It has almost become common knowledge that restrictive covenants are not looked-upon kindly by the courts and tend not to be valid or enforceable. Courts consider it contrary to public policy to enforce restrictive covenants because they put an improper restraint on business. But, not all restrictive covenants are created (or treated) equally. Depending on when it is used, a properly drafted restrictive covenant can not only be enforceable, but it can serve as a very useful negotiating tool. Specifically, when negotiating the sale of a business, a restrictive covenant can be an excellent tool to help both parties reach an agreement.
To take a step back, the term restrictive covenant, as it is used in the business context usually means one or more of the following things:
- An agreement not to compete with another person or business;
- An agreement not to solicit the customers of another business; or
- An agreement not to solicit the employees of another business to work for your business.
In some contexts, understandably, it is very unlikely that a restrictive covenant will be legally enforceable. The obvious example is the employment context: for instance, where a company hires an engineer and part of their employment agreement states that they can’t compete with other engineering firms for 5 years. In that case the provision can be seen as taking away the livelihood of that person, and therefore a court is very unlikely to enforce it. However, in other contexts the analysis is not so clear-cut.
When it comes to the sale of a business, there is no blanket prohibition on restrictive covenants, rather the provisions themselves must pass a certain threshold of reasonableness to be enforceable.
The reasonableness of a provision is judged on three criteria: (1) the extent to which the company asking for the restrictive covenant has something legitimate to protect; (2) the reasonableness of the provision in terms of its duration and geographic scope; and (3) the extent to which the provision is a restriction against competition generally.
As one might expect, the less restrictive the provision, the more likely it is to be enforceable, for instance a 20 year non-competition restriction covering the whole world is very unlikely to be enforceable except in the most extreme situations. However, courts have upheld 5-year restrictions and it is not uncommon for a restriction to cover all of Canada. That said, the circumstances will be considered carefully. For instance, if a company only operates in Toronto, restrictions covering all of Canada are unlikely to be enforceable.
Given the apprehensiveness that courts have shown to enforcing restrictive covenants in other situations, a prudent lawyer will often include specific language in a purchase agreement and acknowledgements by the restricted person that the restriction is reasonable and that they have been adequately compensated for it. All drafting points aside however, the key to ensuring your restrictive covenants are enforceable is to be reasonable and carefully consider the circumstances, including the business and the transaction.