In a decision released on January 23rd, 2009, the Supreme Court of Canada has confirmed the increasing scrutiny now brought to bear on restrictive covenants in employment contracts entered into by employees, including those in the insurance industry.

In Shafron v. KRG Insurance Brokers (Western) Inc. [2009] S.C.C. 6 (January 23, 2009, S.C.C.docket number 31981), the Court rejected efforts by KRGto use the courts to rewrite what was essentially a defective restrictive covenant.

Morley Shafron worked in the insurance business for a number of years, and in 1987 he sold his insurance agency to KRG. During the period from 1987 to 2001, Shafron was employed pursuant to a series of employment contracts entered into with the purchaser of his business and its successors. The apparent lack of care taken in drafting the post-employment restrictions came back to haunt the employer. Each employment contract which Shafron signed contained a similarly worded restrictive covenant provision which provided as follows:

Shafron shall not, upon leaving the employment of the Corporation for any reason, save and except for termination by the Corporation or KRG management without cause, for a period of three years thereafter, directly or indirectly, carry on, be employed in, or be interested in or permit his name to be used in connection with the business of insurance brokerage which is carried on within the Metropolitan City of Vancouver.

In December 2000, as the last of his employment agreements was about to expire, Shafron left KRG's employment and began working as an insurance salesman for another agency, Shaw Insurance Agency Ltd., in Richmond, B.C.

Mindful of protecting its interests and purporting to have rights which precluded Shafron from moving because of the provisions in the employment agreement, KRG commenced an action to enforce the restrictive covenant. Claims were also asserted that Shafron had breached his fiduciary and equitable obligations.

At trial, Parrett, J. dismissed KRG's action, finding that, among other things, the term "Metropolitan City of Vancouver" was neither clear nor certain and, in any event, was unreasonable. The trial judge also found that Shafron owed no fiduciary duty to KRG, and did not breach any duty relating to confidential information.

The trial decision was reversed by the B. C. Court of Appeal. Although the Court found that Shafron had no fiduciary duty to his former employer, the Court held that the restrictive covenant was enforceable. In the opinion of the B. C. Court of Appeal, although the term "Metropolitan City of Vancouver" was ambiguous, it was possible to apply the doctrine of notional severance. Under this concept, it is possible to construe a provision like that contained in Shafron's contract as applying to the City of Vancouver and municipalities contiguous to it. As a result, the B. C. Court of Appeal held the covenant would cover the City of Vancouver, the University of British Columbia endowment lands, Richmond and Burnaby. Having regard to this geographic area and the non-competition term of three years, the Court of Appeal found the covenant reasonable and therefore enforceable.

In overturning the decision of the B. C. Court of Appeal, the Supreme Court took the opportunity to summarize the legal principles applicable to restrictive covenants, and the importance of demonstrating mutual agreement between the parties about the nature of the restrictions being sought by the employer and agreed to by the employee. The term "Metropolitan City of Vancouver" was uncertain and ambiguous, and the SCC held it was inappropriate for an appeal court to rewrite such a covenant. Though commenting on a specific case from B.C., a number of the principles outlined in the case would clearly be applicable to employers throughout the country.

Restrictive covenants are, as a general proposition, restraints of trade and thus contrary to public policy. While the legal system provides that freedom of contract will allow exceptions for reasonable restrictive covenants, the onus is on the party seeking to enforce the restrictive covenant to show that it is reasonable. The key, therefore, is for the employer seeking to enforce an ambiguous covenant to demonstrate that there was a clear intention of the parties to be bound by the specific wording. Restrictive covenants in employment contracts will be scrutinized more rigorously than those negotiated in the context of a sale of a business. This is obviously sensible because there is often an imbalance of power between employees and employers. There is also typically some payment on account of goodwill made in the context of a sale transaction.

The KRG provision fell down for a number of reasons, including the fact that the higher standard of scrutiny applicable to Shafron's employment contract could not be satisfied. The concept of notional severance was expressly rejected by the SCC as an approach which should not be adopted for defective restrictive covenants. Under the notional severance doctrine, documents may be construed in some instances as though certain portions of the document do not exist. In other words, the document is interpreted or read as though one portion which offends legal principles has been deleted.

The SCC provided two significant reasons why notional severance will have no place in the construction of restrictive covenants in employment contracts. First, covenants must be interpreted using a test of reasonableness. An example where notional severance might apply is a contract which provides for an illegal interest rate, with notional severance being used to bring the rate down to the legal rate of 60 percent. In the case of an unreasonable restrictive covenant, there is no so-called "objective bright-line" rule that can be applied to render the covenant reasonable. As a result, the Court expressed its concern that using notional severance in this type of situation "simply amounts to the court re-writing the covenant in a manner that it subjectively considers reasonable in each individual case." As the Court acknowledged, this type of approach really only creates uncertainty for employers and employees, since there is no obvious direction about what might be found reasonable in any specific case.

A second concern which the Court cited with notional severance involves what employers will do as a practical matter. If notional severance is allowed, employers would be invited to impose unreasonable restrictive covenants on employees in every contract. Then, the only potential sanction would be that if the covenant is found to be unreasonable, the Court would still enforce the provision to the extent of what might otherwise have been validly agreed to. This involves a substantial change to the risks assumed by the parties. Having regard to the generally accepted imbalance of power between employees and employers, the Court focused on the importance on ensuring that employers not be provided what would essentially be a further incentive to force employees to abide by unreasonable covenants.

The Court also further clarified its approach to so-called "blue-pencil severance". The "blue-pencil" notion involves having a contract read as though an editor took a blue pencil and removed part of a contractual provision. While many commentators have noted the limited application of blue-pencil severance, the SCC's decision in KRG confirms explicitly that blue-pencil severance payment will be resorted to sparingly, and only in cases with the part being removed is clearly severable, trivial and not part of the main purported restrictive covenant. Blue-pencil severance could not be applied to remove the word "Metropolitan" from the restrictive covenant in the Shafron contract because it was neither a trivial nor severable part of the provisions agreed by the parties. In reviewing the trial record, the Court found no evidence that the parties unquestionably would have agreed to remove the wording "Metropolitan" from the non-competition clause without varying any other terms of the contract or otherwise changing the bargain.

The SCC also rejected the argument that rectification might be relied upon to resolve the ambiguity in this case. Rectification is used in contractual cases to restore what the agreement of the parties actually was, but for an error in the written agreement. Here, a series of contracts had been entered into which contained the same provisions. There was no indication that the parties had actually put their minds to what their bargain was and then mistakenly included something different in their contract. Instead, the ambiguous and improper contract provision had been included in the successive contracts and KRG could not point to any prior agreement, written or oral, that explained the term "Metropolitan City of Vancouver".

The KRG case resoundingly emphasizes the challenges which employers face in seeking to enforce restrictive covenants. Any clauses which seek to prohibit post-employment conduct will only be enforceable if they are carefully prepared, having regard to the specific industry. The fact that Shafron had obtained $700,000 when he sold his business to KRG was essentially irrelevant, since the parties failed to pay particular attention to relevant issues, including what the insurance brokerage industry might consider to be a reasonable covenant, what amounted to an appropriate restraint of trade, and what was reasonable in this specific case. Since these disputes invariably involve employers looking to enforce covenants, it is essential that appropriate care and attention be paid to crafting clear clauses with appropriate restrictions on prohibited activity, together with reasonable geographic and temporal restrictions.