Non-competition covenants: what are they and are they enforceable?
Maybe you’ve seen a non-compete clause in a recent employment contract, included one in an offer to purchase a business, or heard the term thrown around in a legal drama. No matter where you came across it, one thing is for sure: non-competition clauses are rampant – and for a good reason.
Non-competition covenants seek to limit a party from competing with another party. Such a clause is frequently used in the employment context, mitigating an employee’s ability to compete with their employer upon their departure. It’s also common, and often vital, in agreements to purchase and sell a business or in agreements between shareholders.
Historically, non-competition covenants were viewed as severe restraints on trade and commerce and contrary to public policy. Courts routinely voided these provisions and enabled the competition to flourish. By the early eighteenth century, the hostility towards non-compete provisions began to relax.[1] Today, the enforcement of a non-competition clause involves a reasonableness inquiry.
The restriction on competition must be sufficiently limited in temporal (time) and geographical scope (space), otherwise the entire provision may be stricken.[2] With regards to time, non-competition provisions are generally limited to a period of 5 years. Geographically, the provision likely can’t restrict a vendor from competing on a global scale. Typically, reasonable non-compete clauses restrict competition within a specified radius of several kilometers from the location of the purchased business.
Non-Competition Clauses between Employer and Employee: enforceable?
Agreeing to a non-compete provision is often a condition set by employers in employment contracts. These provisions generally seek to prevent an employee from starting a competing business upon departure from the role or restrain an employee from leveraging and ‘taking’ the employer’s customers. Nonetheless, a limit on non-compete covenants exist: employees are entitled to utilize information they’ve memorized.[3] Meaning, non-compete clauses can preclude employees from retaining lists or documents but can’t restrict an employee from utilizing information they’ve memorized.
Further, Courts may be reluctant to enforce a non-compete clause in the employment context, especially where the circumstances are excessively restrictive. This reluctance stems from the concern that enforcing a non-compete clauses on employees may prevent them from earning a sufficient income. As well, in assessing the enforceability of a non-compete clause, courts factor the power imbalance evident in employee-employer relationships.
Whether you’re an employer or an employee looking for insight on non-competition provisions, you should consult with a lawyer before drafting or signing such a clause.
Non-Competition Clauses between Buyer and Seller or shareholder agreements: enforceable?
When buying or selling a business, a large portion of the value paid for is derived from the company’s goodwill: the expectation that customers will remain as customers under new management. For this reason, a buyer’s lawyer will often negotiate a strict non-competition clause within the agreement of purchase and sale. Otherwise, nothing would be preventing a seller from opening a competing business down the street and taking away customers from the new owners of the sold business.
Non-competition clauses are included in shareholder agreements for a similar reason. Shareholders, who often function as directors and officers of a corporation, have access to sensitive and valuable information. Information from which much of the business’s value might be driven by. A non-compete clause in shareholder agreements functions to mitigate the ability of shareholders from setting up a competing company with that of the business central to the agreement.
Non-competition clauses in shareholder agreements and business transactions are much more likely to be enforced for several reasons. First, the power imbalance present in the employer-employee relationship is reduced in the context of shareholders or parties to a business transaction. Additionally, the goodwill of a business is likely more vulnerable to the actions of a shareholder or previous owner than they are to the those of an employee. Rendering a non-compete covenant void within an agreement of purchase and sale immediately opens the door for the seller to starting a competing business.
Still, while the prospects of having a non-competition covenant declared void in the context of commercial transactions, such clauses are subject to limitations. For a deeper dive into the significance of a non-compete clause in a business transaction read our article on the topic.
Indirect approaches to enhancing the likelihood of non-compete compliance
Contractual conditions can be leveraged to enhance the chances that an employee abides by a non-compete clause. For instance, the payments of certain benefits may be made contingent on the compliance of the party to the non-compete clause. An employer may opt to link the payment of retirement benefits to an employee’s compliance with a non-competition clause. No payments would be made during a period where the past employee violates the non-compete clause… Although courts still consider the reasonableness of these indirect compliance strategies, such approaches offer an enhanced likelihood of compliance with non-compete clauses.
If you’re thinking of adding a non-competition clause to a shareholder agreement or planning to sell/buy a business, we highly advise that you contact a lawyer at Kalfa Law Firm and confirm what the provision should look like.
[1] Mitchel v. Reynolds, [1711] EngR 38
[2] Maguire v. Northland Drug Co., [1935] S.C.R. 412
[3] Herbert Morris Ltd. v. Saxelby, [1916] 1 A.C. 688
-Ocean Enbar, Summer Law Student, JD Candidate
Ocean Enbar is a JD candidate and summer student at Kalfa Law Firm. Ocean assists our corporate, commercial, and tax lawyers in preparing research memoranda, conducting due diligence, drafting letters, and tending to the general corporate needs of our clients. Ocean completed his honours political science degree at Western University. He then worked as an intern on parliament hill until he transitioned to the private sector, interning for a reputable international lobbying firm.
© Kalfa Law 2021
The above provides information of a general nature only. This does not constitute legal advice. All transactions or circumstances vary, and specified legal advice is required to meet your particular needs. If you have a legal question you should consult with a lawyer.
