Economic Disincentives to Compete Found to be Restraints of Trade

The B.C. Court of Appeal’ decision last year in Rhebergen v. Creston Veterinary Clinic, 2014 BCCA 97, is both a win and a loss for employers seeking to restrain employees from competing with them post-employment. In both instances, the decision will have long-reaching effects over employer’s strategies to implement effective restraints and the courts’ decisions on enforceability.

In this, the first of two articles, I will review the Rhebergen’s implications for the use of economic disincentives to compete (as opposed to outright prohibitions). Next week, I will review the Court’s approach to addressing whether a restrictive covenant is ambiguous and therefore unenforceable.

The Facts

The Respondents operated a veterinary clinic in the Creston Valley. The primary business consisted of servicing eight dairy farms in the immediate vicinity. There were no other such clinics within B.C. within a 100-mile radius.

The Appellant graduated from veterinary college and obtained her license. In order to gain practical experience, she applied for work at the clinic and entered in to a three-year “Associate Agreement” under which she was paid $65,000 per year.

The agreement set out particular financial consequences should the Appellant set up a competing practice within three years of the termination of the Agreement. The relevant provisions stated:

  2. The Associate acknowledges and agrees that she will gain knowledge of and a close working relationship with the CVC’s [Creston Veterinary Clinic Ltd.’s] patients and clients which would injure CVC if made available to a competitor or used for competitive purposes.
  3. The Associate covenants and agrees that in consideration of the investment in her training and the transfer of goodwill by CVC, if at the termination of this contract with CVC she sets up a veterinary practice in Creston, BC or within a twenty-five (25) mile radius in British Columbia of CVC’s place of business in Creston, BC, she will pay CVC the following amounts:

If her practice is set up within one (1) year termination of this contract – $150,000.00;

If her practice is set up within two (2) years termination of this contract – $120,000.00;

If her practice is set up within three (3) years termination of this contract – $90,000.00.

* * *

  2. CVC agrees not to terminate this agreement during the term hereof except for just cause as hereinafter defined.
  3. The Associate cannot terminate this agreement prior to the expiry of the term, except for death, permanent disability preventing the Associate from continuing to practice veterinary medicine, or default of this agreement by the CVC….

The two principals of the clinic calculated the amount to be paid if the Appellant were to set up a practice within 25 miles of Creston based primarily on their experience in hiring a former associate. They took into account the recoverable and unrecoverable investment made in mentoring, training and equipment and the impact on the clinic’s good will and business if she were to compete for its clientele.

Differences arose between the parties and after 14 months Rhebergen advised she was terminating the agreement and would no longer work for it, whereupon the clinic told her she had no right to terminate the agreement and then proceeded to terminate her employment for cause. Five months later, Rhebergen gave notice that she intended to set up a mobile dairy practice and commenced proceedings seeking to have the section requiring a payment to the clinic declared unenforceable.

Economic Disincentives Considered to be a Restraint of Trade

The trial judge, relying on  Shafron v. KRG Insurance Brokers (Western) Inc., 2009 SCC 6 (CanLII), held the clause to be in restraint of trade and unenforceable on several grounds.

At the Court of Appeal, the panel first deal with the issue of whether section 11, not being an outright prohibition on competition, was nonetheless a restraint of trade and therefore unenforceable if unreasonable. The Court noted there are two strands of authority as to whether a clause that creates financial consequences arising from competition, but does not outright prohibit competition, is a restraint:

…there appears to be essentially two strands of authority in the employment context: first, what one may call a ‘functional’ approach, which asks whether the clause at issue attempts to, or effectively does, restrain trade, in which case it will be captured by the doctrine and subjected to reasonableness scrutiny; and second, a more ‘formalist’ approach, in which the clause must be structured as a prohibition against competition to constitute a ‘restraint’.  On the latter approach, mere disincentives to post-employment competition are not sufficient to trigger the doctrine, even if those disincentives operate as effectively at dissuading competitive conduct and participation in the marketplace as a prohibition.

(at para. 28)

Lowry, J.A.,  after reviewing case law in the U.K.,  B.C. and Ontario, held:

 the functionalist approach established in English law is to be preferred as the legal basis for determining whether clauses that burden employees with financial consequences, whether by payment or forfeiture, they would not otherwise have for engaging in post-employment completion constitute a restraint of trade….it is a matter of the effect of the clause in practice over its form.

(at para. 42)

The Court’s decision to adopt the functionalist approach aligns British Columbia with the reasoning of the Ontario Superior Court in Levinsky v. The Toronto-Dominion Bank, 2013 ONSC 5657. Clauses that impose financial consequences for competing post-resignation, such as the “claw-back” of exercised stock options, will only be enforceable if they can be said to be reasonable.

By contrast, in an earlier decision of the Ontario Superior Court, Nortel Networks Corp. v Jervis, 2002 CanLII 49617, the departing employee was sued under a “claw-back clause” which required re-payment of market gains from exercised stock options if he went to work for a competitor within 12 months of exercising the options. The Ontario court held that as Jervis “was not precluded from going elsewhere or from doing whatever he chose to do”, the clause was not a restraint of trade.

Going back to Rhebergen, if “permissive” clauses that allow competition but demand a price constitute restraints of trade, how will they be assessed for reasonableness? Lowry J.A., on behalf of the Court, suggests the amount to be paid, or the amount forfeited “may have to be considered as an element of the fairness of a non-competition clause of that kind.”

Should that be the case, employers will need to carefully weigh the amount of money being forfeited or required to be repaid when insisting on financial consequences if a key employee competes after resigning. While the law of penalties has no application to payments upon the occurrence of an event, i.e. competition, extravagant or unconscionable requirements may cause a court to consider such clauses to be nonetheless unfair and hence unenforceable.

Is Forfeiture of a Bonus for Resigning a Restraint of Trade?

Does the forfeiture of a bonus for leaving an employer constitute a restraint of trade?

This question was recently put to the Ontario Supreme Court of Justice in Levinsky v. TD Bank, 2012 ONSC 5110. The Court’s ultimate response may encourage more employers to require forfeiture or repayment of bonuses to incent employee loyalty as opposed to the use of non-compete clauses.

Enforcement of non-compete clauses in Canada is notoriously difficult. The courts begin from the proposition that the public has an important interest in every person carrying out his or her trade freely, as does the individual. All restrictive covenants are deemed to be restraints of trade, and, without more, are void. An employer, therefore, has the onus of establishing that a non-compete clause is necessary to protect is legitimate proprietary interest.

But what constitutes a restraint of trade? In Levinsky, the applicant contended that a term within a restricted share unit plan that caused him to forfeit $1.75 million in bonuses when he resigned constitutes a restraint of trade and should not be enforced. The plan provides that RSUs do not “fully vest” until three years after they have been allocated and that an employee forfeits his unvested RSUs if he resigns before this date.

(While not stated in the decision, according to the website of Mr. Levinsky’s current firm, he was previously employed by the bank in investment management and, after resigning, co-founded his own investment management firm. I should also note that the opening paragraph of the decision states that the amount at issue is only $174,708, which appears to be a typographical error, as the decision later refers to $1,750,000 being at issue.)

TD Bank argued that the purpose of the plan is to provide “additional” compensation to create “incentives” for employee retention.

Mr. Levinsky proceeded by way of an application instead of by trial. The Court found that he had not provided the appropriate evidence for the court to determine whether or not the provision in dispute is in restraint of trade and, if so, is justifiable, and therefore remitted the matter to the trial list.

While much will obviously depend on the evidence put before the court at trial, prior decisions suggest the court will adopt a more relaxed approach toward enforcement of the forfeiture clause than it would to a non-compete clause.

Indeed, there is considerable question whether the forfeiture clause will be determined to be a restraint of trade at all. In Nortel Networks Corp. v. Jervis, 2002 CanLII 49617 (ON SC), an Ontario Court ordered the defendant, a former Nortel employee, to pay the company more than $625,000 in stock option profits after he joined a competitor.

The terms of the stock option plan stipulated that if, within 12 months (later extended to 24 months) of exercising a stock option, the employee left to join a competitor, Nortel reserved the right to require repayment of the gain.

Jervis exercised options, realized a profit of more than $625,000 and within 12 months left to join a competitor. Nortel sought repayment of the gain.

The court held that this form of clawback provision was not a restraint of trade. Relying on a 1941 decision of the Ontario Court of Appeal in Inglis v. Great West Life Assurance Co., [1941] O.R. 305 (C.A.), the court held that “Where a former employee is required to forego a benefit if he or she chooses to compete, that is not a restraint of trade.” (at para. 29)

Since its release in 2002, Nortel has not received much judicial consideration. Its underlying premise, however, that the foregoing of a benefit if someone chooses to compete is not a restraint of trade, makes good sense. In Levinsky, the particular clause in question in the RSU plan does not even appear to tie the loss of the bonus to competition – the forfeiture takes place merely upon resignation. TD Bank’s argument that the provision is meant to create incentives to promotion employee retention (and not a restraint of trade) is persuasive.

Should Levinksy be decided by the trial court, the decision may provide further support for the use of forfeiture or clawback provisions as an alternative to the use of non-compete clauses.

(Some of the analysis for this argument is taken from an article I wrote, “Protecting Employers from Departing Employees: Alternatives to the Use of Restrictive Covenants”, published in The Advocate, vol. 64, part 1, January 2006, p. 79.)