict the right to contract, particularly when that right has been exercised by knowledgeable persons of equal bargaining power. In assessing the opposing interests the word one finds repeated throughout the cases is the word “reasonable.” The test of reasonableness can be applied, however, only in the peculiar circumstances of the particular case. Circumstances are of infinite variety. Other cases may help in enunciating broad general principles but are otherwise of little assistance.

It is important, I think, to resist the inclination to lift a restrictive covenant out of an employment agreement and examine it in a disembodied manner, as if it were some strange scientific specimen under microscopic scrutiny. The validity, or otherwise, of a restrictive covenant can be determined only upon an overall assessment, of the clause, the agreement within which it is found, and all of the surrounding circumstances.

The distinction made in the cases between a restrictive covenant contained in an agreement for the sale of a business and one contained in a contract of employment is well-conceived and responsive to practical considerations. A person seeking to sell his business might find himself with an unsaleable commodity if denied the right to assure the purchaser that he, the vendor, would not later enter into competition. Difficulty lies in definition of the time during which, and the area within which, the non-competitive covenant is to operate, but if these are reasonable, the courts will normally give effect to the covenant.

A different situation, at least in theory, obtains in the negotiation of a contract of employment where an imbalance of bargaining power may lead to oppression and a denial of the right of the employee to exploit, following termination of employment, in the public interest and in his own interest, knowledge and skills obtained during employment. Again, a distinction is made. Although blanket restraints on freedom to compete are generally held unenforceable, the courts have recognized and afforded reasonable protection to trade secrets, confidential information, and trade connections of the employer. [Footnotes omitted.]

[35] In Payette, at para. 58, Wagner J. concluded that in the commercial context – i.e. the sale of a business – the courts will treat a restrictive covenant as lawful unless it is shown on a balance of probabilities to be unreasonable.

[36] Whether a restrictive covenant in a franchise agreement should be viewed and treated as it is in a contract of employment because of an imbalance in bargaining power, or as it is in the sale of a business is the subject of recent ongoing debate. See Peter J. Klarfeld & Mark S. VanderBroek, “Law on Covenants Against Competition Shifts Toward Greater Enforceability by Franchisors” (Fall 2011) Franchise LJ 76; and Jennifer Dolman, Adam Ship, Rebecca Hall-McGuire & Tyler Wentzell, “Governing Principles & Recent Trends in the Enforcement of Restrictive Covenants in Franchise Agreements” (2014) Advocates’ Q 448.

[37] Although this case involves a restrictive covenant in a franchise agreement, I do not need to decide what level of scrutiny properly applies, because the focus of the inquiry is not the reasonableness of the extent of the temporal or territorial restrictions. Instead, it is whether there is a legitimate interest of the franchisor in this case that is entitled to the protection of the covenant. The requirement of a legitimate protectable interest is common to both levels of scrutiny.

[38] As Wagner J. explained in Payette, the test for reasonableness is whether the clause is “limited, as to its term and to the territory and activities to which it applies, to whatever is necessary for the protection of the legitimate interests of the party in whose favour it was granted”: para. 61 (citation omitted; emphasis added). See also Tank Lining Corp. v. Dunlop Industrial Ltd. (1982), 1982 CanLII 2023 (ON CA), 40 O.R. (2d) 219 (C.A.), at p. 224: “In all the cases the entitlement of a party to a contract to enforce a restrictive covenant is based in the protection of a legitimate or proprietary interest such as the goodwill of a business which has been purchased or the confidential information peculiar to employment.”

. Shafron v. KRG Insurance Brokers (Western) Inc.

In Shafron v. KRG Insurance Brokers (Western) Inc. (SCC, 2009) the Supreme Court of Canada set out the parameters for an acceptable non-competition agreement:

A. Reconciling Freedom of Contract and Public Policy Considerations Against Restraint of Trade

[15] A restrictive covenant in a contract is what the common law refers to as a restraint of trade. Restrictive covenants are frequently found in agreements for the purchase and sale of a business and in employment contracts. A restrictive covenant precludes the vendor in the sale of a business from competing with the purchaser and, in an employment contract, the restrictive covenant precludes the employee, upon leaving employment, from competing with the former employer.

[16] Restrictive covenants give rise to a tension in the common law between the concept of freedom to contract and public policy considerations against restraint of trade. In the seminal decision of the House of Lords in Nordenfelt v. Maxim Nordenfelt Guns and Ammunition Co., [1894] A.C. 535, this tension was explained. At common law, restraints of trade are contrary to public policy because they interfere with individual liberty of action and because the exercise of trade should be encouraged and should be free. Lord Macnaghten stated, at p. 565:

The public have an interest in every person’s carrying on his trade freely: so has the individual. All interference with individual liberty of action in trading, and all restraints of trade of themselves, if there is nothing more, are contrary to public policy, and therefore void. That is the general rule.

[17] However, recognition of the freedom of the parties to contract requires that there be exceptions to the general rule against restraints of trade. The exception is where the restraint of trade is found to be reasonable. At p. 565, Lord Macnaghten continued:

But there are exceptions: restraints of trade and interference with individual liberty of action may be justified by the special circumstances of a particular case. It is a sufficient justification, and indeed it is the only justification, if the restriction is reasonable — reasonable, that is, in reference to the interests of the parties concerned and reasonable in reference to the interests of the public, so framed and so guarded as to afford adequate protection to the party in whose favour it is imposed, while at the same time it is in no way injurious to the public. That, I think, is the fair result of all the authorities. [Emphasis added.]

Therefore, despite the presumption that restrictive covenants are prima facie unenforceable, a reasonable restrictive covenant will be upheld.

[18] It is important at this juncture to differentiate between a contract for the sale of a business and an employment contract.

[19] In Nordenfelt, Lord Macnaghten pointed out that there is greater freedom to contract between buyer and seller than between employer and employee. At p. 566, he wrote:

To a certain extent, different considerations must apply in cases of apprenticeship and cases of that sort, on the one hand, and cases of the sale of a business or dissolution of partnership on the other. A man is bound an apprentice because he wishes to learn a trade and to practise it. A man may sell because he is getting too old for the strain and worry of business, or because he wishes for some other reason to retire from business altogether. Then there is obviously more freedom of contract between buyer and seller than between master and servant or between an employer and a person seeking employment. [Emphasis added.]

Although the comments of Lord Macnaghten focus on apprenticeship, the same concept has been extended and applied to contracts between employers and employees.

[20] In the House of Lords’ decision of Herbert Morris, Ltd. v. Saxelby, [1916] 1 A.C. 688, Lord Atkinson made some observations on the difference between contracts of employment and those for sale of a business. He cited with approval Leather Cloth Co. v. Lorsont (1869), L.R. 9 Eq. 345, at p. 354, quoting James V.‑C. in that case:

The principle is this: Public policy requires that every man shall be at liberty to work for himself, and shall not be at liberty to deprive himself or the State of his labour, skill, or talent, by any contract that he enters into. On the other hand, public policy requires that when a man has by skill or by any other means obtained something which he wants to sell, he should be at liberty to sell it in the most advantageous way in the market; and in order to enable him to sell it advantageously in the market it is necessary that he should be able to preclude himself from entering into competition with the purchaser.

Lord Atkinson then stated that “[t]hese considerations in themselves differentiate, in my opinion, the case of the sale of goodwill from the case of master and servant or employer and employee” (p. 701).

[21] The sale of a business often involves a payment to the vendor for goodwill. In consideration of the goodwill payment, the custom of the business being sold is intended to remain and reside with the purchaser. As Lord Ashbourne observed at p. 555 of Nordenfelt:

I think it is quite clear that the covenant must be taken as entered into in connection with the sale of the goodwill of the appellant’s business, and that it was entered into with the plain and bona fide object of protecting that business.

And as stated by Dickson J. (as he then was) in Elsley v. J. G. Collins Insurance Agencies Ltd., 1978 CanLII 7 (SCC), [1978] 2 S.C.R. 916, at p. 924:

A person seeking to sell his business might find himself with an unsaleable commodity if denied the right to assure the purchaser that he, the vendor, would not later enter into competition.

See also Burgess v. Industrial Frictions & Supply Co. (1987), 1987 CanLII 2722 (BC CA), 12 B.C.L.R. (2d) 85 (C.A.), per McLachlin J.A. (as she then was), at p. 95.

[22] The same considerations will not apply in the employer/employee context. No doubt an employee may build up a relationship with customers of the employer, but there is normally no payment for goodwill upon the employee leaving the employment of the employer. It is also accepted that there is generally an imbalance in power between employee and employer. For example, an employee may be at an economic disadvantage when litigating the reasonableness of a restrictive covenant because the employer may have access to greater resources (see, for example, Elsley, at p. 924, and Mason v. Provident Clothing and Supply Co., [1913] A.C. 724 (H.L.), per Lord Moulton, at p. 745, quoted below at para. 33).

[23] The absence of payment for goodwill as well as the generally accepted imbalance in power between employee and employer justifies more rigorous scrutiny of restrictive covenants in employment contracts compared to those in contracts for the sale of a business.

[24] An initial question in the present case is whether the restrictive covenant at issue is properly characterized as being contained in an employment contract or a contract for the sale of a business. The December 31, 1987 agreement covering the sale of Shafron’s business did not contain a restrictive covenant. However, the agreement he entered into in early 1988 did. Whether the restrictive covenant in the 1988 agreement should be construed as being in relation to the sale of the business and the $700,000 goodwill payment is not the issue before the Court.

[25] After Shafron sold his business, KRG Western was sold again in 1991 to Intercity. Shafron received no payment on account of goodwill when the shares of KRG Western were sold to Intercity. The contract in which the restrictive covenant at issue in this case was contained was entered into in 1998, some 11 years after Shafron sold his business and after it was sold a second time. The 1998 employment contract was entirely independent of the 1987 sale agreement and 1988 agreement. The fact that the restrictive covenant in the 1998 employment contract originated in the 1988 agreement has no bearing on the interpretation of the 1998 employment contract. The 1998 agreement is an employment contract and, as found by the trial judge, the reasonableness of the restrictive covenant must stand up to the more rigorous test applicable to employment contracts.

B. Determining Reasonableness

[26] As a general rule, according to Dickson J. in Elsley, at p. 925, the geographic coverage of the covenant and the period of time in which it is effective have been used to determine whether a restrictive covenant is reasonable. The extent of the activity sought to be prohibited is also relevant.

[27] However, for a determination of reasonableness to be made, the terms of the restrictive covenant must be unambiguous. The reasonableness of a covenant cannot be determined without first establishing the meaning of the covenant. The onus is on the party seeking to enforce the restrictive covenant to show the reasonableness of its terms. An ambiguous restrictive covenant will be prima facie unenforceable because the party seeking enforcement will be unable to demonstrate reasonableness in the face of an ambiguity. As stated at the outset, the main difficulty that arises in this case is the ambiguity of the geographical restriction contained in the covenant. However, before turning to the case at hand, I will discuss the doctrine of severance as it applies to restrictive covenants in employment contracts.

[28] As we see in this case, the limits on geographic scope often give rise to questions of severance. Can a restrictive covenant that is unreasonably wide in its geographic scope be severed in some manner so as to leave in place what the court regards as reasonable?