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Unexpected impact of share buyout of senior management

When one corporation “buys out” another (by asset purchase, share purchase, or other transaction), the impact on the buyers and sellers is clear. There are clearly winners and losers which is what presumably drove the transaction to begin with. While the employers of the purchasing and selling companies. The structure of the transaction can have a significant impact on their futures. Fortunately, the Ontario Employment Standard Act does provide certain safeguards for employees in the circumstances. For example the Employment Standard Act imposes a requirement for payment of up to one week per year of service.

However, what becomes of senior executives who are also shareholders in the company being purchased. Such senior employees will often be bound by either common law or contractual obligations to refrain from competing with their former employer or soliciting the former co-workers to leave the purchased business. These restrictions will obviously have a marked impact on the ability of these executives to find replacement employment.

In many of these transactions, the former executives, although well-compensated on the sale of their shares, will seek to leverage their experience by obtaining employment with the similar business where their experience will command the highest compensation. Understandably, the vendor corporation will see this as diminution in the value in the asset purchased and will take whatever steps are available to prevent the former employee from competing improperly.

As expressed in this blog in the past, Courts in Ontario have demonstrated a reluctance to enforce non-competition and solicitation covenants. There is a strong judicial tradition of supporting the existence of a free and open-market for labour, capital and ideas. The Courts will examine the provisions of such clauses to determine whether the geographical, temporal, business scope are reasonably necessary to protect legitimate business interest of the company seeking to enforce them.

In the most recent Ontario decision on this issue, released by the Ontario Court of Appeal on February 5th, 2013, the Court again seeks to weigh the conflicting priorities of these groups.

In this case, the employee had been employed by the corporation since 1990. He began his career in the company as a general labourer and worked his way up to a management position. In the course of doing so, he also acquired a minority interest in the capital stock of the company.

The business was then sold and the employee in question received payment for his shares. However, based on the structure of the transaction, he retained a minority interest in the new company. In order to continue working for this reconstituted entity, he was required to execute an Employment Agreement which contained non-competition and non-solicitation covenants, similar to the covenants he had with the previous company. However, these new agreements provided that the non-competition and non-solicitation covenants would remain enforced for a period of 24 months after employee disposed of his shares in any manner. The clauses in question provided that the non-solicitation and non-competition obligation applied across Canada for a period of 24 months.

At some point after the initial sale, the applicant was offered a significant payment for his interest in the company together with a senior position with the purchasing company. As the company refused to consent to the sale, he brought an application before the Ontario Superior Court for a declaration that the non-competition and non-solicitation covenants were unenforceable so that he could accept the new position and sell his shares.

The application judge reasoned that the applicant had signed the agreements with full knowledge of their terms, and had received significant consideration from the transaction. The judge therefore refused the employee’s application.

Given the significant amount of money at stake, the employee appealed to the Ontario Court of Appeal, which allowed the appeal and ruled that the clauses were not binding on the employee.

Although the Employment Agreement provided that the applicant could not be terminated for 2 years except for cause, the company fired him after just 6 months alleging that it had cause.

Eight days after his dismissal, the former employee started his own competitive business. He hired a number of his former co-workers and some of his former managers. Together they started to solicit business from the customers of their former employer. Not surprisingly, this caused a reaction from the former employer including an application for an injunction enforcing compliance with the restrictive covenants, as well as damages for lost revenue.

The application judge upheld the enforceability of the restrictive covenants, reasoning that they were part of a commercial transaction, and that the scope and duration of the provisions were reasonable in those circumstances. The application judge concluded that the employer had a reasonable business interest to protect by way of these covenants. The application judge also tied the employee’s obligation to the fact that he retained an indirect 25 percent interest in the company being acquired.

In determining whether to uphold the restrictive covenants, the Court of Appeal referred to the widely accepted principle that “covenants in restraint of trade are contrary to public policy” and are therefore presumed to be unenforceable. In considering whether such clauses were reasonable, the moving party must convince the Court that the clause is reasonable as between the parties to the litigation. If these clauses are in any way ambiguous, the Court found that it will not be “… possible to demonstrate that it is reasonable.” This is demonstrative of why so much care must be taken in drafting such provisions.

It is interesting to note that the Court referred to prior cases which stated that the test for the enforceability of such clauses drafted as part of a purchase or sale of a business will be subject to a lower standard, as they are part of a commercial transaction between equals. The Court of Appeal held that the motion’s judge was correct in his conclusion as to the reasonableness of the geographic scope of the clause. The Court of Appeal also relied on the presentation material, including the slide show, which demonstrated the intent of the parties to operate the business Canada wide.

One area in which such clauses are frequently successfully challenged is in the duration of the prohibition against competition or solicitation. The Courts will examine the nature of the business to see determine how long the “goodwill” lasts in the marketplace. In this case, the Court of Appeal found that the way in which the temporal limitation was drafted resulted in an undetermined time period with no fixed outside limit. As well, the requirement of a consent from the “lender” made the condition of the settlement irretrievably uncertain as it was not clear who the lender was or within what relevant time these consents were required to be delivered. The Court found the clauses were too uncertain to enforce.

What should employers to take from this decision?

  1. Even the most carefully drafted non-competition and non-solicitation covenants will be open to attack;
  2. It is always better to rely solely on a non-solicitation provision and take your chances with competition in the marketplace;
  3. A clearly drafted termination clause will protect the employer much more than any letter agreement.

Earl Altman
Partner
Garfinkle, Biderman LLP

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Earl Altman

Legal consultant at EA Consulting
Earl Altman was a partner at Garfinkle, Biderman and now heads his own consulting firm. Earl has practiced commercial and employment litigation. Earl’s practice focuses on employment disputes, including acting for employees and employers in wrongful dismissal claims, and in breach of contract and breach of fiduciary duty claims. Read more
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