5. Enforceability of Financial Consequences for Competitive Activity

Restrictive Covenants - Detailed Analysis

Last Updated: October 2022

5. Enforceability of Financial Consequences for Competitive Activity

Where a clause imposes a financial consequence for competitive activity, whether by way of a required payment or forfeiture of a benefit, the court may be called upon to determine whether that consequence, also known as a stipulated remedy, is enforceable. The initial question is whether the financial consequence arises by reason of a breach of a covenant, i.e. a prohibition on competitive activity, or instead amounts to a forfeiture of a benefit caused by the occurrence of competitive activity which is not prohibited but that attracts financial consequences.

(a) Breach of a Covenant that Attracts Financial Consequences

Where the financial consequence arises by reason of a breach of a covenant, i.e. a prohibition on some form of competitive activity, the court, regardless of whether it is in a jurisdiction that follows the formalist or functionalist approach, may be called upon to determine whether that consequence is a penalty and, if so, whether it is enforceable. The word “may” is used because the court may first decide that the prohibition on competitive activity is not enforceable under the usual tests and determine it therefore need not assess the enforceability of the financial consequence.

If it is determined the prohibition on competitive activity is reasonable, then the court often will be asked by the litigants to assess the enforceability of the financial consequence. See the further discussion below in this section under “Judicial Approach to Stipulated Remedy Clauses.”

(b) Competitive Activity Which is Not Prohibited but Attracts Financial Consequences

Where there is a forfeiture of a benefit cause by the occurrence of competitive activity which is not prohibited but which attracts financial consequences, it must be determined whether the courts in that jurisdiction follow the formalist approach as opposed to the functionalist approach (see Section 5 above, “Is the Clause in Restraint of Trade?”). Where they follow the formalist approach (such as in Ontario), the courts will not apply the tests applicable to restrictive covenants, since there is no actual restriction on competitive activity.¹ Rather, the court will only consider whether the clause imposing the financial consequence is enforceable.

On the other hand, where the forfeiture of a benefit takes place in a jurisdiction that follows the functionalist approach (such as in British Columbia), then the court will assess the clause as a restrictive covenant, as the law in those jurisdictions views such clauses as having the effect of restricting competition.² It may also assess the enforceability of the financial consequence if that is necessary to the case.

(c) Judicial Approach to Stipulated Remedy Clauses

As is seen in the discussion above, a court may need to determine the enforceability of a financial consequence arising from a breach of prohibition on competitive activity if it finds that the prohibition itself is reasonable as a restraint of trade.

In the case of a financial consequence arising from competitive activity that is not actually prohibited, the courts in jurisdictions following the formalist approach (such as Ontario) will necessarily assess whether the clause is enforceable, since they do not deem such clauses as in restraint of trade and therefore do not apply the tests applicable to restrictive covenants. Courts following the functionalist approach (such as British Columbia), may also assess whether the financial consequence is enforceable, but may not if they determine first that the clause – which they view as being in restraint of trade – is not enforceable based on the tests applicable to restrictive covenants.¹

Once the court determines it needs to address the enforceability of the financial consequence, also known as a stipulated remedy clause, then the approach used in Canadian common law jurisdictions is quite similar.

Where the clause at issue provides for payment in the event of a breach of a prohibition on some form of competition (a non-compete or non-solicit clause), the inquiry will turn to whether the clause amounts to a penalty and, if so, whether it should nonetheless be enforced. If the clause requires the withholding of a payment or a “clawback” of equity or a bonus already paid, it may be seen as a “forfeiture clause” because it involves “the loss, by reason of some specified conduct, of a right, property, or money.” Such clauses may also have “penal consequences as the right or property forfeited by the defaulting party may bear no relation to the loss suffered by the innocent party.”²

The Ontario Court of Appeal reviewed the historical treatment of stipulated remedy clauses in Peachtree II Associates – Dallas L.P. v. 857486 Ontario Ltd., noting that attempts to enforce payment of sums for breach of contract historically were dealt with by the common law, which decided whether the sum at issue amounted to a penalty, while courts of equity addressed whether a forfeiture clause had penal consequences. The court noted that we are still dealing today with issues arising from these differing streams, but articulated an approach to bring the law with respect to stipulated remedy clauses more in line with the approach adopted by equity as opposed to the common law.³

The court explained the lingering different treatment of penalty clauses as opposed to forfeiture clauses that have penal consequences:

[23] There is a venerable common law rule to the effect that the courts will not require a party to pay a genuine or true penalty on grounds of public policy. The parallel, but distinctive, equitable rule is to the effect that penal forfeitures will be relieved against where their enforcement would be inequitable and unconscionable.

[24] While both doctrines have the effect of relieving the breaching party of the penal consequences of stipulated remedy clauses, in their traditional formulations they bear significant differences. The common law penalty rule involves an assessment of the stipulated remedy clause only at the time the contract is formed. If the stipulated remedy represents a genuine attempt to estimate the damages the innocent party would suffer in the event of a breach, it will be enforced. On the other hand, again to quote Lord Dunedin from Dunlop, supra, “[i]t will be held to be a penalty if the sum stipulated for is extravagant and unconscionable in amount in comparison with the greatest loss that could be conceivably be proved to have followed from the breach”. Laskin C.J.C. adopted a virtually identical formulation (taken from Snell’s Principles of Equity, 27th ed. (London: Sweet & Maxwell, 1973) at p. 535) in H.F. Clarke Ltd. v. Thermidore Corp. Ltd., 1974 CanLII 30 (SCC), [1976] 1 S.C.R. 319, 54 D.L.R. (3d) 385, at p. 338 S.C.R. Although the common law defined penalties in terms of unconscionability, that assessment is to be made at the time the contract was formed. The common law doctrine did not include any discretion to be exercised in the light of circumstances that may exist at the time of breach.

[25] Equity, on the other hand, considers the enforceability of forfeitures at the time of breach rather than at the time the contract was entered. Equity also looks beyond the question of whether or not the stipulated remedy has penal consequences to consider whether it is unconscionable for the innocent party to retain the right, property, or money forfeited. As explained by Denning L.J. in Stockloser v. Johnson, [1954] 1 All E.R. 630, [1954] 1 Q.B. 476 (C.A.), at p. 638 All E.R.: “Two things are necessary: first, the forfeiture clause must be of a penal nature, in the sense that the sum forfeited must be out of all proportion to the damage; and, secondly, it must be unconscionable for the seller to retain the money.”⁴

Despite these historical differences, the court endorsed an approach which, as far as possible, assimilates the assessment of both types of clauses under unconscionability and does not extend the strict rule of common law that refuses to enforce penalty clauses. While not explicitly stated, one presumes the assessment of unconscionability in the case of both types of clauses is to be made at the time of invocation of the clause. That has always been equity’s approach to forfeiture clauses and the court seems to be suggesting it should be the approach with clauses that may amount to a penalty. (That was the approach articulated by the BC Court of Appeal in Maxam Opportunities Fund v. Greenscape Capital Group Inc., as discussed further below.)

The court in Peachtree noted that:

Unconscionability is also the direction suggested by the dictum of Dickson J. in Elsley v. J.G. Collins Insurance Agencies Ltd., 1978 CanLII 7 (SCC), [1978] 2 S.C.R. 916, 83 D.L.R. (3d) 1, at p. 937 S.C.R.: “It is now evident that the power to strike down a penalty clause is a blatant interference with freedom of contract and is designed for the sole purpose of providing relief against oppression for the party having to pay the stipulated sum.”⁵

The court also noted that section 98 of Ontario’s Courts of Justice Act appears to direct an inquiry to unconscionability, given it provides courts discretion to relieve “against penalties and forfeitures, on such terms as to compensation or otherwise, as are considered just.”⁶

Relying on section 21 of British Columbia’s Law and Equity Act, the courts in that province have developed a similar approach to determining whether relief should be granted against penalties. The analysis also turns, ultimately, on unconscionability, to be assessed as of the date of the invocation of the clause. The BC Court of Appeal, in Maxam Opportunities Fund v. Greenscape Capital Group Inc., described the approach as follows:

[53] This court has ruled that the following approach is to be taken to payments that are stipulated to be payable on a breach of contract: … where the issue is whether a contractual clause is for liquidated damages or is a penalty: 1. The question of “penalty” or “liquidated damages” is to be answered as at the date of the making of the agreement; 2. If the answer is “liquidated damages”, that is the end of the matter, but, if the answer is “penalty”; then, 3. There arises the next question: should relief be granted against the penalty? 4. The answer to that question depends upon whether to enforce the penalty would be unconscionable, and that unconscionability has to be determined at the date of the invocation of the clause. 5. Sec. 21 [now s. 24] of The Law and Equity Act only applies if and when stage 3 has been reached.⁷

In Rhebergen v. Creston Veterinary Clinic, 2014 BCCA 97, the majority upheld the clause at issue, which required payment of an amount in the event of competition, both on the basis that the clause was reasonable and on the basis that the amount to be paid could not be said to be “extravagant and unconscionable.” See para. 50.
Peachtree II Associates – Dallas L.P. v. 857486 Ontario Ltd., 2005 CanLII 23216 (ONCA), at para. 22.
Peachtree II Associates – Dallas L.P. v. 857486 Ontario Ltd., 2005 CanLII 23216 (ONCA).
Peachtree II Associates – Dallas L.P. v. 857486 Ontario Ltd., 2005 CanLII 23216 (ONCA), at paras. 23-25.
Peachtree II Associates – Dallas L.P. v. 857486 Ontario Ltd., 2005 CanLII 23216 (ONCA), at paras. 29, 31.
Peachtree II Associates – Dallas L.P. v. 857486 Ontario Ltd., 2005 CanLII 23216 (ONCA), at paras. 32.
Maxam Opportunities Fund v. Greenscape Capital Group Inc., 2013 BCCA 460, at para. 54.

(d) Application of Judicial Approach to Stipulated Remedy Clauses in the Context of Departing Employees

The BC Court of Appeal held that a clause which required payment of $150,000 if a veterinarian set up a practice within 25 miles of her employer’s place of business could not be said to be “extravagant and unconscionable” as the amount represented her employer’s calculations of its unrecoverable mentoring, training and equipment costs if she were to leave within a certain period of time and the impact on the clinic’s goodwill and volume of business if she was to compete within a year of leaving.¹

An optometrist who departed a clinic to establish her own clinic had signed an agreement under which she was obligated to transfer patient files to her employer and was subject to a $100 fine for each patient file she did not transfer. She was also subject to a payment of up to $250,000 in liquidated damages for breach of non-competition or non-solicitation covenants or for breach of the requirement to transfer patient files. The court found it “extravagant and unconscionable” that a single breach of the requirement to transfer patient files would result in a $100 payment but also expose the optometrist to a claim for $250,000 in damages. It concluded that the latter provided for a penalty and not liquidated damages. The court held that it had not been presented with enough evidence, however, to determine whether relief should be granted against the penalty.²

The question of whether relief should be granted against a penalty clause attached to a restraint of trade, it is suggested, is put in doubt by the Supreme Court of Canada’s decision in Shafron.

The Court in Shafron refused to apply the doctrine of notional severance to a restrictive covenant, as its application would:

Invite the employer to impose an unreasonable restrictive covenant on the employee with the only sanction being that if the covenant is found to be unreasonable, the court will still enforce it to the extent of what might validly have been agreed to.

Not only would the use of notional severance change the terms of the covenant from the parties’ initial agreement to what the court thinks they should have agreed to, it would also change the risks assumed by the parties. The restrictive covenant is sought by the employer. The obligation is on the employee. Having regard to the generally accepted imbalance of power between employers and employees, to introduce the doctrine of notional severance to read down an unreasonable restrictive covenant to what is reasonable provides no inducement to an employer to ensure the reasonableness of the covenant and inappropriately increases the risk that the employee will be forced to abide by an unreasonable covenant.”³

Similarly, it is submitted that if a financial consequence attached to a restraint of trade is found to be a penalty, the courts should not impose a lesser financial consequence in accordance with what the evidence shows would be appropriate or reasonable. Doing so would engage all of the dangers the court in Shafron warned against in that employers would be invited to draft clauses imposing significant penalties in an effort to dissuade competition.

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Restrictive Covenants - Detailed Analysis