Restrictive Covenants - Detailed Analysis
Last Updated: October 2022
4. Is the Clause in Restraint of Trade?
A threshold issue may arise as to whether a clause is properly characterized as a restraint of trade and therefore subject to the usual analysis. This issue often arises where a clause requires an employee to forfeit an economic benefit such as a stock option or repay a bonus if the employee competes with the employer, but does not outright prohibit such activity.
The BC and Ontario courts have diverged as to whether to adopt the “functionalist approach” as opposed to the “formalist” approach to such clauses, with the BC Court of Appeal characterizing the two approaches as follows:
…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.1
The BC Court of Appeal adopted the functionalist approach in Rhebergen. There, a clause which required a veterinarian to make a payment to her employer “in consideration of the investment in her training and the transfer of goodwill (by her employer)” if she set up a veterinary practice within a certain distance after termination of the contract was held to be a restraint of trade, even though it did not outright prohibit competition. The court stated that the payment “compromises the opportunity to compete with the clinic” that the defendant otherwise would have had.2
The court’s decision to adopt the functionalist approach means that, in British Columbia, clauses that impose financial consequences for competing post-resignation, such as a “claw-back” of exercised stock options, will only be enforceable if they can be said to be reasonable.
Alberta courts, applying Rhebergen, have applied the functionalist approach. In one decision, a court found a covenant essentially constituted a “license fee to compete”, rejecting the argument that the clause permitted the Defendants to freely compete. This argument, it held, “fails the ‘duck test’: ‘If it looks like a duck, swims like a duck, and quacks like a duck, then it probably is a duck’. Here, the paragraph in question looks, swims and quacks like a restrictive covenant.”3
A decision by the Ontario Superior Court in Levinsky v. The Toronto-Dominion Bank 4suggests Ontario may move toward the functionalist approach, but for now the prevailing law follows the formalist approach.
In Levinsky, a managing director of TD Securities received restricted share units as part of his compensation, which cliff-vested after three years, i.e. they did not mature until three years after grant, as opposed to other plans under which RSUs vest on a three-year rolling basis. The plan also provided for immediate forfeiture of unvested RSUs upon resignation. Levinsky resigned and contended that the forfeiture provisions amounted to a restraint of trade, as their intent was to discourage employees from working for a competitor.
The court rejected that argument, finding, based on the terms of the plan and other evidence, that the plan was designed to incent employee loyalty. As forfeiture was not tied to working for a competitor, the clause at issue did not operate as a restraint of trade.
In arriving at this conclusion, the court summarized the law as follows:
I conclude that in examining a clause in an employment contract which operates to forfeit deferred compensation upon or following the cessation of the contract, a court must assess whether the clause, on its face or in its practical operation, ties the forfeiture of compensation to the event of termination or whether it ties it to the employee’s conduct following the end of his employment. If the forfeiture results simply from the cessation of the employee’s service, without more, the clause does not operate in restraint of trade because it does not fetter the employee’s ability to choose where he or she wants to work next.5
Notably, the court did not go the next step and hold that if the forfeiture arises because of competitive activity post termination, it does operate as a restraint of trade. It is submitted it could not do so because of binding authority from a 1946 decision of the Ontario Court of Appeal, Inglis v. The Great West Life Assurance Co.6
In Inglis, the contract between an insurer and insurance sales agent stated that, on termination, the company would continue to pay the agent commissions on policies written during the agreement to which the agent would have become entitled if the agreement was still in force. However, if the agent, after termination of the contract, did business directly or indirectly for any other life insurance company, he would forfeit and waive any claim to such commissions.
The court held that, as the employee was not precluded from working anywhere else (such as in a non-competition covenant), there was no restraint of trade.
Ontario’s formalist approach is also evident in a decision of the Ontario Superior Court, Nortel Networks Corp. v Jervis,7 where 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. In another earlier decision, the same court held that the payment of a monthly retirement benefit which would cease if the retired employee competed also was not in restraint of trade, though the court also went on to assess whether the clause was unreasonable or contrary to the public interest.8
The court in Levinsky focused its decision on the fact that the employee’s forfeiture of compensation was not tied to post-employment competition, and hence there was no restraint of trade. The logical extension of such a finding is that if the forfeiture had been tied to competition, it would have been considered a restraint of trade. To say so, however, would have conflicted with binding authority of the Court of Appeal in Inglis.
It does appear, however, that the Court in Levinsky, after an extensive review of authorities from around the globe, preferred the functionalist view, a point recognized by the BC Court of Appeal in Rhebergen.9 One hopes that the Ontario Court of Appeal will soon have an opportunity to decide whether the functionalist approach is to become the law in that jurisdiction or whether it will maintain the formalist approach set out in Inglis.
In an older case, Cameron v. Canadian Factors Corp.,10 the Supreme Court of Canada considered the enforceability of clauses under which the defendant agreed not to solicit or compete for five years and to pay $10,000 if he did. The court held the clauses were unreasonable, applying a restraint of trade analysis under Quebec civil law (and citing similar common law authority). Unfortunately, the court did not consider the formalist vs. functionalist approach to interpreting such clauses.
Where a clause made annual payments to a former business partner for his shares contingent on him continuing to act as a fiduciary, the BC Court of Appeal was prepared to apply the doctrine of restraint of trade as it did not matter to the outcome, but left often the question as to whether the clause actually was a restraint of trade.11 In light of Rhebergen, it is suggested that if the same question came before the court today, it would find such a clause to be a restraint of trade.
- Rhebergen v. Creston Veterinary Clinic, 2014 BCCA 97, at para. 28.
- Rhebergen v. Creston Veterinary Clinic, 2014 BCCA 97 at para. 43. Earlier authority at the BC Supreme Court level had followed the formalist approach. See Canaccord Capital Corp. v. Clough, 1999 CanLII 5286 (BCSC).
- Jones v Gerosa, 2016 ABQB 207, at paras. 178-194. See also MHK Insurance Inc v Wass, 2021 ABQB 721, though, curiously, the court there stated the covenant “does not restrain trade but permits it at a price” at para. 3. It nonetheless then considered enforceability based on the functionalist approach.
- Levinsky v. The Toronto-Dominion Bank, 2013 ONSC 5657.
- Levinsky v. The Toronto-Dominion Bank, 2013 ONSC 5657, at para. 81.
- Inglis v. The Great West Life Assurance Co., 1941 CanLII 85 (ONCA).
- Nortel Networks v. Jervis, 2002 CanLII 49617 (ONSC).
- Woodward v. Stelco Inc., 1996 CanLII 8180 (ONSC), at para. 60, aff’d 1998 CanLII 17686 (ONCA), though the Court of Appeal found it unnecessary to consider whether the clause was in restraint of trade, since the trial judge’s finding that it was neither unreasonable nor against the public interest was well supported by the evidence.
- Rhebergen v. Creston Veterinary Clinic, 2014 BCCA 97 at para. 38.
- Cameron v. Canadian Factors Corp. Ltd.,  SCR 148, 1970 CanLII 163 (SCC)
- Burgess v. Indust. Frictions & Supply Co., 1987 CanLII 2722 (BCCA), at para. 24.