Overview and Key Practical Takeaways
Restrictive covenants such as non-compete clauses and non-solicitation clauses are a critical part of many M&A deals.
They also present an inherent tension. While the buyer seeks maximum protection against the seller competing with the target post-closing, the more restrictive the covenants are, the more vulnerable they may be to being held unenforceable.
The recent ruling by the Alberta Court of King’s Bench in Intellimedia v Jawad highlights this tension and gives guidance to Canadian dealmakers. Our key practical takeaways include:
- The non-solicitation clause was unenforceable for ambiguity: the seller could not reasonably know who the “customers” of the target were after he had left the company.
- The non-compete was enforceable: its core restriction was tied to the target’s products as they existed or were under development at the time of sale.
- It was unclear whether the geographic scope of the non-compete was limited to the scope of the target’s business at the time of sale. However, even if it was not, the court was prepared to save the clause using “blue-pencil” severance.
- The court’s openness to using “blue-pencil” severance is notable. Canadian courts have historically been reluctant to do so. The ruling therefore represents a growing divide between Alberta and the rest of Canada on this point.
Our key drafting takeaways follow. For more Fasken M&A thought leadership, visit our Capital Markets and M&A Knowledge Centre and subscribe.
Restrictive Covenants in Canadian M&A Transactions
Restrictive covenants are a critical aspect of many M&A transactions, and for good reason: the buyer seeks assurance that one or more of the sellers who have been key to the target’s success will not, post-closing, undermine the target’s business going forward by competing with it.
Non-compete clauses create such protection by prohibiting the seller(s) from competing with the target for a specified period and within a specified geographic area. Non-solicitation clauses create such protection by prohibiting the seller(s) from soliciting business from the target’s customers.[1]
This pursuit of protection through restrictive covenants by an M&A buyer creates an inherent tension. While the buyer seeks maximum protection against a seller competing with the target post-closing, the more onerous in scope (i.e., limiting) a restrictive covenant is, the more vulnerable it will generally be to being held unenforceable by a court.
That said, this tension is less acute in the M&A context than in the employment context. As held by the Supreme Court of Canada, restrictive covenants in M&A are not subject to the same “rigorous scrutiny” as in the employment context.[2] This is because the “imbalance of power that generally characterizes the employer-employee relationship” is generally absent between a buyer and seller. The Supreme Court also noted that, in M&A, restrictive covenants act to “protect the purchaser’s investment.”
The Facts of the Dispute in Brief
The buyer purchased the target business (the Target), a Canadian software company, under an asset purchase agreement (the APA) and hired a co-founder (the Founder) of the Target to continue with the company post-closing as its CEO.
The APA included both a non-solicitation clause and a non-compete clause binding on the Founder. These took effect on closing and continued for five years after the Founder stopped working for the Target. The acquisition closed in April 2020, and the Founder worked as CEO of the Target until summer 2024.
Following his departure, the Founder founded a new software company with a product that competed with the Target, and which was set to launch as early as May 2026. The Buyer applied to the Court seeking an interlocutory injunction enforcing the restrictive covenants.
The Court applied the “usual three-part test” to decide whether it should exercise its discretion to grant the injunction.[3] That said, while this test normally involves the court deciding that there is a “serious issue to be tried”, in the circumstances the Court held that it should apply the more onerous “strong prima facie case” standard because the proposed injunction would effectively determine the buyer’s action against the Founder.[4]
The Non-Solicitation Clause Was Unenforceable for Ambiguity
The Court held that, for a non-solicitation clause to be enforceable, its scope “must be ascertainable and it must be possible to predict when it is being breached.” This means that the clause must be limited to a “reasonably knowable group of people”.
The Court held that the non-solicitation clause did not meet this mark. Key here was that, as the clause was drafted, it was not limited to persons who were customers etc. of the Target during the period of the Founder’s employment. Rather, the clause used the present tense generally to cast a wider net. For the Court, this was “fatal” as it meant the Founder “could never know whether a particular person became a customer [etc.] after his employment ended.”
Lastly, the Court took issue with the clause’s use of the term “business relations”. It noted that this phrase created an “additional ambiguity” as it was “unclear what this would cover”.
The Non-Compete Clause Was Enforceable for Being Reasonably Tied to the Scope of the Target’s Business
The Court held that to be enforceable a non-compete clause must be limited to the duration, scope of activities and geographic scope necessary to protect the “legitimate interests” of the protected party. The Court noted that, in the M&A context, a non-compete clause will be presumed to be lawful unless it can be shown on a balance of probabilities that its scope is unreasonable. The Court further noted that, in the APA, the Founder had agreed that the non-compete clause was reasonable. While this was not determinative, it was “a factor in favour of enforceability.”
Regarding the 5-year period of the clause beginning at the end of the Founder’s employment, the Court noted that the Founder had not argued that this was unreasonable. This term was consistent with precedent both of the Alberta Court of Appeal and the Supreme Court of Canada.
Regarding the prohibited scope of activities under the clause, the Court disagreed with the Founder that the barred conduct was unreasonably broad. The clause’s “core restriction” was the creation of software products that directly competed with any of the Target’s software products. This restriction also related to the Target’s software products “as they existed or were under development at the time of the APA”. This meant the clause was clearly intended to protect the assets sold under the APA.
The Court’s analysis of the geographic scope of the clause was more complex. The Court noted that, per rulings by the Alberta Court of Appeal and Supreme Court of Canada, the geographic scope of a non-compete clause in the M&A context should “generally be limited to the area where the [target] was active”. This was key as, while the non-compete clause was not limited to Alberta, the Target’s business was potentially limited to the province.[5]
Two results followed. First, because the Founder had not established as a fact that the Target’s business was limited to Alberta, the “presumption of the reasonability of the geographic scope” of the non-compete clause applied. Second, the Court held that, even if this was wrong, the non-compete clause could be “saved as reasonable” by reducing its scope “through the use of ‘blue-pencil’ severance by deleting the geographical jurisdictions other than Alberta”. The Court noted that this “type of severance [was] expressly contemplated” by the APA. The Court also did not indicate that over-extensions regarding geographic scope “ran through” the non-compete, a problem that the Court had earlier noted prevented it from applying blue-pencil severance to save the non-solicitation clause.
A Note of Caution Regarding Blue-Pencil Severance of Restrictive Covenants in Canada
The Court of King’s Bench’s openness to applying “blue-pencil” severance is noteworthy. Canadian courts have historically been reluctant to do so.
The Supreme Court of Canada in Shafron v. KRG recognized two types of severance in contract.[6] “Notional” severance involves reworking a clause to make it enforceable. “Blue-pencil” severance is more targeted in that it strikes out a specific part of a clause to make it enforceable.
The dispute at hand was in the employment context rather than the M&A context. The Supreme Court held that notional severance is not an appropriate mechanism to cure a defective restrictive covenant. The Supreme Court did not rule out the possibility of blue-pencil severance completely. However, it stated that blue-pencil severance may only be resorted to in rare cases where the part being removed is trivial, and not part of the main purport of the covenant.
The Supreme Court identified two concerns with applying notional severance in the employment context. The first was that there is no bright-line test for reasonableness. The second was that allowing notional severance would invite employers to overreach in drafting restrictive covenants assuming they could fall back on the court to enforce a narrower version of the clause.
Although the Supreme Court’s ruling was limited to the employment context, Canadian courts in most provinces have generally not granted either type of severance in the M&A context and their logic has largely followed that of the Supreme Court: they do not want to encourage commercial parties to view the courts as a backup plan or as prepared to decide the scope of the parties’ rights and obligations for them.
Alberta has been the principal outlier in this regard. In confirming its readiness to apply blue-pencil severance, the Court in Intellimedia v Jawad cites only Alberta precedent. Among these is a 2020 Alberta Court of Appeal ruling that expressly held that, because Shafron v. KRG did not speak to blue-pencil severance in the M&A context, its application was not precluded in M&A disputes. The ruling in Intellimedia v Jawad is therefore only the latest chapter in a growing divide between Alberta and other Canadian provinces on blue-pencil severance for restrictive covenants in M&A, and this should be borne in mind by dealmakers from other Canadian jurisdictions.
Key Practical and Drafting Takeaways for Canadian M&A Lawyers
Intellimedia v Jawad highlights the importance of drafting restrictive covenants in M&A with care and due regard for the particular acquisition at hand. Simply put, one size does not fit all.
We note:
- Restrictive covenants should be tailored to the particular transaction. Whether a non-compete clause or a non-solicitation clause, they should generally be scoped in reference to the target business as it was at the time of sale.[7]
- The person bound by a restrictive covenant should be reasonably capable of knowing what conduct would breach it. For example, the covenant should not be scoped in reference to matters the person will not be able to know post-departure. Potentially ambiguous terms (e.g., “business relations”) should also be avoided.
- Buyers should ensure that the persons bound by a restrictive covenant acknowledge the reasonableness of the covenant’s scope. This will not be determinative, but it may assist with enforceability.
- A severance clause may not be of any value outside of restrictive covenants governed by Alberta law.[8] Buyers should therefore focus on negotiating restrictive covenants that are reasonable in scope and unambiguous in substance.
- The possibility of blue-pencil severance in Alberta means that buyers in Alberta should seek to ensure that any potentially overly onerous element in a restrictive covenant does not “run through” the covenant. For blue-pencil severance to be applied, the court must be able to strike out a discrete portion of the clause.
