Worldwide: Non-Competes In M&A – Part 1: Caution Flags From Canadian And Delaware Courts
Capital Markets and Mergers & Acquisitions Bulletin

Overview

The recent decisions of the Delaware Court of Chancery in Kodiak Building Partners¹ and Intertek Testing Services² has private equity (PE) and strategic buyers alike talking.

If, in the acquisition of a target, a PE buyer seeks to prevent the seller not only from competing with the target, but also from competing with the PE fund's other portfolio companies (either in different jurisdictions or in different business lines), will the clause be enforceable to protect the PE buyer? Or even target itself? This was the issue in Kodiak, and the Court struck down the clause for overreach despite the activity in question being directly competitive with the target.

More recently, in Intertek the Delaware Court of Chancery applied the same line of reasoning as Kodiak and struck down a covenant that purported to restrict a seller of a business from competing anywhere in the world for five years despite the target's business and new business venture involving activity nationwide in the United States.

In this three-part series, we explore the enforceability of non-competition clauses in the context of M&A transactions, and the related guidance that has been offered by both Canadian and Delaware courts on this subject. In Part 1, we take a closer look at Kodiak and Intertek and ask what might have been the fate of the disputed non-competes had they been litigated in Canada.³ In Part 2, we turn from non-competes among buyers and sellers to non-competes within employment agreements that are executed in the M&A context, including the evolving statutory landscape. In Part 3, we survey different drafting techniques available to PE and other buyers, with the aim of increasing the likelihood of enforcement of non-competes executed with sellers in Canada.

The Non-Compete in Kodiak

Kodiak arose from the acquisition of an Idaho manufacturer of roof trusses, Northwest Building Components. Kodiak, the PE buyer, held a number of portfolio construction companies across the U.S. which also manufactured roof trusses as well as provided other manufacturing and construction services beyond the scope of Northwest's business. The non-compete at issue, executed with a seller and manager of the target, prohibited competition with Northwest or any of the Kodiak's other portfolio companies in Washington, Idaho, or within 100 miles of Northwest or of any other Kodiak portfolio company location for a period of two and a half years post-closing. A year and a half after closing, the seller/manager resigned from Northwest and began working for a competitor which, like the some of Kodiak's other portfolio companies, manufactured roof trusses in addition to providing other construction services that did not compete with Northwest's business. The new employer was located in Washington, less than 100 miles from Northwest. Kodiak sought an injunction on the basis of the non-compete clause in the purchase agreement.

Despite the activity in question being competitive with Northwest itself, both in terms of the scope of business (the new employer manufactured roof trusses) and geography (the new employer was only 24 miles from Northwest), the Court of Chancery held the non-compete was unenforceable. Specifically, it held the clause went "too far" by not only prohibiting competition with Northwest, but also with the Kodiak's other portfolio companies.⁴ The court stated:

Put differently, the Court explained that Delaware law has not "recognized a legitimate business interest in protecting all the acquirer's pre-existing goodwill that predated the acquirer's purchase of the target."⁶ The Court noted the provision was overbroad in its geographic scope "to the extent it prohibits competition in geographic areas around subsidiaries other than ^Northwest."⁷ It was also overbroad in that the restricted business "encompasse^d more than just ^Northwest's industry segment of roof trusses."⁸

The Intertek Non-Compete

Jeff Eastman was the CEO, co-founder and a major shareholder of Alchemy Investment Holdings, Inc., a Texas-based business engaged in workforce training and related services "nationwide". As part of the sale of Alchemy to Intertek, Jeff and other "restricted parties" agreed not to compete with Alchemy "anywhere in the world" for five years. When Jeff invested in and agreed to sit on the board of a startup founded by his son three years later, a company that also provided workforce training services and also operated "nationwide", Intertek commenced proceedings in Delaware. It sought an injunction claiming Jeff's actions constituted a breach of his non-competition and related covenants.

The Court in Intertek was clear and unambiguous in holding the non-compete covenant unreasonable and unenforceable. The Court acknowledged that relatively broad restrictive covenants have been enforced by courts in sale transactions, but also that "such covenants must be tailored to the competitive space reached by the seller."⁹ However, in this case the Court concluded that the "geographic scope far exceeds any legitimate economic interests that Intertek might have in protecting the assets and goodwill it acquired"¹⁰ as part of the purchase. Intertek conceded that Alchemy only serviced clients in the U.S. and not internationally. Citing Kodiak, the Court therefore determined the non-compete was overbroad in that it "extends to markets untouched by Alchemy's business" and as such "covered areas not essential to the protection of the buyer's legitimate interests in the acquired company."¹¹

Kodiak and Intertek in Canada

Would the fate of these non-competes have been similar in Canada? We can of course only speculate, but several points nonetheless remain noteworthy.

First, thanks to a trio of decisions by the Supreme Court of Canada (SCC),¹² the fundamental principles applicable to non-competes in Canada are relatively well-settled. They also appear to generally parallel the basic rules of play in Delaware.¹³ One principal is that the enforceability of a non-compete involves balancing the competing interests of freedom of contract and prohibiting restraints on trade. Another principal is that a non-compete must be "reasonable" in its restrictions, i.e., in its duration, its geographic scope and the extent of activities forbidden. A third principal is that a non-compete executed by a seller in the context of a sale of a business will be subject to less rigorous scrutiny than a non-compete in the employment context, the rationale being that the imbalance of power present in the latter is generally absent in the former.

From here, comparisons between Canada and Delaware as they relate to Kodiak and Intertek become difficult to draw definitively, not least because of variations among the laws of Canada's different provinces and territories. Furthermore, not all Canadian jurisdictions enjoy the same depth of non-compete caselaw. Nor have many Canadian courts encountered a fact scenario similar to that in these Delaware decisions. That said, what direction we have received on this subject matter from Canadian courts suggests there is reason for PEs and strategic buyers to proceed with caution.

In Payette, the SCC addressed a non-compete undertaken by the seller of a construction crane rental business. At issue was the reasonableness of the non-compete's geographic scope, and in holding that the clause was indeed enforceable, the Court indicated as follows:

Unlike in Kodiak, Payette did not involve a non-compete framed by reference to the buyer's wider business interests (as opposed to merely the business being purchased). However, this was the case in another Canadian decision, Poole, in which the Alberta Court of Appeal (ABCA) relied directly on this passage from Payette.

The appellant sold his tow truck business to a local competitor and in connection therewith, undertook not to compete with the buyer within "Alberta, British Columbia and Saskatchewan" as well as "any other location in Canada ^{where the buyer or} its Affiliates are carrying on the Business at any time during the Restriction Period". A question for the ABCA was therefore whether the geographic scope of the non-compete was unenforceable for exceeding the "legitimate interests" of the buyer.

The ABCA held that the clause indeed stretched too far, and similar to Kodiak and Intertek, explained that where a non-compete is executed in the M&A context, "the question of adequate protection is judged by the scope of the business sold rather than the business of the purchaser..."¹⁵ Put differently, the Court stated that to be enforceable, the geographical scope of the non-compete had to be "generally... limited to the area where the vendor's business was active..."¹⁶ The ABCA therefore reversed the chambers judge's ruling for having the "wrong focus". Whereas she should have considered only "the area in which ^{the target} carried on business at the time it was sold", she instead concentrated on the geographic scope of the buyer's business and those regions into which it intended to expand.

Practical Takeaways for Private Equity and Strategic Buyers in Canada

Unlike Kodiak and Intertek, Payette did not involve a non-compete framed by reference to the buyer's business but by reference to the business being purchased. Poole on the other hand did involve a non-compete framed by reference to the buyer's wider business. Neither case is completely on point with the conclusions reached in Kodiak and Intertek. Nonetheless, taken together, they warrant caution, at least in Alberta and Quebec, for a buyer considering a non-compete extending beyond the purchased business to also include the business lines or territories of the PE buyer's other portfolio companies or, in the case of a strategic buyer, other business interests or expansion aspirations it might have beyond the scope of the business being purchased.

Of key concern for buyers is that it appears, even if the subsequent activity would clearly be in breach of a non-compete limited to the target's business and geographic scope of operations, if the clause also extends to the buyer's (or its affiliates') other business or locations of operation, courts could strike the entire clause for overreach such that the buyer loses all protection thereunder and that the seller is free to compete directly with the business it just sold.

Moreover, similar cause for caution can be found elsewhere. The Ontario Court of Appeal, for example, has indicated their agreement with refusing "to enforce a ^non-compete covering a greater area than where the purchased business actually operated."¹⁷ That said, this comment was made in the context of the litigation of a non-compete in a franchise agreement.

We will therefore turn next – in Part 2 of our series, coming soon – from non-competes among buyers and sellers to non-competes within employment agreements that are executed in the M&A context, including the evolving statutory landscape.

Footnotes

1. Kodiak Building Partners, LLC v Philip D. Adams, C.A. No. 2022-0311-MTZ, Memorandum Opinion (Del. Ch., October 6, 2022) [Kodiak]

2. Intertek Testing Services NA, Inc. v. Jeff Eastman, C.A. No. 2022-0853-LWW, Memorandum Opinion (March 16, 2023) [Intertek]

3. We caution that our discussion is high-level, non-exhaustive and for the purposes of initial strategizing by PE and other M&A buyers and sellers. In particular, each definitive non-compete entered into must be drafted for the specific circumstances of the subject transaction as well as with a fulsome appreciation for the applicable governing provincial or territorial law.

4. Kodiak at page 21.

5. Kodiak at pages 22-23 (emphasis added). See also page 27.

6. Kodiak at page 21.

7. Kodiak at page 27.

8. Kodiak at page 28.

9. Intertek at page 8.

10. Intertek at page 2.

11. Intertek at page 9.

12. See Elsley v. J.G. Collins Ins. Agencies, 1978 CanLII 7 (SCC), [1978] 2 SCR 916; Shafron v. KRG Insurance Brokers (Western) Inc., 2009 SCC 6 (CanLII), [2009] 1 SCR 157; Payette v. Guay Inc., 2013 SCC 45 (CanLII), [2013] 3 SCR 95 [Payette]

13. See A. Turnbull, C. Spinelli and D. Papas, "Trio of Delaware Cases Signal Stricter Review of Sale-of-Business Non-Competes" (May 2023) Vol. 27(5) The M&A Lawyer at pages 7-11.

14. Payette at para. 65 (emphasis added). Note that, as a decision of the SCC arising under Quebec's civil law, Payette's application to non-compete disputes outside of Quebec and under another province's common law may be subject to interpretation and the decision may ultimately only be persuasive.

15. City Wide Towing and Recovery Service Ltd v Poole, 2020 ABCA 305 (CanLII) [Poole] at para. 34 (emphasis in original).

16. City Wide at para. 34 (emphasis in original).

17. MEDIchair LP v. DME Medequip Inc., 2016 ONCA 168 (CanLII) at para. 40 (emphasis added).

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.