Legal Update: Seller Beware – SCC Enforces Restrictive Covenants in Purchase Agreement

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Legal Update: Seller Beware - SCC Enforces Restrictive Covenants in Purchase Agreement

October 23, 2013

By John Roberts, at McInnes Cooper

The Supreme Court of Canada recently decided that the non-competition and non-solicitation covenants to which the seller of a business agreed in an asset purchase agreement are enforceable – even though the purchaser and seller later entered two employment contracts, neither of which contained any such covenants. The decision reminds buyers of a business of the importance of requiring restrictive covenants in purchase agreements to protect their interests. It is also a warning to the sellers of such businesses that courts may still hold them to their obligations under such agreements – even if they subsequently enter an employment contract with the buyer that does not include restrictive covenants:

The “Cardinal Rule”. The SCC reconfirmed the “cardinal rule”: parties negotiating a commercial transaction (like a business sale) have greater freedom of contract than those negotiating an employment contract – and courts will give the terms of restrictive covenants in commercial contracts substantial deference.
Buyers Take Care. Business buyers who subsequently hire the seller should take care deciding in which agreement(s) any restrictive covenants are located – and their wording – to ensure they clearly relate to the purchase agreement so courts take a more liberal approach to their interpretation.
Sellers Beware. Similarly, sellers should carefully consider the obligations to which they agree in the purchase agreement and any subsequent agreements; courts will not disregard restrictive covenants only because they are in a contract that preceded the formation of a separate employment contract.

BACKGROUND

Guay Inc. is a crane rental company based in Quebec. Guay purchased Groupe Fortier’s assets. Payette was a co-owner of Groupe Fortier. In the purchase agreement, Payette agreed to two restrictive covenants: not to compete with Guay for five years after his employment with Guay ended, and not to solicit its customers or employees. To ensure a smooth transition after the sale, Payette agreed to work with Guay as a consultant for six months. Payette and Guay subsequently entered into an employment contract with a set end date; they later renewed this contract without any set end date. Neither employment contract included restrictive covenants. Guay terminated Payette’s employment without cause. Within a year, Payette went to work for one of Guay’s competitors. Days later, seven of Guay’s most experienced employees left Guay and went to work for that competitor.

Guay applied to court for an injunction – an order requiring Payette to comply with the restrictive covenants in the purchase agreement. Guay initially failed but succeeded at the appeal court. Payette appealed to the SCC.

RESTRICTIVE COVENANTS IN PURCHASE AGREEMENT ENFORCEABLE

The SCC decided the restrictive covenants in the purchase agreement were enforceable against Payette even though he had subsequently entered into two employment agreements with Guay – neither of which included the restrictive covenants.

Different Interpretation Rules. The SCC reconfirmed a long-standing principle: the law for the enforceability of restrictive covenants is different for covenants in a commercial contract and those in an employment contract: courts will interpret restrictive covenants in employment contracts with “more rigour and intensity”.

Commercial v. Employment Contract. The restrictive covenants were in the purchase agreement – but the duration was triggered by Guay’s employment. The case was subject to Quebec law; thus the Civil Code of Quebec applied. Under the Code an employer cannot rely on the employment contract when it terminates an employee’s employment without “serious reason”. The SCC thus had to decide whether the restrictive covenants were linked to the purchase agreement –subject to the commercial interpretation rules – or the subsequent employment contracts –subject to the more stringent rules. The SCC decided Payette agreed to the covenants for reasons related to the sale of his business (the purchase agreement) – not to his post‑sale services as Guay’s consultant or employee (the employment contract); the covenants could not be dissociated from the purchase agreement:

Wording & Intention. The parties’ intention and the wording of the restrictive covenants confirmed they undertook the commitments in relation to the sale – even though their duration referred to the termination of Payette’s employment.
Purpose. The purpose of restrictive covenants in a business sale is the protection of the assets the buyer acquired in exchange for the purchase price. The restrictive covenants in the purchase agreement were necessary to protect the good will, skilled employees and customers that Guay acquired.

Non-Competition Covenants. Restrictive covenants in a commercial contract – unlike those in an employment contract – are presumptively enforceable. When interpreting restrictive covenants in the commercial context, the seller must prove their scope is unreasonable. In the commercial context, a non-competition covenant is reasonable if its term, the territory and the restricted activities are limited to what is necessary to protect the buyer’s legitimate interests in light of the circumstances in which the partied entered the contract Courts can consider the following factors: the sale price, the nature of the business’s activities, the parties’ experience and expertise and the parties’ access to the services of legal counsel and other professionals. Here, both the term and territorial scope were reasonable considering the unique nature of the business and the lack of a power imbalance between the parties throughout negotiations.

Non-Solicitation Covenants. Unlike a non-competition covenant, a non-solicitation covenant will not be unreasonable only because it lacks a territorial limitation. First, geographic limitations are unnecessary because territorial limitations can be identified by analyzing the target customers. Furthermore, territorial limitations in non-solicitation clauses have generally become obsolete in the context of today’s modern economy and new technologies.

The SCC decided Payette was bound by the restrictive covenants.

Click here to read the SCC’s decision in Payette v. Guay.

BUYERS TAKE CARE – AND SELLERS BEWARE

Payette v. Guay reminds buyers of a business of the importance of including restrictive covenants in purchase agreements to protect their interests – and a warning to sellers of such businesses that they will be held to their obligations under such agreements, even if they subsequently enter an employment contract with the buyer.

The “Cardinal Rule”. The SCC reiterated and reconfirmed the “cardinal rule”: parties negotiating the sale of assets have greater freedom of contract than those negotiating an employment contract. Furthermore, the court will interpret restrictive covenants differently. In a commercial context, courts will give substantial deference to the terms of the restrictive covenants the parties negotiated, bearing in mind the relevant circumstances.

Buyers Take Care. It is common for the seller of a business to enter an arrangement with the buyer to ease the change in ownership – in the form of a consulting agreement or an employment agreement, or both. Often, restrictive covenants would also be in the subsequent consulting and/or employment agreement(s). In light of the SCC’s decision, buyers should take care in deciding which agreement(s) restrictive covenants are located in and their wording, with a view to maximizing the length of the restriction period and the likelihood that a court will find the covenants relate to the commercial purchase (as opposed to employment) agreement and take the more liberal, commercial approach to interpreting them.

Sellers Beware. Similarly, a seller should carefully consider the obligations to which he agrees in both the purchase agreement and any subsequent agreements. The SCC has made it clear that a court must not disregard the existence of restrictive covenants only because they are in a contract that preceded the formation of a separate employment contract.

A Note on the Quebec Effect. In this case, the SCC had to decide whether the restrictive covenants were linked to the purchase agreement or the subsequent employment agreement because of the express provisions of the Code. While not entirely clear, it seems likely the SCC would have taken the same approach even if the issue were not subject to Quebec law – and the Code did not apply.

Please contact your McInnes Cooper lawyer or any member of our McInnes Cooper Corporate and Business Team to discuss this topic or any other legal issue.

McInnes Cooper has prepared this document for information only; it is not intended to be legal advice. You should consult McInnes Cooper about your unique circumstances before acting on this information. McInnes Cooper excludes all liability for anything contained in this document and any use you make of it.

© McInnes Cooper, 2013. All rights reserved. McInnes Cooper owns the copyright in this document. You may reproduce and distribute this document in its entirety as long as you do not alter the form or the content and you give McInnes Cooper credit for it. You must obtain McInnes Cooper’s consent for any other form of reproduction or distribution. Click here to request our consent.

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