THE CANADIAN INSTITUTE'S CONFERENCE

EMPLOYMENT IN THE INFORMATION AGE: A LEGAL GUIDE FOR EMPLOYERS
OF KNOWLEDGE AND HIGH TECH WORKERS

Monday, January 29 and Tuesday, January 30, 2001

Restrictive Covenants: The Employer's Golden Handcuffs

by

Brian A. Grosman, Q.C. and
Natalie C. MacDonald

Introduction

Enter the Internet: a global super-network of over 15.000 computer networks used by over 30 million individuals, corporations, organizations and educational institutions worldwide... The Internet makes it possible to conduct business throughout the world entirely from a desktop.¹

We live in a technological, interconnected, information driven society. Today, with the simple click of a button, the Internet enables information to flow instantly knowing no time or geographic boundaries. Technology has revolutionized the way in which we conduct business. E-mail, cellular phones, voice mail and pagers have dramatically Increased the number of hours we work, making us available 24 hours a day, 7 days a week. Due to the fact that work has become so all-encompassing, this technological revolution has also had a significant effect on the work ethic. Employees have re-prioritized their goats, finding satisfactory work and building a career to be today's primary concerns. Technology has also enabled individuals to become self-employed, No longer do corporate employers have traditional employees, loyal and dedicated to their corporate employer, until retirement. Today, corporate employees are in many ways independent contractors. These new age employees will change jobs seven to eight times within their career. The Internet Serves to facilitate that process.

Driven by speed and globalization, this new economy is intensely dependent on information and knowledge as the source of competitive advantage. Corporate employers are threatened more than ever with the cost of losing key information via departing or disloyal employees. In an effort to prevent such loss, corporate employers traditionally use restrictive covenants to maintain key information and to restrict competitive activities of departing employees. The usual remedy for breach of restrictive covenants is an injunction. Most often an injunction is obtained after the information has already been transferred. The consequences to the corporation can be devastating since special information may be the corporation's primary asset. The threat of a lawsuit does not deter determined key employees from breaching such agreements, as demonstrated by the number of cases before the courts. The legal tools that were apparently successful in the past no longer seem adequate to stem the tide of information loss in an Internet-based economy that encourages information sharing and provides the tools to move specialized information, confidential or not, at warp speed.

The History of the Restrictive Covenant

In employment contracts, restrictive covenants usually take the form of non-solicitation clauses, non-competition clauses or confidentiality clauses. Non-solicitation clauses prevent the employee from soliciting either employees or customers of the employer for a fixed term. Non-competition clauses restrict the employee's ability to compete or assist others to compete for a fixed term. Confidentiality clauses are used by employers in an attempt to protect goodwill, trade secrets, formulas, software programmes and similar confidential information from leaving the company and thereby causing significant damage,

The leading case in respect of restrictive covenants is Nordenfelt v. Maxim Nordenfelt Guns & Ammunition Co.  [1894] A.C. 535 at p. 552 (H.L.). In Nordenfelt, Lord Watson stated:

The public have an interest in every person's carrying on his trade freely: so has the individual. All interference with individual liberty of action in trading, and all restraints of trade of themselves, if there is nothing more, are contrary to public policy, and therefore, void. That is the general rule, But, there are exceptions; restraints of trade and interference with individual liberty of action may be justified by the special circumstances of a particular case. It is a sufficient justification, and indeed it is the only justification, if the restriction is reasonable - reasonable, that is, in reference to the interests of the parties concerned and reasonable in reference to the interests of the public, so framed and so guarded as to afford adequate protection to the part in whose favour it is imposed, while at the same time it is In no way injurious to the public.

The criteria set out in Nordenfelt was addressed by the Supreme Court of Canada in JG Collins insurance Agencies v. Elsley, (1978) 83 D.L.R. (3d) 1 at p. 5 (S.C.C.). Former Chief Justice Brian Dickson set out that "the test of reasonableness can be applied however, only in the peculiar circumstances of the particular case. Circumstances are of infinite variety. Other cases may help In enunciating broad general principles but are otherwise of little assistance".

In any analysis of a restrictive covenant, a court will begin with the premise that a restrictive covenant between an employer and employee which ~s a restraint of trade is prima facie void or unenforceable. A restrictive covenant in an employment contract will not be enforced unless it is justified. The onus is on the employer to prove that it is justified. To do so, the employer must prove that the restrictive covenant is reasonable. And, the covenant must be found by the court to be reasonable in relation to the following factors:

Assessing the reasonableness of a restrictive covenant is largely a matter of balancing the right of the employer to protect its business interests from harm against the right of the former employee from earning a living in her chosen field. In Canada, courts have taken the position that most non-competition restrictive covenants are in restraint of trade and contrary to the public interest. If a restrictive covenant is to be enforced, it must be reasonable, promote an interest worthy of protection, and must go no further than protecting the employer's legitimate interest. Again, that legitimate interest must be restricted in terms of geography, time, and scope of activities that it prohibits.

Generally, the courts will not enforce a non-competition clause if a non-solicitation clause will adequately protect the employer's Interest. The Ontario Court of Appeal's recent case of Lyons v. MultAri, (2000) 50 O.R. (3d) is a testament to this proposition- In Lyons, the plaintiff and defendant were both oral surgeons. The plaintiff had practiced in the same city for almost 25 years and was looking for a new associate He and the defendant decided to work together, They signed a handwritten contract containing a non-competition clause. The clause stated, in Its entirety, "Protective covenant, 3 yrs-5 mi". The defendant worked for the plaintiff for 17 months. He gave six months notice that he was leaving pursuant to the employment agreement. Six months later, he and another dentist opened an oral surgery practice in the same city. That practice contravened the 3 years / 5 mile restriction in the non-competition clause. The plaintiff brought an action against the defendant for damages for breach of contract.

At trial, the judge upheld the restrictive covenant, holding that it was not overbroad and did not restrict competition generally. On appeal the Ontario Court of Appeal held that the clause was too broad and could not be enforced on the basis that it was required to protect confidential information, as the defendant did not take any confidential information.

Rather, the court stated that the plaintiffs legitimate interest could have been adequately protected with a non-solicitation clause. Referring specifically to Elsley, Mr. Justice MacPherson stated:

"In my view, this is not an exceptional case, Indeed, the Lyons-Multari relationship strikes me as the norm in a professional setting. Accordingly, the non-competition covenant is unenforceable."

In a knowledge-based economy, the loss of a key employee and the knowledge that she has may instantly damage her former corporate employer beyond repair. Accordingly, restrictive covenants are used in an attempt to ensure that the employee does not take key corporate information and enhance her own value by trading it to a new employer engaged in a competitive enterprise. There is a willingness on the part of corporate employers to enforce restrictive covenants by way of injunctive proceedinqs if they are forced to do so Such proceedings send an important political message to like-minded individuals and other corporate employers who may wish to entice away key employees, that their present employer is prepared to take all the steps required to enforce Its rights to limit employee departures to competitors.

Despite the strong message an injunction sends, there are certain drawbacks to this approach. The test that an employer must satisfy in order to obtain an injunction is difficult. The employer must be able to establish the following:

1. There must be a prima fade case of illegality on the employee's part;
   
   
2. The employer must adduce concrete evidence to show that it will suffer irreparable harm unless the injunction is granted immediately;
   
   
3. The degree of harm that the employer would suffer if the injunction were refused must exceed the degree of harm that the employee would suffer if the injunction were granted;
   
   
4. It must be fair and equitable In all circumstances to grant the injunction pending a full trial.²

Additionally, seeking an injunction is expensive. Courts are costly, inefficient, time-consuming and, generally not sympathetic to employers. Even more importantly, by the time the employer gets to court, the information is gone, clicked away with the press of a button, and the damage is done. When an employee is likely to change career paths as frequently as seven to eight times, and when information can be transmitted with the click of a button, it is clear that controls, other than that provided by an injunction prior to trial, are needed. It is becoming more difficult to apply traditional legal remedies to stem activities so central to a high-tech commercial environment

The Hiring Line

In today's new economy, enticement of employees is standard corporate practice. Typically, employees are given signing bonuses or stock options. In an effort to attract specialized employees, many of the dotcom companies in California, other parts of the United States, and in Canada offer young employees inducements such as BMW convertibles, significant signing bonuses, stock options, gym memberships and a wide variety of other incentives in order to sign a potentially key employee. In one Web-consulting and services firm, 'Etensity', located in Vienna, Virginia, the company offers car payments as part of a program called "Hot Wheels". The company also offers $10,000.00 toward a new home in its program called "Raise the Roof"³. Incentives like these have become common as corporate employers attempt to attract and to hold on to key employees.

Long-term vesting of stock options, 'the golden handcuff help to hold employees as long as the options continue to be worth serious money at the time of payout. However, if the employee does decide to jump ship, that employee takes the inducements with him, such as club memberships, automobile or mortgage financing, unless these items are specifically excluded. Without a clause in an employment contract returning the lease to the employer, the employer is left paying the bill. Carefully drafted employment contracts have assumed a role of even greater significance than in the past.

The Employment Contract

It is now in the employers interest to build into the employment contract provisions which secure the commitment of the employee to the term of the arrangement rather than inmate injunctive proceedings after commitment is lost. In executive employment contracts self-triggering' and 'transition agreements' that form part of the employment contract are often used to protect the executive employee on a takeover, merger or sale.

These types of agreements provide employees with a much needed safety net during corporate disruption, reorganization, mergers or sale, Specific provisions guarantee severance payout if certain events negatively impact on the employee's ongoing employment relationship. For example, if his or her reporting relationship is fundamentally altered or job description negatively impacted by change, the employee has the option of notifying his Or her employer that the clause has been triggered and the transition provisions, i,e. severance package, must, under these circumstances, be paid- Such provisions combat the insecurity that might otherwise be felt by an executive employee who may feel that events beyond his control may impact negatively on his future with his employer. Self-triggering and transitional provisions in the contract not only provide security to the potentially vulnerable executive employee but they provide continuity to the corporate employer as the employee Is much less likely to jump ship during a disruptive period if he knows that his personal financial situation remains secure.

Golden Parachutes

Golden parachutes are self-triggering agreements in employment contracts which serve to compensate executives at a time when either the business or the executive's position may not be secure, The well known description of a golden parachute is that it provides a "safe landing" when there is a corporate change in control.

A golden parachute becomes effective on the occurrence of two triggering events. The occurrence of one or both of the triggering events will result in the executive becoming eligible for the compensation set out in the agreement. The first event which activates golden parachutes is a change in control of the employer. An example of a change in control is a change in the board of directors of a company. The second event is a change in control of the employer and a termination of the executive's employment without cause. Once either of these situations occurs, the executive becomes eligible to receive the compensation set out in the golden parachute clause of his employment agreement.

Golden Handcuffs and Pension Top-ups

Similar to the trigger effect in golden parachutes, golden handcuffs are used in executive employment contracts in order to ensure the employee adheres to his agreement. Executive level employment contracts not only contain provisions for a variety of golden handcuffs such as stock options, share participation and backend loaded vesting, but may also contain provisions for retention bonuses and pension top-ups. In certain cases, the pension top-up may be tied to a tough restrictive covenant. Some companies, in order to insert a restrictive covenant during the term of employment, provide pension top-ups as the consideration for the inclusion of a restrictive covenant The argument has been made that a pension top-up does not provide adequate new consideration fur tough restrictive covenants because a pension is earned throughout the currency of employment and the top-up ought not to be made conditional on the employee's agreement to new restrictions. The courts, however, have treated the pension top-up as adequate fresh consideration because the employee has the option of either accepting or not accepting the financial incentive of a top-up.

One of the leading decisions in Canada on the enforceability of a non-competition restriction in a pension top-up agreement is the decision of Mr. Justice Stayshyn of the Ontario Superior Court of Justice in Woodward and Stelco Inc. (1996), 20 C.C.E.L. (2d) 70. In Woodward, the plaintiff signed a retirement benefits contract after he had been employed for a period of 27 years and in his capacity of vice-President, Sales and Marketing. Clause 4 provided that after his retirement, Mr. Woodward would not engage In any activity that was directly or indirectly competing with any business carried on by Stelco or any of its subsidiaries without the consent of Stelco,

Mr. Woodward retired from Stelco in 1991. in May of 1994. Stelco discontinued Mr. Woodward's supplemental pension benefits under the retired benefits contract on the basis that he breached clause 4 of the retirement benefits contract to refrain from competing with Stelco.

Mr. Woodward commenced a law suit against Stelco in which he requested specific performance of the retirement benefits contract. In addition, he argued that the non-competition clause was unenforceable on the basis that it was unreasonable and contrary to the public interest. In the alternative, he argued that the non-competition restriction should be interpreted narrowly so that his consulting activities did not amount to a breach of the covenant.

Ultimately, Mr. Justice Stayshyn dismissed Mr. Woodward's claim. He stated in part:

This Court should not interfere with the Retirement Benefits Contract, Stelco and Mr. Woodward are both sophisticated and experienced parties who, without any undue influence entered into a bona fide agreement. Stelco agreed to pay a monthly retirement benefit to Mr. Woodward by supplementing his base pension handsomely. Woodward in exchange would not compete with Stelco upon his retirement without Stelco's written consent. Even if the restraint of trade clauses are applied to this case, the restraint of trade prescribed by Clause 4 of the Contract was reasonable as between Stelco.

The same type of analysis used by the court in Woodward was also used in the British Columbia Supreme Court decision of Henriksen V. Tree island Steel Co. (1983), 45 B.C.L.R. 114 (S.C.), except this case involved salary continuation rather than pension top-ups.

In Henriksen, Mr. Henriksen had been employed as Tree Island's Vice-president, Sales and Marketing for some years. When he left the employ of Tree Island on November 13, 1981, he signed an agreement whereby Tree Island agreed to continue the salary of Mr. Henriksen for more then a year following his departure from the company. The only stipulation was that payments of the salary would cease if Mr. Henriksen engaged in an activity which might be "detrimental to the well being" of Free Island. In February of 1982, Mr. Henriksen took over as President of a company which was the chief competitor of Tree Island in one of its principal markets. Tree Island refused further payments. Mr. Henriksen sued for the money which Tree Island had agreed to pay him by way of salary continuation.

As in Woodward, Mr. Henriksen's claim was dismissed. The court held that the restraint was reasonable, since it did not restrain the former employee from working for a competitor, but simply provided that payments would cease if Mr. Henriksen engaged in an activity which might be "detrimental to the well being" of the employer.

Both of these cases illustrate the need for the restrictive clauses of the employment contract to be clearly defined. The application of the restrictive covenants can be linked to compensation. In both these cases, it was the former employee who sued the employer, not the employer who sued the employee. And, in both cases, the former employee, who sought to have his compensation restored was unsuccessful because of the clearly defined terms within the employment contracts which made, in the Judge's view, compensation or pension top-up a precondition of the restriction.

Does the Restrictive Covenant Have a Future?

In much the same way in which both golden parachutes, golden handcuffs and pension top-ups are used, if corporate employers are to protect against the departure of key information and the future competitive activities of their employees, employers today must combine the positive inducements to the employee in conjunction with the restrictive covenants to maintain control.

Restrictive covenants must be drafted with a view to their reasonableness in reference to geography, time and activity they seek to prohibit. Where possible, non-solicitation clauses should be used in place of non-competition clauses. The employment agreement must be carefully drafted to ensure that maintaining the positive inducements is linked to not breaching the restrictive covenants. The employee must understand and appreciate that a breach of the restrictive covenant will automatically result in losing the attractive monetary arrangement. Where car leases, mortgages, non-interest-bearing loans are Involved, the employee may be motivated to think twice about breaching the agreement. The psychological effect of losing a lease on a car or payments on a mortgage to an employee who is counting on the continued compensation can be quite devastating, particularly when it is a young employee. In some cases the new employer will replace these inducements and even indemnify a key employee against an injunction or lawsuit. Although there is no iron-clad guarantee that the employee will not breach the covenant, the link between the arrangement and the restrictive covenants will undoubtedly create a more pro-active approach for the corporate employer attempting to maintain a competitive advantage.

In our technological, information driven society, to maintain competitive advantage corporate employers must treat the employee as an investor in the company and invest in the employee. People are not a company's greatest assets. The right people are a company's greatest  assets. Therefore, good employees must be given incentives to continue to work for the employer. One such incentive beyond those already discussed is the provision by the company of opportunities for advanced training and education. Commitments to educational goals provides continuity within the corporate context. In today's high-tech world, corporate employers must be smart to attract and hold smart employees. Corporate employers who provide their employees with a meal return for their commitment make available not only financial and other benefits but provide for an employee's individual growth through training end self-help programmes. Such a programme may not be easily replaced elsewhere, Employers who invest in employees and employees who indeed are made to feel that they are the employer's most important asset are more likely to value the continuity of commitment, than those whose talents are easily purchased and always available to the highest bidder. Maintaining commitment is much easier than attempting to enforce it once it is lost.

Brian A. Grosman, Q.C. and
Natalie C. MacDonald
Grosman, Grosman & Gale LLP
Barristers & Solicitors
I I I Richmond Street West, Suite 800
Toronto, ON M5H 2H5
Tel: (416) 364-9599
Fax: (416) 364-2490
E-mail: lawyers@grosman.com
Website: http://www.grosman.com

Copyright © January 2001.
Not to be reproduced In whole or in part unless permission obtained in writing from Brian A. Grosman.

¹ Judge McLaughlin of the United States District Court W.D. Pennsylvania in Zippo Manufacturing Co. v. Zippo Dot Com. Inc. (952) F. Supp. 1119. This case is the leading case on the Internet jurisdiction in the United States.

² see G. England. Individual Employment Law. Toronto: Irwin Law, 2000 at p. 53.

³ Theodore Spencer. "Paycheck, Health Benefits and a Mercedes", Fortune, June 25, 2000

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