Getting the Most Out of Non-Competes

Businesswomen shaking hands over the table

Despite significant headwinds generated by global conflict over trade and other economic and political issues, the Canadian mergers and acquisition (M&A) market was strong last year, with the third quarter hitting a record 881 announced transactions. Deal making activity remained healthy as we entered 2019, which shows that Canadian companies are as willing as ever to negotiate deals whenever the potential benefits appear to outweigh the risks.
The importance of mitigating risks, of course, should never be underestimated. As Peter Buzzi, RBC’s co-head of mergers and acquisitions, told The Globe and Mail: “M&A is driven by confidence and the greatest enemy of M&A is uncertainty.” And unfortunately, uncertainty comes in multiple forms. In other words, not all risks to M&A deals involve national economics or international trade wars.

Whenever a purchaser closes an M&A transaction, the vendor could potentially turn around and inhibit—or entirely prevent—them from realizing the deal’s investment expectations. Fortunately, non-compete clauses barring a vendor from competing against their former business are typically enforceable in Canada. But purchasers beware—not all non-compete clauses are created equal.

This article outlines the differences between enforcing non-compete clauses in employment and M&A contexts and describes how to make your clause enforceable. It also provides strategies to protect against post-closing vendor competition and unexpected tax consequences.

Purchasers often hire the vendor to stay on as an employee after the transaction is closed. And it is important to note that courts can be reluctant to enforce non-compete clauses in employment agreements because they are anti-competitive. They may stop a person from earning a living and deprive the public of that person’s skills and labours. Courts are also concerned with the imbalance in bargaining power that frequently exists in the employment context.

By contrast, courts presume that a non-compete clause in an M&A context is lawful unless the party opposing the clause shows that its scope is unreasonable. In determining whether the non-compete was given as part of the sale or as part of the employment relationship, the court will consider whether the non-compete was included in the sale agreement and whether the consideration given for the non-compete was part of the purchase of the business. If the vendor provides a non-compete covenant as part of an M&A transaction, the presumption that the non-compete is lawful will apply even if the vendor stays on as an employee.

The law in M&A transactions differs from the employment context because different policy considerations apply to M&A transactions. There is no assumed imbalance of bargaining power in the M&A context. Further, a purchaser needs to have a clear period of time free from vendor competition to operate the business and recover the purchase price paid to the vendor. Courts have also recognized that a vendor’s business may be unsalable unless the vendor can assure the purchaser that he or she will not compete against the business after the sale and that the prohibition will be upheld by the courts.

Generally speaking, courts are more likely to uphold a non-compete clause given as part of an M&A transaction where:

  • the sale price is high;
  • the nature of business involves personal relationships with customers or suppliers the business enjoyed, a high proportion of market share at the time of sale, or other aspects of the business that suggest the clause should be upheld;
  • the parties have experience and business expertise; and
  • the parties had access to the services of legal counsel and other professionals in the sale process.

But being focused and reasonable is the trick to ensuring that an M&A non-compete clause is enforceable. Canadian courts will not usually save an overly broad non-compete clause. In rare cases, the courts have taken a limited “blue pencil” approach to narrow an overly broad non-compete by deleting part of the clause—but only when the deleted part is trivial. When determining what is reasonable, the courts apply a four-part test.

First, the business must have a legitimate proprietary interest deserving of protection. In an M&A transaction, the proprietary interest of the purchaser will be the business that it is seeking to protect from vendor competition. In most cases, this requirement is relatively simple to meet. However, you could have difficulty if the purchased business has engaged in little recent activity, as the vendor may argue that there is no current business interest to protect.

Second, the time limit, territorial scope, and precluded activities—usually ascertained during a purchaser’s due diligence and established through negotiation with the vendor—must be limited to the protection of the legitimate interests of the purchaser.

A non-compete clause without a time limit risks being found unreasonable. That said, the time period specified can be lengthy and still enforceable. Courts regularly uphold five-year terms in non-competition clauses given in M&A deals. Where a well-informed vendor has been represented by capable lawyers during the transaction negotiations, a court will likely find that whatever length of time the parties agreed upon for the non-compete was reasonable.

The territorial scope of the non-compete clause should be limited to the geographic areas in which the purchased business operates. If the purchased business does not operate within a certain geographic area, it is arguable that the purchaser cannot have a proprietary interest in that area to protect. However, a non-compete clause may be enforceable despite the absence of any geographic limit if the scope of the prohibited activities is very narrow. A purchaser might also succeed in enforcing a non-compete clause in areas where a developing product or service has not yet been implemented. Again, the policy reason for enforcement is to permit investment realization without vendor interference.

“In considering whether the non-compete is contrary to public policy, courts will not entertain allegations that the purchaser has engaged in improper business practices if they are unrelated to the non-compete clause.”

The prohibited activities must also be limited to what is reasonably needed to protect the proprietary interest of the business post-closing. Prohibiting activities that do not compete with the purchased business could render the clause unlawful.

Third, the terms of the non-compete must be clear and unambiguous. Parties must take care when drafting the non-compete clause so that it does not contain ambiguous terms. An ambiguous non-compete clause is unenforceable because the party seeking to rely on it will be unable to show that its terms are reasonable.

Finally, if the court finds an M&A non-compete clause reasonable based on the factors above, a vendor can still argue that it is contrary to the public interest. For example, courts may consider whether the loss of the prohibited activity will deprive the public of a needed service or otherwise harm the public. This issue would more likely arise in small communities, where the prohibited activity is a critical service (e.g., healthcare), or in industries with little natural competition.

In considering whether the non-compete is contrary to public policy, courts will not entertain allegations that the purchaser has engaged in improper business practices if they are unrelated to the non-compete clause. For example, a purchaser’s improper accounting practices would not affect the enforceability of the non-compete clause. However, the court may consider the purchaser’s conduct if it affects the non-compete or the vendor directly. In one somewhat unusual case, the vendor worked for the purchaser after the sale but resigned to avoid participating in the purchaser’s improper conduct. The court in that case refused to uphold a non-compete given by the vendor as a matter of public policy.

The following strategies can assist purchasers in protecting their new acquisitions from vendor competition and minimizing unexpected tax consequences:

Include It in the Recitals: Specify in the recitals to the purchase agreement that the vendor’s non-compete clause has been sought by the purchaser as a fundamental condition of completing the acquisition and for the purchaser to realize a return on its investment over the agreed time period.

Use a Confidentiality Clause: Confidentiality clauses prohibit the vendor from making use of specified confidential information. Where the business activities require use of confidential information (e.g., a manufacturing process, trade secrets, pricing, future projects under development but not yet launched), confidentiality clauses may serve the same function as a non-competition clause by indirectly preventing the vendor from competing against the former business. Courts uphold confidentiality clauses more often than non-compete clauses because confidentiality clauses do not restrain competition generally. As such, parties should always include a confidentiality clause wherever possible in M&A transactions.

Use of a Non-Solicitation Clause: Non-solicitation clauses prohibit the vendor from soliciting the business’s customers, suppliers, and employees. As these relationships are often fundamental to ongoing business activities, curtailing the vendor from soliciting also has a protective effect for the purchaser.

Limit Scope Where Possible: Although non-compete clauses given in the sale of a business are much more broadly enforced than those given in employment contexts, you should still reduce the risk that a court will refuse to enforce the clause by drafting it in the narrowest possible terms.

Prevent Surprise Taxes: Payments received by a vendor for a non-compete are potentially subject to adverse tax treatment in Canada. Even in circumstances where no amount is expressed as being payable for a non-compete, the Canada Revenue Agency may be permitted to allocate a portion of the acquisition proceeds to the non-compete and assess tax on that basis. Where a vendor in an M&A deal is a non-resident and a non-compete is given, the vendor may be subject to non-resident withholding tax and the purchaser may be required to withhold tax from the purchase price and remit such amounts to the Canada Revenue Agency. A purchaser that fails to withhold and remit such tax when required can be held personally liable for the non-resident vendor’s tax liability. In many instances, careful planning, or the execution of special tax elections, can preclude the adverse tax treatment of a non-compete from arising. Parties to an M&A transaction should consult with counsel at the outset of negotiations to ensure that the tax consequences of a non-compete are fully identified and managed.

Require Proper Representation: Although this is frequently assumed in most sophisticated transactions, the purchaser should require that the vendor retain experienced legal counsel. The presence of experienced and capable legal counsel is one of the key factors that a court will consider when deciding whether to uphold the non-competition clause.

Consider Using Non-Competes in Other Commercial Agreements: Non-compete clauses can be used in commercial agreements other than asset purchase or share purchase agreements. For example, an Ontario court upheld a non-compete clause that was contained in a shareholder agreement where the shareholders exchanged confidential business information as part of their business together.

Extra-Territorial Enforcement of Non-Compete Clauses in Canada: Many larger businesses have operations in multiple countries and may be sold in one global M&A transaction. Will a Canadian court enforce a non-complete clause in a transaction agreement governed by foreign law? Yes, so long as the clause is not contrary to Canadian public policy. In other words, the foreign non-compete clause must still meet the requirements above that apply when enforcing a Canadian non-compete clause.

M&A transactions are often a strategic way to meet corporate goals. But when a purchaser closes a transaction, the investment involved is frequently a high multiple of the purchased company’s earnings. It can take years to recover that investment. And during that recovery period, a purchaser should have every expectation that the vendor will not get in the way.

Brand Solutions by Promotion Solutions Inc. v. Elsey, 2015, ONSC 2985.
Doerner v. Bliss & Laughlin Industries Inc., 1980, 2 SCR 865.
Guay inc. v. Payette, 2013, 3 SCR 95.
J.G. Collins Insurance Agencies Ltd. v. Elsley, 1978, 2 SCR 916.
JTT Electronics Ltd. v. Farmer, 2014, BCSC 2413.
Key Pos Business Systems Inc. v. Singh, 2008, O.J. No. 1791.
KRG Insurance Brokers (Western) Inc. v. Shafron, 2009, SCC.
Luen Sing Foods Inc. v. Southseas Noodles Ltd., 2011, BCSC 344.
MEDIchair LP v. DME Medequip Inc., 2016 ONCA 168.
St. Clair Group Investments Inc. v. Seater, 67 ACWS (3d) 991.
1978 CarswellOnt 1235.
18090194 Ontario Inc. v. Meghna Pacific International Inc., 2016, ONSC 7625.

Leave a Reply

Your email address will not be published. Required fields are marked *