Non-Compete and Non-Solicitation Clauses

Taking the mystery out of a defence mechanism requiring some restraint

Non-compete and non-solicitation clauses are a defensive measure used by companies of all sizes.

While useful when a shareholder is still holding the company’s shares, they become all the more important following a share transfer or when a dispute arises.

Whether it is a question of protecting the interests of a purchaser of company assets or shares, or those of an employer or one of the remaining shareholders after a shareholder has left, the drafting of such clauses must be preceded by a thorough analysis of the actual circumstances of the company involved, as well as the needs of the intended beneficiary of the clause.

Otherwise, these restrictive clauses could prove to be of limited dissuasive effect, due to their unenforceability in a court of law. In other words, the clause will amount to being no more than a shot in the dark, incapable of preventing potentially serious consequences.

The essential principles applicable to restrictive covenants

It is important to first of all distinguish between the tests for the validity of restrictive clauses agreed to by a shareholder and those agreed to by an employee. Because of the balance of power in favour of the employer, limits on a former employee’s freedom to compete will be subject to more rigorous scrutiny and must be less restrictive.

As one might expect, a minority shareholder will benefit from the same degree of legal protection as a former employee, due to the inequality of bargaining power inherent in the situation.

Thus, when dealing with a minority shareholder, the drafter of a non-compete and non-solicitation clause must exercise greater restraint when defining the territorial scope, duration and activities targeted by the restriction. This concern for the protection for minority shareholders can be best seen in the limits on duration of the restriction on targeted activities, which generally range from a few months to no more than two years.

If the parties are negotiating on an equal footing, however, the restrictive clause will be valid if it is reasonably necessary to protect the legitimate interests of the party for whose benefit it was drafted¹.

Including the non-compete and non-solicitation covenant in a comprehensive agreement rather than drafting it as a single, stand-alone undertaking will often allow the reality of the parties’ situation to be more apparent. This can make all the difference when the restrictive clause is contested.

It is also worth mentioning that from a tax standpoint, a stand-alone undertaking may have adverse consequences for its intended beneficiary.

The key to success: a balancing act

The reasonableness of restrictive clauses will depend on the result of an overall examination of the balance between the right of one of the parties to earn a living, and the protection of the legitimate interests of the party in whose favour the restriction was granted.

The key question: what are the legitimate interests of the beneficiary of the restrictions?

This question, which is at the heart of the analysis of the reasonableness of non-compete and non-solicitation clauses, will be determinative of the outcome. 

Generally speaking, the following will be taken into account when it comes to identifying the legitimate interests of the beneficiary: 

• The relevant activities of the company are those that it actively carries on in doing business, i.e. those that allow it to generate revenue. Consequently, neither contemplated future activities nor business opportunities will be taken into account.
• The territorial scope will generally be limited to the area where the company currently carries on business.
• The duration will usually be from two to five years.

As the analysis is an overall one, the Courts tend to consider that the greater the number of prohibited activities and the wider the scope of the territory involved, the shorter the duration will be, and vice versa².

As far as clauses on restrictions on business activities are concerned, the powers of the Courts are effectively limited to determining whether or not they are reasonable. Thus, if the clause under scrutiny is found to be unreasonable, it will be deemed invalid and unenforceable, and incapable of being reduced or corrected.

The upstream analysis of the actual circumstances of the company involved and the legitimate interests of the beneficiary of this type of clause will therefore be of crucial importance.

The penalty clause: dissuasion and sanction

One dissuasive tool that frequently accompanies such restrictions on doing business is the penal clause. Such a clause generally provides that the person undertaking the non-compete and non-solicitation obligations also undertakes to pay a specified lump sum as a predetermined penalty in the event of a breach, without prejudice to any other rights and recourses the beneficiary may have under applicable law.

The purpose of this type of clause is to spare the beneficiary the burden of having to prove the amount of damages it suffered as a result of the prohibited competition or solicitation.

But be forewarned: this doesn’t mean the beneficiary will automatically get a judgment for the specified amount, as proof of the breach of the non-compete or non-solicitation covenant will be required in each case.

In addition to denying that any breach occurred, the defendant can also argue, in the alternative, that no damages were suffered. If the defendant succeeds in convincing the Court that no damages flowed from its breach of the covenant, the penalty clause will not apply.

Thus, while the beneficiary may be dispensed from having to prove the full extent of the damages sustained, it nonetheless must establish that damage was in fact suffered.

It should be mentioned that are cases holding that the penalty clause applies even though the beneficiary may not have suffered any damage³.

The amount of the penalty is no exception to the proportionality rule

The Courts can also look into the reasonableness of the amount stipulated in a penalty clause. And, contrary to what applies to the non-compete or non-solicitation covenant itself, the amount of the penalty may be reduced if the clause in which it is stipulated is considered abusive.

The case law shows that a penalty clause may be ruled abusive, particularly where there is a disproportion between the amount and the importance of the obligation meant to be enforced thereby, or where the penalty is disproportionate to the damage actually suffered.

And while a monetary penalty is the most common, additional penalties, such as the obligation to automatically tender one’s shares for sale to the other shareholders, can be combined with a monetary penalty.

Here again, disproportion is to be avoided, and the key is a thorough understanding of what needs to be protected.

A reasonable penal clause can prove to be an important dissuasive measure that in most cases will spare the beneficiary the need to resort to the full legal arsenal at its disposal. Bear in mind however that a little restraint will go a long way in helping the intended beneficiary protect its rights.

In conjunction with your company’s management, our business law team can take stock of your company’s true need for this type of protection and prepare any restrictive clauses that may be required.

If you would like additional information on the foregoing, or have questions concerning any legal issue involving your business, please contact a member of our business law group at your convenience.