Restrictive Covenants in the Sale of a Business
Davis LLP Corporate / Commercial Bulletin
Friday, 15 June 2012
Restrictive covenants, by their nature, are contrary to public policy and prima facie void. A restrictive covenant can be enforceable if it is reasonable as between the parties and in the public interest. Therefore, reasonableness of the clause is central to the determination of enforceability.
The Sale of Business Context
Canadian courts distinguish between covenants arising in the course of the sale of a business and those in an employer/employee context. While non-competition clauses are assumed to be unreasonable for being a restraint on trade in both contexts, a restrictive covenant that is imposed in the purchase and sale of a business is more likely to be upheld. In Martin v. ConCreate USL Limited Partnership (“Martin”) 1, the court stated, in the context of the sale of a concrete construction business, that a restrictive covenant in the sale of a business is the “paradigm of a justifiable restraint on trade.” As compared to the power imbalance that is inherent in employment contracts, the parties to a commercial contract are sophisticated and more likely to have equal bargaining power. There is significant value in upholding freedom of contract in such cases.
The courts are also more willing to uphold restrictive covenants in the sale of a business because they frequently involve a payment to the vendor for goodwill. In consideration for that payment, the inherent value of the business is intended to remain and reside with the purchaser. As stated by Dickson J. (as he then was) in Elsley v. J.G. Collins Insurance Agencies Ltd.,
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.2
Bargaining for a restrictive covenant can assist the parties in reaching a mutually beneficial agreement because it can give the purchaser some comfort that the business will be protected.
The Legal Test
In considering whether to uphold a restrictive covenant in the sale of a business, the courts consider reasonableness through an overall examination of the clause, the agreement in which it is found, and all of the surrounding circumstances. The courts will look at whether the restrictive covenant is fair given the geographic and temporal restrictions set out in the covenant. The legal test is as follows:
The trends in the case law suggest that a temporal restriction of five years is reasonable in the context of the sale of a business. The scope of the spatial restriction will be considered in light of the operations of the purchased business. For example, a restrictive covenant against competition in Canada may be found reasonable for a business that operates throughout multiple Canadian provinces, but may not be found reasonable for a business that operates only in Vancouver.
Payment for the Restrictive Covenant
A question that often arises in the sale of a business is whether a part of the purchase price should be allocated as consideration or payment for a restrictive covenant. The case authority does not impose such a requirement. However, in practice, it is not uncommon to allocate payment for a restrictive covenant and, or in the alternative, to use specific language in the Recitals and elsewhere in the agreement where the restrictive covenant is referenced to make it clear that the sale price of the business is consideration for the imposition of the restrictive covenant.
The allocation of funds towards the goodwill of the business or as a specific payment for the restrictive covenant may be important in situations where the owner is retained as an employee of the purchased business. In some cases, the payment may be determinative that the covenant arose during the sale of the business rather than through the subsequent employment contract. This, in turn, can assist the purchaser in upholding the covenant because it arose in the commercial context and not in the employment context.
In Coast Testing (Canada) Ltd. v. Cook 3, the British Columbia courts considered a situation where the vendor owner agreed to a restrictive covenant in a share purchase agreement for five years in the sale of the vendor’s non-destructive testing services business. The vendor simultaneously entered a consulting agreement with the purchaser which contained a restrictive covenant against competition for two years from the end of the consulting arrangement. Both of the covenants were worldwide in scope. In considering whether the covenants arose in the sale of the business or through the vendor’s employment, the court was persuaded by the evidence that the total consideration for the sale of the business was not represented by the amount to acquire the assets alone. Rather, the purchaser had negotiated consulting agreement and provided compensation for the goodwill through those agreements. The court also found that the covenants were primarily designed to protect the business and concluded that the restrictive covenant arose in the sale of the business.
The court then considered the reasonableness of the covenant in the context of the sale of the business. The court concluded that the covenant was excessive in the circumstances because the geographic component was too broad. The evidence was that the business derived 90% of its revenue from the British Columbia market. Therefore, a restrictive covenant that covered all areas within and outside of Canada was an unreasonable restriction on trade. The court did not find that the five-year and two-year temporal components were too broad.
In Anderson v. Berry (Heldt) 4, the petitioner argued that the situation involved both an employment contract and the sale of a business, and that, because the situation was more akin to employment, the employment contract should govern as the standard of reasonableness. The court disagreed with that argument on several grounds. First, the covenant was found in a shareholders’ agreement and not in an employment contract. Second, the clause was intended to operate once a shareholder sold or disposed of her shares, and therefore received value for the non-competition clause. Third, the court noted that the non-competition clause was an important feature in the deal and factored significantly into the pricing of the shares. Therefore, the exchange of consideration for the covenant was an important factor in the circumstances.
Finally, in Restauronics Services Ltd. v. Forster 5, Restauronics purchased the shares of Forster and his three sons in Forster Food Services. The share purchase agreement provided that Forster would not engage in the business of providing food services within B.C. or Alberta, or within a 100-mile radius of any regional or branch operations of the purchaser, which had operations all over Canada. The covenant was for a time period of five years.
The court found that the purchase price of the business took into account the goodwill that had been built by Mr. Forster in British Columbia with his long term clients in the food services business. The restrictive covenant was intended to protect the value of the assets sold by the agreement as well as the goodwill. Therefore, the court concluded that the five-year duration of the covenant was reasonable. However, the court found that the geographic restrictions were too broad. Even though the purchaser had operations all over Canada, Forster Food Services did not provide food services outside of British Columbia. The court applied the doctrine of “blue pencil severance” and severed the offending portions of the covenant to make it enforceable.
It is important to note that the courts are showing an increased hesitation towards applying the doctrine of blue pencil severance to restrictive covenants, following the Supreme Court of Canada decision in Shafron v. KRG Insurance Brokers (Western) Inc. 6 In that case, the court stated that the doctrine of blue pencil severance should only be resorted to in rare cases.7 Therefore, it is less likely going forward that the courts will strike the offending portion of a restrictive covenant to make it enforceable.
Draft income tax legislation applies to restrictive covenants granted since 2003. The rules are complex and can apply to a sale of a business involving a sale of the shares or the assets. In some cases the new rules can require a full income inclusion for the value of the restrictive covenant even where the parties have not allocated any consideration to the restrictive covenant. Tax advice is therefore recommended where restrictive covenants are entered into on the sale of a business.
1. 2012 ONSC 1840, at para. 11.
2.  2 S.C.R. 916, at p. 924.
3.  B.C.J. No. 181.
4. 2005 BCSC 1825, upheld at 2007 BCCA 100.
5. 2001 BCSC 922, decision appealed by one plaintiff and decision reversed on other grounds, 2004 BCCA 130.
6. 2009 SCC 6.
7. Ibid, at paras 2, 36, 49 and 50. This principle was applied in Martin.