Economic Disincentive

Certain agreements have not imposed a direct restrictive covenant, but rather have set out a pre-determined intended estimate of damages which the offending party must pay, in exchange for carrying on business or accepting employment within the limitations imposed by the contract.

The starting point of the analysis is a 1941 decision of the Ontario Court of Appeal in Inglis v Great West Life Assurance. The provision of the contract denied the plaintiff payment of commissions on business which was renewed following the cessation of his employment,   should he work for a competitor post-termination. The court found the commissions were not vested on termination, but rather contingent upon compliance with the terms of the contract.

Submissions were made by the plaintiff that this clause was unenforceable as it was one made in restraint of trade and secondly was a penalty. Both pleas failed.

As to the argument on the restraint of trade, the court determined that he was free to work anywhere he chose and hence saw no impediment to the enforcement of the clause in favour of the employer.

Hughes J. of the Ontario Supreme Court in the 1964 decision of Furlong v Burns reviewed a covenant which arose from a settlement agreement which included a pension sum stated to be an "allowance to be continued at the discretion of the Company subject to your attitude and conduct not being, in the opinion of the Executive of the Company, detrimental to the Company or its personnel". The clause was enforced by the employer when the plaintiff took employment with a competitor.

The court found this to be a restrictive covenant and unenforceable.

The Ontario Supreme Court in the 1996 decision of Woodward v Stelco considered whether a clause allowing for an incremental unfunded pension payment in exchange for the plaintiff’s non-compete covenant was enforceable. Stayshyn J, concluded that the clause, which arose from a termination settlement, was a restrictive covenant and then concluded that it satisfied the tests of enforcement.

Rivard J. of the Ontario Superior Court in his 2002 decision of Nortel Networks v Rivard found in favour of the employer in enforcing the agreement to repay profits taken on the company’s stock option plan which were made prior to the employee’s resignation and decision to join a competitor, in violation of this covenant. The court followed the Inglis decision and held that the clause was not akin to a restrictive covenant as imposed no obligation not to compete, but rather contemplated the event.

The February 2007 decision of J. MacKinnon J. of the Ontario Superior Court in Renaud and Otten v Graham reviewed an employment agreement which required the defendant employee to repay his salary based on a formula up to a cap of $20,000 in the event he were to resign his employment and work with a competitor real estate broker within one year of his departure.

This term was found not to be one in restraint of trade. No review of past authorities was provided on this subject. The Divisional Court did review past case law and concluded that this term was not one in restraint of trade. ¹

The Ontario Superior Court in the 2013 decision of D.M. Brown J. in Levinsky v T-D Bank referenced the decision of the Privy Council of Stenhouse v Phillips to conclude that it is the substantive effect of the words of the document, not the form, which rules the day. In Stenhouse, the clause did not directly prohibit competition, but rather imposed a financial burden. This was determinative as the Court looked not to the form of the covenant, but its effective consequences:

  Whether a particular provision operates in restraint of trade falls to be determined not merely by the form of the clause, but by the effect of the clause in practice. So, for example, where a clause on its face contained no direct covenant to abstain from any form of competition, but did require the former employee to share profits with his former employer on any new business written following his resignation, the clause operated to cause the employee to refuse business he otherwise would take, thereby constituting a restraint of trade.

The British Columbia Court of Appeal considered a similar issue in its recent 2014 decision in Rhebergen v Creston Veterinary Clinic.

The plaintiff was a veterinarian who had signed an agreement requiring her to pay a stipulated sum to her employer in the event she chose to compete against it within a radius of 25 miles. The damage sum to be paid decreased in each of three years from $150,000 to $90,000 from within year one to year 3. The initial employment contract was for a fixed term of three years, which neither party could terminate, save for a right of cause in favour of the employer.

The trial judge found the clause to be a restrictive covenant, one which was unenforceable on account of vagueness and that the contemplated damage sum was in any event a penalty.

The employer successfully appealed.

The Court of Appeal raised the first question as to whether it may be said that such a clause, which does not prohibit competition, but rather allows it, subject to payment of a pre-determined sum, must pass the test of a restrictive covenant.

This issue, the Court stated, had been the subject of divergent views which it referenced as the “functional” and “formalist” views. The former looks to the effective impact of the clause and the second has no time to look to the consequences, and rather rests on the lever that economic disincentives are of no moment:

  With respect to the modern jurisprudence, however, there appears to be essentially two strands of authority in the employment context: first, what one may call a ‘functional’ approach, which asks whether the clause at issue attempts to, or effectively does, restrain trade, in which case it will be captured by the doctrine and subjected to reasonableness scrutiny; and second, a more ‘formalist’ approach, in which the clause must be structured as a prohibition against competition to constitute a ‘restraint’.  On the latter approach, mere disincentives to post-employment competition are not sufficient to trigger the doctrine, even if those disincentives operate as effectively at dissuading competitive conduct and participation in the marketplace as a prohibition.

The Court reviewed the historical development of the law and concluded that the preferred approach is the functional test:

Here, against this background of conflicting authority, like the judge, I consider clause 11 of the associate agreement constitutes a restraint of trade.  In my view, the functionalist approach established in English law is to be preferred as the legal basis for determining whether clauses that burden employees with financial consequences, whether by payment or forfeiture, they would not otherwise have for engaging in post-employment competition constitute a restraint on trade.  In the words of Lord Wilberforce, it is a matter of the effect of the clause in practice over its form.

[43]        While clause 11 is not a conventional non-competition clause in that it contains no prohibition, it is, as its title in the agreement suggests, a kind of non-competition clause because it effectively provides for no competition within the stipulated radius during a three-year period after the termination of the associate agreement in the absence of the required payment.  The payment is a restraint – it compromises the opportunity to compete with the clinic Dr. Rhebergen would other­wise have.  The clause requiring the payment then constitutes a restraint of trade and is enforceable only if, in the circumstances, it can be said to be reasonable.

Lowry J. also noted, that given the finding that the clause is subject to the test of a restrictive covenant, the reasonableness of the covenant must be determined by the nature of the financial impediment to competition:

While the authorities shed little light on the point, consideration of the amount to be paid may, in my view, be supportable in law as a significant factor to be taken into account in the overall fairness of a permissive clause.  Under a conventional non-competition clause, the prohibition constitutes the restraint and is what must be reasonable to be enforceable; under a permissive clause it is, if anything, the amount to be paid, or for that matter forfeited, that constitutes the restraint and may have to be considered as an element of the fairness of a non-competition clause of that kind.

Lowry J., in partial dissent, agreed that the trial judge’s finding that this payment was a penalty was wrong.

This decision differed from the majority in concluding that the operative clause was ambiguous as the wording of carrying on a professional practice was capable of various meanings and for that reason would have upheld the appeal.

The majority decision was delivered by D. Smith J.A. and concurred in by Bennett J.A.

These reasons were in agreement with those of Lowry J.A. on all aspects, save the finding that the covenant was ambiguous. There was hence unanimity on the issue of the clause being interpreted in a “functional” manner and that the test to be applied was that of a restrictive covenant. The majority found that the clause met the test and hence upheld the employer’s position and enforced the agreement.

It is to be noted in this instance that the employer offered evidence as to how the damage sum was rationalized and that the sum was intended as a means to recapture training costs and account for the loss of potential goodwill.

 Forfeiture of Deferred Compensation

The above decision in Levinksy reviewed the terms of an employment agreement which nullified compensation which had been deferred at the time of termination of employment. The contingent event to allow for payment was the covenant of the employee not to compete.

The court found that the first step in the analysis is to determine whether the event which brought about the cancelation of the payment was the event of termination of employment alone, in which case the clause was binding, apart from any plea that the provision was penal in nature and was unfairly bargained:

I conclude that in examining a clause in an employment contract which operates to forfeit deferred compensation upon or following the cessation of the contract, a court must assess whether the clause, on its face or in its practical operation, ties the forfeiture of compensation to the event of termination or whether it ties it to the employee’s conduct following the end of his employment.  If the forfeiture results simply from the cessation of the employee’s service, without more, the clause does not operate in restraint of trade because it does not fetter the employee’s ability to choose where he or she wants to work next. 

The clause in question required the employee to be employed until the maturity date of the compensatory award. This term was silent as to any post-termination restrictions. The court found, as a practical consequence, that this term did not operate with restrictive consequence to the plaintiff and was hence enforceable.

Repayment of Training Expenses

The decision of Clancy J. of the Supreme Court of British Columbia in Cannacord Capital v Clough considered the term of employment which required the departing employee to repay to the plaintiff a formulaic sum for training expenses, should he become employed with a competitor within a set time frame.

This term is very similar in concept to that considered in Rhebergen v Creston Veterinary Clinic although in this instance the repayment obligation was described specifically as training expenses.

The Court appeared implicitly to accept the proposition that this was a covenant in restraint of trade as it applied the same test as would be considered for a restrictive covenant and upheld the clause as enforceable. The Court stated:

I conclude that Canaccord was entitled to protect its investment in Mr. Clough as a trainee provided that the protection goes no further than achieving that goal and does not unduly restrain Mr. Clough.  I find that the provisions of paragraph 2.1 are reasonable as between the parties.  They do not prohibit Mr. Clough from joining a competitor.  They simply require a price to be paid if he does so.  The recovery of some of the cost of his training is a reasonable requirement.  The public would understand that a broker would wish to protect itself against competition from someone on whom it has expended funds and whom it has instructed in its business philosophy and methods.  The protection the clause affords is adequate but not excessive.  It is in no way injurious to the public interest.