News & Media

A Fine Balance: The Characteristics of Effective AND Enforceable Restrictive Covenants

by Safina Lakhani and Alexandra Grishanova, PCMA E-News Brief

In the securities industry, relationships are the key to success. Among the most important relationships are those between a firm and its key workers, be they employees or contractors. Such workers bring the firm’s goals from plan to reality and foster relationships with issuers, clients, distribution networks and other key contacts. Correspondingly, the departure of a key person at the firm can be highly disruptive, especially if that key person decides to compete with the previous firm.

Firms in the private capital markets space are well aware of these risks, and often seek to protect themselves by imposing restrictions on departing workers. Some firms impose tight restrictions that are intended to ‘bench’ a departing worker entirely for a period of time. Ironically, highly restrictive post-employment covenants often have the opposite of their intended effect, and are deemed unreasonable and therefore unenforceable by Ontario courts, leaving the departing worker free to compete.

The state of the law on restrictive covenants leaves employers in a precarious position, whereby an employer must strike a delicate balance between the imposition of a restrictive covenant that will protect their legitimate business interests while meeting the prevailing standard of “reasonableness”.

This article is intended to shed light on the kinds of restrictive covenants that are common in this industry, identify common traps in structuring restrictive covenants, suggest strategies for the implementation of enforceable and effective restrictive covenants and provide guidance on what to do if a departing worker breaches such a covenant.

Restrictive Covenants 101

In general, an employee or a contractor for personal services is free to leave his or her engagement and compete with a former employer as soon as his or her employment or contract ends, provided that he or she does not misuse the employer’s confidential information. The law favours free competition for goods and services and mobility of employment.

Accordingly, many firms include restrictive covenants in their employment agreements or services contracts such that the worker contracts out of the right to compete following the termination of employment. However, courts are highly sceptical of restrictive covenants in employment agreements, due to the inherent inequality of bargaining power between employers and employees and the public policy goal of encouraging, rather than restricting, people from working. Courts will only enforce “reasonable” restrictive covenants, and will almost invariably deem an entire covenant unenforceable even if one discrete element is considered to be unreasonable. As a result, it is critical that organizations draft restrictive covenants narrowly, precisely, and with regard to the interests they seek to protect.

What will be deemed “reasonable” will depend on the kind of restrictive covenant that is imposed.

This paper describes two common types of restrictive covenants:

  • Non-competition clauses; and
  • Non-solicitation clauses.

Non-Competition Clauses

Non-competition clauses are the most draconian of restrictive covenants, and are seldom upheld in court. A non-competition clause restrains the departing employee from conducting business with former clients. In effect, a non-competition covenant purports to keep the former employee out of the business, rather than simply protect the employer’s client or customer base.

Such clauses are upheld by courts only in rare circumstances where it is clear that a less restrictive non-solicitation clause prohibiting a departing employee from soliciting former clients’ business would not be sufficient to protect the employer’s interests such as confidential information, trade secrets or trade connections.[1] One court commented that a non-competition covenant would be enforceable “where the nature of the employment will likely cause customers to perceive an individual employee as the personification of the company or employer.”[2]

Non-Solicitation Clauses

On the other hand, non-solicitation clauses are much more commonly found to be reasonable and enforceable. A non-solicitation clause prohibits a departing employee from actively asking for or soliciting business. Courts have held that accepting work from clients post-resignation does not, by itself, constitute solicitation.[3] More is required.

If the restriction is limited in time and scope and only captures identifiable customers with whom the employee dealt on behalf of the employer, such clauses are often found to be enforceable. Such clauses are typically found by courts to reasonably balance the employers’ interests in protecting their trade connections, while allowing employees to continue to earn a living.

Common Traps

Any restrictive covenant, regardless of its type, may be challenged in court. In determining whether the covenant should be upheld, the court will consider whether it is reasonably required for the protection of the employer and is not overly broad in the restrictions it places on the employee.

As a result, a firm should determine the specific and legitimate business interests that it seeks to protect, such as its trade connections with its existing customers, trade secrets and confidential information, and structure its restrictive covenants to narrowly protect those interests. It is critical that the restrictions be tailored to the interest at stake, because a court is likely to strike down a restrictive covenant in its entirety if it overreaches. Accordingly, restrictive covenants should:

  • Be reasonably limited in time – usually one or two years;
  • Be reasonably limited in its geographical scope – which will depend on the business conditions and the nature of competition in the area where the employer operates; and
  • Reasonably limit the restricted activities.

In addition, the wording of the restrictive covenant must clearly define the restriction. Courts have found restrictive covenants that are capable of more than one meaning to be ambiguous and therefore unreasonable and unenforceable.

What to do if the covenant is broken

If your firm learns that a former employee may be breaching a restrictive covenant, taking action immediately is imperative. Swift action will allow your firm to appreciate the extent of the breach and take immediate steps to prevent or limit the harm done. The first order of business is to serve the former employee with a cease and desist letter demanding that the employee stop whatever he or she is doing.

Depending on the nature and severity of the breach, your firm may also seek an injunction or interim order from the court on an expedited basis, preventing the former employee and others complicit in the breach, from continuing to breach the covenant. Once a covenant is broken, most of the damage is done. An injunction is often the most effective way to contain the damage and help restore the status quo.

 

[1] Lyons v. Multani (2000), 50 O.R. (3d) 526 (Ont. C.A.).

[2] Lyons v. Multani (2000), 50 O.R. (3d) 526 (Ont. C.A.) at para 44.

[3] Andrejs Management Inc. v. Bourdignon, 2015 ONSC 3988.

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