Name of Case: Shafron v. KRG Insurance Brokers (Western) Inc.

Date of Decision: January 23, 2009

Supreme Court Panel: Chief Justice Beverley McLachlin, Justices Ian Binnie, Louis LeBel, Marie Deschamps, Rosalie Abella, Louise Charron and Marshall Rothstein

Judgment under Appeal: Judgment of the British Columbia Court of Appeal dated February 12, 2007

Facts: In 1961, Morley Shafron established an insurance agency business in Vancouver. He sold the business in 1988 to an Ontario company that continued to employ him as the agency's only salesperson under a written employment contract. The contract contained a restrictive covenant under which Shafron agreed that "upon his leaving the employment of ... KRG Insurance for any reason save and except for termination by KRG Insurance without cause, he shall not for a period of three (3) 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 1991, the agency was sold again and Shafron entered into a new employment agreement with its new owner that contained the same restrictive covenant. He continued to work for the company until 2000, when he left of his own volition. In 2001, he began working as a salesperson for another agency in Richmond, an incorporated city that is part of the Greater Vancouver Regional District. The former employer sued Shafron for breach of the non-competition agreement.

Case History: B.C. Supreme Court Judge Glen Parrett dismissed the company's action in a November 2005 decision, ruling that the non-competition clause was fatally vague with regard to the spatial area covered, since there existed no such entity as the "Metropolitan City of Vancouver" specified in the agreement. That terminology came from a Toronto lawyer who had drafted the original 1988 employment contract with the Ontario-based purchaser of Shafron's business and who was unfamiliar with Vancouver.

In a February 12, 2007 decision, the British Columbia Court of Appeal allowed the former employer's appeal. Writing for a unanimous three-member panel of the Court, Justice Charles Chiasson acknowledged that "[t]here is no fixed, recognized meaning for the phrase 'Metropolitan City of Vancouver,'" and that "[t]o strike the word 'metropolitan' would not reflect the obvious intention of the parties," since they clearly intended a geographic reach that included the City of Vancouver and something more." However, he held that this did not make the covenant unenforceable, as it was possible to interpret the phrase in a way that would give effect to the parties' intentions.

Justice Chiasson relied on the decision of the Supreme Court of Canada in Transport North American Express Inc. v. New Solutions Financial Corp., [2004] 1 S.C.R. 249, in which, he said, the Court "endorsed 'remedial flexibility' with the objective of giving effect to the 'substance of the bargain or consideration involved' rather than allowing the result to be 'dependent upon accidents of drafting and the form or expression of [an] agreement'." Noting that the employer's customer base was in the south-western area of the City of Vancouver where its business was located and in municipalities reasonably close to the area, Chiasson decided that "I would construe 'Metropolitan City of Vancouver' to prevent Mr. Shafron from competing in the City of Vancouver and municipalities directly contiguous to it. Geographically, I would include the City of Vancouver, the University of British Columbia Endowment Lands, Richmond and Burnaby."

Chiasson held that, "[b]y reading down the phrase 'Metropolitan City of Vancouver' to an area consistent with the need to protect KRG Western's business, an area that likely was in the reasonable contemplation of the parties when they made their agreement, the substance of their bargain is respected and enforced." Allowing the appeal on behalf of the Court, he referred the matter back to the B.C. Supreme Court to determine the damages to be awarded. Shafron obtained leave to appeal this decision to the Supreme Court of Canada.

Issue(s): The central issue on appeal to the Supreme Court of Canada was whether the Court of Appeal improperly invoked the doctrine of severance to resolve an ambiguous term in the restrictive covenant.

Supreme Court's Decision (7-0): Emphasizing that "the general rule must be that a restrictive covenant in an employment contract found to be ambiguous or unreasonable in its terms will be void and unenforceable," the Supreme Court of Canada allowed the appeal and restored the decision of the trial judge dismissing the action against Shafron.

Reasons: Writing for a unanimous seven-member panel of the Court, Justice Marshall Rothstein noted that "[r]estrictive covenants give rise to a tension in the common law between the concept of freedom to contract and public policy considerations against restraint of trade." Citing the Supreme Court's seminal ruling in Elsley v. J. G. Collins Insurance Agencies Ltd., [1978] 2 S.C.R. 916, he observed that, "despite the presumption that restrictive covenants are prima facie unenforceable, a reasonable restrictive covenant will be upheld."

In determining the reasonableness of a restrictive covenant, Rothstein stated that it is important to differentiate between contracts for the sale of a business and employment contracts. In the case of the former, as noted by the Supreme Court In Elsley, without a restrictive covenant "[a] person seeking to sell his business might find himself with an unsaleable commodity if denied the right to assure the purchaser, that he, the vendor, would not later enter into competition."

In the case of the latter, however, Justice Rothstein emphasized that "[t]he same considerations will not apply.... The absence of payment for goodwill as well as the generally accepted imbalance in power between employee and employer justifies more rigorous scrutiny of restrictive covenants in employment contracts compared to those in contracts for the sale of a business." That being the case, he declared, "for a determination of reasonableness to be made, the terms of the restrictive covenant must be unambiguous. The reasonableness of a covenant cannot be determined without first establishing the meaning of the covenant.... An ambiguous restrictive covenant will be prima facie unenforceable because the party seeking enforcement will be unable to demonstrate reasonableness in the face of an ambiguity."

Will the courts narrow or "sever" parts of a restrictive covenant in an employment contract, where it is overbroad, to the point where it is legally enforceable? In this regard, Rothstein identified two types of severance: "'blue-pencil' severance and 'notional' severance. Both types of severance have been applied in limited circumstances to remove illegal features of a contract so as to render the contract in conformity with the law." Rothstein quoted the explanation in Transport North American Express Inc. v. New Solutions Financial Corp., [2004] S.C.J. No. 9 (QL), that "[u]nder the blue-pencil test, severance is only possible if the judge can strike out, by drawing a line through, the portion of the contract they want to remove, leaving the portions that are not tainted by illegality, without affecting the meaning of the part remaining." On the other hand, he explained, "[n]otional severance involves reading down an illegal provision in a contract that would be unenforceable in order to make it legal and enforceable," as the Supreme Court had done in Transport "to effectively read down the interest rate [in a commercial contract] to the legal statutory maximum of 60 percent."

Restraint is the watchword. Because "the court is altering the terms of the original contract between the parties by applying the doctrine of severance, whether blue-pencil or notional" even though "the purpose is to give effect to the intention of the parties when they entered into the contract," Rothstein held, "courts will be restrained in their application of severance because of the right of parties to freely contract and to choose the words that determine their obligations and rights." He considered that "[w]here the provision in question is a restrictive covenant in an employment contract, severance poses an additional concern. While the courts wish to uphold contractual rights and obligations between the parties, applying severance to an unreasonably wide restrictive covenant invites employers to draft overly broad restrictive covenants with the prospect that the court will only sever the unreasonable parts or read down the covenant to what the courts consider reasonable."

Against this background, Rothstein ruled that "blue-pencil severance may be resorted to sparingly and only in cases where the part being removed is clearly severable, trivial and not part of the main purport of the restrictive covenant. However, the general rule must be that a restrictive covenant in an employment contract found to be ambiguous or unreasonable in its terms will be void and unenforceable." Moreover, he held, "notional severance [on which the B.C. Court of Appeal said that it relied to resolve the ambiguity in the geographic scope of the restrictive covenant in Shafron's case] has no place in the construction of restrictive covenants in employment contracts."

He explained that "there are at least two reasons why it would be inappropriate to extend the doctrine of notional severance to the case of restrictive covenants in employment contracts." First, unlike the situation in Transport, where "[t]he Court inferred that the parties' original common intention was to charge and pay the highest legal interest rate and notional severance was applied to read down the rate to the highest legal rate," in the case of an unreasonable restrictive covenant "there is no objective bright-line rule that can be applied in all cases to render the covenant reasonable." Consequently, "[a]pplying notional severance in these circumstances simply amounts to the court rewriting the covenant in a manner that it subjectively considers reasonable in each individual case. Such an approach creates uncertainty as to what may be found to be reasonable in any specific case."

Second, Rothstein held, applying notional severance to restrictive covenants in employment contracts "invites 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.... 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."

Declaring outright that "the doctrine of notional severance does not apply in respect of restrictive covenants in employment contracts," Justice Rothstein ruled on behalf of the Court that in Shafron's case "[t]he term 'Metropolitan City of Vancouver' was ambiguous and there was no context or other evidence demonstrating the mutual understanding of the parties at the time they entered into the contract as to what geographic area it covered.... It was inappropriate for the Court of Appeal to rewrite the geographic scope in the restrictive covenant to what it thought was reasonable."

Lancaster Reference: For analysis of the Supreme Court of Canada's decision, see Lancaster's Wrongful Dismissal E-Bulletin, July 17, 2009, Issue No. 240.

Full text of the decision: http://onlinedb.lancasterhouse.com/images/up-SCC_Shafron.pdf