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Penalty Clauses or Liquidated Damages Provisions?: A Review of a Growing Trend in Restrictive Covenants in Employment Contracts
In certain circumstances, employers try to limit their employee’s ability to work at competing businesses, especially when employees are involved in a sales or business development role. There is a growing trend across professional service industries of including liquidated damages clauses in place of traditional restrictive covenants such as non-competition and non-solicitation clauses.
These new protections are clauses found within employment contracts in professional service fields that state the employee can compete against the employer right away, even the day after leaving, but at a price. If the employee competes within the same region, or solicits clients, the employee will owe damages to the employer, usually measured by a certain number of months of revenue or billings.
When the courts have examined these clauses, they have found that they are in fact restraints on trade, but are not unlawful restraints.
What are traditional restrictive covenants?
Traditionally, employers have used non-competition and non-solicitation provisions to protect their interests. A non-solicitation clause prohibits a departing employee from soliciting the customers of his or her previous employer. A non-competition clause does more than merely attempt to protect the employer’s client or customer base; it attempts to keep the former employee out of the business altogether.
Courts hesitate to enforce these clauses, as they are a restraint on trade, which is against the public interest, as they limit both the employee’s options and consumer choices in the marketplace. The clauses are prima facie unenforceable unless the drafter can show they are reasonable. In determining if the clause is reasonable, the courts will look at temporal and geographic restrictions, the nature of the proprietary interest the business is seeking to protect, and the breadth of the restriction.
In Ontario, where a non-solicitation clause is sufficient to protect the legitimate business interests of an employer, a non-competition clause will be found to be of no force and effect. When courts find errors in either type of clause, the courts will typically strike these clauses down rather than read them down to render them enforceable.
Liquidated damages or penalty clauses?
More and more professional businesses, such as optometrists, veterinarians, and dentists are using liquidated damages clauses to protect their interests instead of traditional restrictive covenants. While to many employment lawyers these appear to be penalty clauses by another name, the courts to date appear willing to uphold these clauses.
The parties in Jones v Gerosa et al are dentists who formerly practiced together in Fort McMurray, Alberta. Dr. Robert Jones the Plaintiff in the case was the owner of the clinic and Dr. Mary Gerosa and Dr. Jack Phan were two associates who worked at the clinic and left to start their own practice. Both Dr. Phan’s and Dr. Gerosa’s contract contained the following clause:
6.01 The Associate shall not, during the term of this Agreement, directly or indirectly, as principal, agent, owner, partner, shareholder, director, officer or otherwise, own, operate, be engaged in the operation of or have any financial interest in any business operation, whether a proprietorship, partnership, joint venture, corporation or other form of business organization, engaged in the practice of Dentistry at any location within the City of Fort McMurray, Province of Alberta or a radius of fifty miles thereof.
(a) However, if the Associate wishes to leave, the Associate is free to practice anywhere in the city of Fort McMurray at anytime provided the Associate buys the goodwill (income from patients the Associate has accumulated) pertaining to the Associate portion of the practice. The price of this goodwill will be assessed at the industry average of 3 – 4 months gross revenue, which in this case as of December 1996 is approximately $90,000.00. This obligation will be in the form of a personal promisory (sic) note offered by the Associate to the owner. The note will be called in only on the termination of this agreement. Be it clear the intent and spirit of this agreement is to allow professional freedom to the Associate and owner and to allow a fair and amicable separation if need be – in essence the Associate is buying her share of the practice, patient goodwill, as fair payment to the owner for the facilities, infrastructure that allowed that goodwill to be accumulated. (emphasis added)
The Defendants argued that this was a restraint on trade that was unenforceable as it was unreasonable. Dr. Jones argued that the restrictive covenant analysis was inapplicable as there was no restraint on trade.
Justice Graesser agreed with the Defendants that this was a restraint on trade, as it is essentially a licence to compete after leaving their employer. However, based on the revenues of the new business, this was found to be a reasonable restraint and the quantum more akin to a liquidated damages provision than a penalty clause.
Two years prior to Jones, the British Columbia Court of Appeal was faced with a similar set of facts in Rhebergen v. Creston Veterinary Clinic Ltd.. In Rhebergen, the employee was a veterinarian employed by Creston Veterinary Clinic who started her own mobile clinic after ceasing employment with the Defendant. Her employment contract had contained the following clause:
1. 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.
2. 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.
As opposed to Jones, the trial judge in this case came to the opposite conclusion and found the clause to be an unreasonable restraint on trade partially due to vagueness and subsequently struck the clause down. Creston appealed the decision to the Court of Appeal.
In its analysis, linking to Jones, the BC Court of Appeal agreed with the trial judge in part and found that the impugned “non-competition” clause to be a prima facie a restraint of trade. However, the Court also found that the amounts were not a penalty, but rather compensation for the costs incurred by the clinic in training Dr. Rhebergen and which the Plaintiff had acknowledged were reasonable. Justice Smith, writing for the majority, held that the language of the clause was unambiguous, the clause was reasonable under the circumstances and reversed the trial judge and found that the clause was enforceable.
If you want to protect your business interests in the event key employees leave, you should ensure an experienced employment lawyer drafts your employment contracts and restrictive covenants. Monkhouse Law has experience in drafting enforceable clauses that protect your interests and enforcing those clauses when a key employee leaves. Contact us at 416-907-9249 today for a free consultation.
While the clauses in these cases were upheld, many restrictive covenants are drafted improperly rendering them unenforceable. If you would like advice on a non-competition and/or non-solicitation clause in your contract, contact us today for a free consultation at 416-907-9249.
About the Author
at Monkhouse Law where she practices Employment, Human Rights and Disability Insurance Law. Laura can be reached at firstname.lastname@example.org.
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