Typically, employers have encountered difficulty in enforcing covenants restricting employees from competing with the employer after their employment ends. Restrictive covenants, which typically deal with post-termination confidentiality, solicitation of employees and clients, and competition with the former employer. Such restrictions are viewed by the courts as unenforceable, as they constitute a "restraint on trade", that is, an unfair impediment to an individual being able to ply his or her trade and earn a living.
However, if the covenants can pass a number of tests for reasonableness, the courts will find them enforceable. First, the employer must be able to establish that the restrictions are reasonably necessary to protect its legitimate business interests, and that the measures imposed are the least restrictive that would meet that objective. If a non-solicitation provision would provide adequate protection, the courts will not uphold a non-competition agreement. If the employer can establish the necessity of the restriction, it must still prove that the limitations imposed are reasonable, in terms of the temporal and geographic scope of the covenant, as well as the nature of the activity that it captures. Again, less is more - a covenant that is not tailored bearing in mind the employee's job duties, their level of responsibility vis-a-vis the employer's business, and the risk posed by their competition with the former employer, it is unlikely to be enforced.
The courts have taken varying views on other types of clauses that are triggered upon termination and which may impact an employee's post-termination activities and entitlements. Two recent decisions illustrate how some of these clauses work, and what the courts think of them.
In Levinsky v. The Toronto-Dominion Bank, the employee was a Vice President in the securities trading area for several years, before resigning to start up his own hedge fund. For several years, he participated in the Bank's Long-Term Compensation Plan (the "Plan"), which provided grants of Restricted Share Units ("RSUs") each year. Each grant of RSUs would vest three years from the date of grant, but any unvested RSUs were forfeited in the event that an employee resigned prior to their vesting date. The plaintiff claimed that the RSU awards were a form of “earned compensation” for past services, and that the forfeiture provision in the Plan amounted to an unreasonable restrictive covenant, as it was actually designed to discourage employees of the Bank from leaving and going to work for a competitor. His claim was for approximately $1.6 million in unvested RSUs. Although the plaintiff was subject to a non-competition agreement, the Bank waived any restriction on his activities and did not challenge his starting a potentially competitive business after he left.
In the Ontario Superior Court of Justice, Justice Brown considered the law on restrictive covenants, including the fact that whether a provision amounts to a restraint of trade is to be determined “by the effect of the clause in practice”, not just its form. After reviewing those cases in which an employee was denied future compensation in the event of his/her resigning and taking on employment with a competitor, the Court summarized the case law as follows (at para. 80):
From this review of the jurisprudence placed before me at the trial, the following legal principles emerge:
(i) No binding decision was put before me which dealt with facts substantially similar to those raised by the present case;
(ii) However, the decision of the Court of Appeal in Inglis, which does bind me, held that a clause in an employment contract under which the entitlement to post-termination future commissions would be forfeit in the event the employee engaged in a competing business was not in restraint of trade because it did not preclude the employee “from going anywhere and doing anything he chose to do”. The Court of Appeal viewed the clause as attaching a contingency to the entitlement to future income, but not the forfeiture of a vested right;
(iii) This Court, in Nortel Networks v. Jervis, did not regard as a restraint of trade a clause in an employment contract which required an employee to reimburse the employer benefits he had received from the exercise of stock options prior to leaving the company in the event that after leaving he went to work for a competitor, again on the basis that it did not preclude the employee “from going elsewhere or from doing whatever he chose to do”;
(iv) The weight of authority from other jurisdictions regarding the treatment of clauses which defer compensation for a period of time and require an employee to remain in service at the time of maturity in order to receive the compensation suggests two principles:
a. If the entitlement depends upon the continuation in service and does not tie eligibility to the nature of the employee’s commercial activity after he leaves his employer, the clause is not viewed as a restraint of trade, but simply a condition for entitlement to part of the employee’s compensation package and a reasonable condition designed to secure the employee’s loyalty through continued service; but,
b. If the deferred compensation has already vested in the employee prior to his termination, a forfeiture provision might be regarded as a restraint of trade if forfeiture was tied to post-termination commercial activity, not simply to the employee’s continuation in service.
Because the Plan in Levinsky did not tie post-termination entitlement to the RSU grant to refraining from taking up employment with a competitor, but was tied solely to his continued employment with the Bank for a specified period of time, the Court viewed it as a retention scheme rather than a restraint of trade. Moreover, it was clear from the terms of the Plan that the compensation at issue had not yet been earned, and was not a vested right that the employee could demand after resigning. In the result, the claim was dismissed.
Similar issues were more recently litigated in Rhebergen v. Creston Veterinary Clinic Ltd., at the British Columbia Court of Appeal. In that case, a veterinary practice retained the plaintiff under an “Associate Agreement” immediately after she completed her veterinary schooling. It was agreed that the plaintiff would work for the clinic for three years, during which time she would receive further hands-on training and mentoring. Under the contract, the plaintiff was subject to a repayment obligation if she “set up” a veterinary practice in the town where the clinic was located or within 25 km of the town. After 14 months of employment, the plaintiff advised the clinic that she intended to leave, and her employment was terminated for cause. She then applied to the court for a declaration that she was not obligated to make any repayment to the clinic if she started her own mobile vet practice, as the provision of the contract was alleged to be in restraint of trade and unenforceable.
In the B.C. Supreme Court, the plaintiff was successful. The Court was of the opinion that the terms of the repayment provision were vague and ambiguous, and that the repayment amounts set out therein were a penalty, rendering the provision unenforceable. The employer appealed.
At the B.C. Court of Appeal, the majority of the Court (Justice Lowry dissenting) found that the trial judge had erred in finding that the repayment provision was ambiguous as to when compensation would be triggered. Given that the former employee had brought her application for a declaration on the basis that she intended to “set up a veterinary practice” in the prescribed area, it was clear that the parties had a mutual understanding of what the clause meant. The Court was unanimous in finding that the repayment obligation did not constitute a “penalty”, and that whether or not it was a penalty was not per se determinative of whether it was unreasonable, where the employee had agreed to the amounts to be repaid.
Perhaps most interestingly, however, the B.C. Court of Appeal was also unanimous in finding that its responsibility in reviewing a clause of this nature was to look at the functional or practical effect, rather than focusing on the form of the provision (as was the case in many of the Ontario cases cited). The Court also observed that the decision in Levinsky supported taking a functional approach, where the courts must focus on whether the clause creates a disincentive for the employee to compete post-termination, even if there is no express prohibition of competition. The Court had no hesitation in finding, on the basis of this functional analysis, that the repayment obligation in the Agreement amounted to a restrictive covenant. However, in the end, it was found that its terms were reasonable and, therefore, enforceable.
These recent cases highlight the variety of approaches that are possible, but also provide some clarity on what types of provisions will be enforceable and which won’t. In most instances, ‘retention’ schemes that tie entitlement to an employee continuing in employment for some period of time, and which do not disentitle the employee on the basis of competitive activity post-termination, will not be found to be in restraint of trade. Accordingly, an employer will not have to justify these provisions on the basis of the ‘reasonableness’ test referred to above. However, if the program provides a vested right, which is then taken away at termination, this may offer another basis for challenging the refusal to pay. Where an employee is required to repay or will lose a significant piece of compensation as a result of post-termination competition, such measures will likely be viewed as a disguised restrictive covenant on the basis of the functional analysis, and will have to be justified as reasonable. In looking at a repayment obligation, it will be necessary to establish that it is not unduly onerous or punitive, and it would be advisable to be able to connect the amount to any costs involved in the loss of the employee, such as foregone training and equipment costs and/or the loss of clients to the employee’s competition (as was the case in Rhebergen). In all cases, however, care must be taken to ensure that the language used is clear and unambiguous – any clause that takes away some component of the employment bargain or which imposes financial obligations will likely fail if it is vague or open to multiple interpretations.
Do you have questions about forfeiture or ‘penalty’ clauses in an employment agreement or other employment-related compensation scheme? Contact Lance Ceaser for professional guidance.