Business

RESTRICTIVE COVENANTS: CONTRACTUAL HANDCUFFS?

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We live in a competitive world. In fact, one of the cornerstones of a free market economy is competition. With competition comes risk to all entrepreneurs. That risk involves the failure to protect business goodwill due to weak restrictive covenants. Although most legal agreements contain some form of restrictive covenants, in many cases they do not go far enough in protecting an entrepreneur who has invested years of blood, sweat and tears in building a top-notch business. Simply put, restrictive covenants are contractual clauses that prohibit a party from doing certain acts for a certain period of time within a certain geographical area. Restrictive covenants typically involve provisions relating to non-competition and non-solicitation of employees. Obviously, such restrictions have to be reasonable otherwise they will not be enforceable.

In an employment context, the interests of both parties must be carefully balanced in order to have an enforceable covenant. On the one hand, employers will be understandably concerned to protect their business interests. On the other hand, some types of restrictive covenants seek to impose unreasonable restrictions on employees which could seriously prevent them from operating in their chosen profession or industry. Don’t get contractually handcuffed if you can help it. Keep in mind that there are clearly two sides to the argument.

In broad terms, there are four types of restrictive covenant:

  1. Non-compete covenants seek to prevent a seller or ex-employee from directly competing or working for a competitor, usually within a specific geographical area, for a set period following a sale or termination;
  2. Non-solicitation covenants seek to prevent a seller or ex-employee from entering into working relationships with former customers, by seeking or accepting orders for goods and services for a set period following a sale or termination;
  3. Non-solicitation of employees clauses seek to prevent a seller or ex-employee from recruiting former colleagues for a set period following a sale or termination;
  4. Restrictions on the use of confidential information seek to prohibit the use of any confidential information (usually identified by a non-exhaustive list of examples) acquired by a party in a transaction or an employee during employment.

Non-competition clauses are the first line of defense that an entrepreneur has in protecting their business goodwill. A common scenario that occurs in buy-sell transactions is a vendor who has sold their business and presumably moved on to other things. Upon the deal closing, the vendor suddenly changes his or her mind and opens a new office in direct competition with the purchaser. This can create a real problem for the purchaser, because many clients can be extremely loyal to their original service provider. The longer a customer has been a client of the vendor, the greater the degree of loyalty. Unless the radius restriction zone in the non-competition clause is adequately broad, many of these types of customer will follow a vendor to his or her new business location and the purchaser faces a huge loss of goodwill. In short, the purchaser has now lost something that they paid a significant amount of money for.

A buy-sell agreement should go further than simply contain a blanket prohibition against establishing a new competitive business within a certain radius restriction zone for a set term. Liquidated damages payable by the vendor to the purchaser in the event of breach should also be included within the scope of any restrictive covenant, as well as the right to seek injunctive relief.

Another valuable component of business goodwill that is often overlooked in many buy-sell agreements are clauses prohibiting the solicitation of staff members for a set period of time after the closing date of the purchase. Typically, entrepreneurs invest significant time and money in training their staff. This investment is factored into the goodwill allocation in any business valuation. Again, a properly drafted liquidated damages clause is critical in the event that a vendor solicits and hires any of their ex-employees at their new location. The best clauses set liquidated damages for soliciting specific employees such as key business development and sales personnel, operations specialists, or office managers. Different employees will be more valuable in different businesses. Obviously, damages must be reasonable otherwise such clauses will not be worth the paper that they are written on and only suitable for recycling purposes.

In an employment context where an employee leaves of their own accord the situation is different. The covenants still need to be reasonable to be enforceable. For example, a covenant prohibiting an employee from soliciting the business of former customers with whom they were regularly involved is more likely to be enforceable than a covenant which simply prohibits contact with any of the former employer’s customers, many of which the employee may never have had contact with. Restrictive covenants must go no further than is reasonably necessary to protect an entrepreneur’s legitimate business interests otherwise the covenants will be deemed to be unlawful restraints of trade and rendered unenforceable. However this fairly simple statement disguises the complex considerations involved in defining what is “reasonable” and what is a “legitimate business interest” in any given circumstance. For example, a covenant which prevents an employee from working for a competitor for a period of six months anywhere within Canada may be enforceable against a national sales director but would not be appropriate for a yoga instructor who only deals with people in the immediate locality. Further, this is not simply an issue about ideas of perceived professional status. A ten mile geographical restriction might be appropriate for an acupuncturist working in a rural area, whereas the same restriction placed on a dentist working in an urban location might well be unreasonable.

At the end of the day, there is no magic formula for restrictive covenants. They must be drafted and shaped to fit your own individual business and jurisdiction. The law relating to restrictive covenants differs from jurisdiction to jurisdiction therefore it is absolutely critical to obtain proper legal advice from an experienced professional. Restrictive covenants are a bit of a game and to get the best results case law has shown, you need to know the rules. To use an old hockey analogy, “defense wins games” and in the entrepreneur’s competitive world, restrictive covenants serve as an excellent defence against unlawful attacks against business goodwill.

With this in mind, C2K Law Corporation provides timely legal advice in relation to all types of corporate/commercial and business law matters. We strive to deliver an affordable, value-added service to suit your individual needs. We recognize that you are concerned about the costs of legal services. We do our best to provide a low cost value added service by leveraging technology and reducing overhead expenses passing the savings on to you. We use our entrepreneurship in our creative problem-solving approach, which enables us to take immediate and decisive action.

*The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

Bal Bhullar
Bal Bhullar is a corporate/commercial lawyer who owns and operates C2K Law Corporation. Bal has over 20 years of international and domestic practice experience. He has worked in private practice in Vancouver and Bermuda as well as in-house with public and private companies in the mining, aviation, telecom and technology, construction, oil and propane, insurance, management consulting and health care industries. Bal's areas of expertise include corporate finance, banking law, mergers and acquisitions, joint ventures, corporate restructurings, governance and compliance, company law, contracts and all types of commercial transactions. Bal is the member of the Law Society of B.C. and is admitted as a Barrister and Attorney in Bermuda. Bal is a business savvy lawyer who is solutions oriented and focused on delivering high value advice and service to all of his clients.
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