Adding Certainty in an Uncertain World: Canadian Court Deference to ‘Reasonable’ Non-Competes in M&A Transactions

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Introduction

A restrictive covenant allows for parties to a contract to restrict, limit or prevent certain future actions of one or more parties to that contract.^[1] One of the most common restrictive covenants is a non-competition covenant. Non-competition covenants are typically used by purchasers to prohibit sellers, in a mergers and acquisition (“M&A”) context, or a former employee or contractor, in an employment context, from competing with the sold business or former employer for a particular period of time within a particular geographic scope.

As we’ve previously noted, M&A practice around restrictive covenants, particularly the requirement for “reasonable” time and geographic scope in non-competition covenants, notably differs between Canadian M&A transactions and those in the U.S. and other international contexts. This reasonableness requirement, along with the lack of inclusion of blue-pencil provisions in non-competition covenants, has complicated the drafting and enforcement of restrictive covenants in the Canadian M&A context.

In a recent decision by the Ontario Court of Appeal (“ONCA” or the “Court”), which focused on the enforceability of a non-competition clause, the Court distinguished between the enforceability of restrictive covenants in M&A and an employment context, finding that restrictive covenants in an M&A context are enforceable unless proven unreasonable.

Enforceability of Restrictive Covenants in M&A

Dr. C. Sims Dentistry Professional Corporation v. Cooke (“Sims”) concerned the sale of a dental practice located in Hamilton, Ont., by way of a share sale for a purchase price of $1.1 million in July 2017. The parties to the sale ended up in a dispute over the enforceability of a non-competition clause which was intended to prohibit Dr. Cooke (the “Seller”) from engaging in the practice of dentistry, or permitting his name to be used to do so, within a 15-kilometre radius for five years following his association with the practice he sold to Dr. Sims (the “Purchaser”). One of the conditions of the sale in question had been that the Seller agree to work in the dental practice for at least two years after the sale, subject to notice of termination, and abide by the terms of the non-competition covenant in favour of the Purchaser.^[2]

Following the notice of termination of the Seller by the Purchaser 2.5 years following closing, the Seller took the position that the non-compete covenant was unenforceable and began working with a dental practice that was within 15 kilometres of the original practice. By deciding to work at a dental practice only 3.3 kilometres away, the Seller would be breaching the restrictive covenant underlying the purchase of the practice, according to the purchase agreement, if the restrictive covenant was found to be enforceable.

In the action commenced shortly thereafter, in which the Purchaser argued that the restrictive covenant should be enforced against the Seller, the trial court cited Payette v. Guay inc. (“Payette”) in its decision that the restrictive covenant was reasonable and enforceable, reiterating the Supreme Court of Canada’s (“SCC”) position in Payette 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.”^[3]

In ruling on the appeal of the trial court’s initial findings, the ONCA in Sims held that a restrictive covenant will be enforceable unless it can be shown to be unreasonable in a commercial context, whereas more scrutiny is and will be applied to restrictive covenants in an employment context, with those restrictive covenants often found overbroad and unenforceable, further relying on the principles enshrined by the SCC in Payette.^[4]

The ONCA endorsed that restrictive covenants protect a buyer’s interest in the goodwill of the acquired business in a commercial transaction. Considering the nature of the dental industry, the Court found a 15-kilometre radius to be appropriate and deemed the five-year duration of the non-competition clause reasonable, as it protected the goodwill of the sold practice and the valuation afforded thereto. Accordingly, the Court found that the non-competition clause at contest in Sims was enforceable, affirming the trial court’s earlier decision.^[5]

Implications for M&A

There are various takeaways from Sims for individuals and businesses (and their advisors) considering the use of restrictive covenants in the Canadian M&A context:

• Restrictive covenants used in M&A, including non-competition clauses, are enforceable unless proven unreasonable within the commercial context of an M&A transaction.
• Agreements which pre-emptively contemplate what is reasonable in a given commercial context aid in the enforceability of a non-compete clause or other restrictive covenants, and well-drafted restrictive covenants can provide clarity in a timely and cost-effective fashion for all parties involved in a potential dispute over what is reasonable.
• Parties to a purchase agreement for the purchase and sale of a business are best placed to determine what is reasonably required to protect the purchaser’s interest in the goodwill. The ONCA noted that goodwill encompasses not only the existing customer base of a business but also the ability to attract new customers within areas that the business operates in.^[6]
• Parties to an M&A transaction should have equal bargaining power and be represented by legal counsel and other professionals. In this case, the ONCA considered that the parties were each represented by legal counsel and had equal bargaining power, and considered evidence that the Seller’s counsel did not see anything wrong with the scope and duration of the covenant when the parties entered into the deal.^[7]
• The common law rules applied to restrictive covenants in an employment context do not apply with the same rigour to M&A and commercial sales where parties to an M&A transaction may have greater freedom of contract.

Conclusion

With the ONCA’s decision in Sims, the Court has affirmed that deference will be given to contracting parties in their use of restrictive covenants as part of M&A transactions, provided that the restrictions are reasonable in the applicable circumstances.

The Capital Markets Group at Aird & Berlis LLP deals with issues related to the enforceability of restrictive covenants on a day-to-day basis. If you are a business owner or potential investor and have any questions on how to best navigate Canadian M&A or how to utilize restrictive covenants in your own proposed commercial acquisition or sale, please contact the authors or a member of the group.

[1] For further information on the interplay of restrictive covenants in Canada in the M&A and employment contexts, please refer to the following article by members of the Aird & Berlis Capital Markets and Labour & Employment practice groups: Know the Limit, Play Within It: Restrictive Covenants in Canada.