In a recent matter involving the sale of a business to a large public company, the vendor was required to sign an agreement with typical confidentiality, non-competition and non-solicitation clauses.
The acquisition was not a business success. The purchaser succeeded in its goal of acquiring the clients, but managed the new business in a way that financial targets were not met, resulting in a significant downward adjustment in the purchase price. The vendor was unhappy and negotiated an agreement whereby he resigned on the basis of certain fixed amounts payable over time.
The public corporation was unhappy with what it considered to be subsequent competitive activity on the part of the vendor/employee who resigned, and retained Ron to advise on the strategy to resolve the matter, on a basis that maximized the scope of permissible business activity on his part as well as the collection of money owed to him. Issues included the past and present conduct of the corporation that gave rise to the dispute, analysis and characterization of the impugned conduct of the now departed employee who was owed money by the corporation, the construction of the resignation agreement with its provisions for confidentiality, non-solicitation and non-competition for a limited period of time, the range of remedies (on both sides) from damages to injunctive relief, and the scope and effect of a release where there had been an arguable failure of consideration.
As in most such matters, successful resolution depended on the appropriate combination of the threat of a lawsuit, the issues of cost, delay and adverse publicity, all considered in light of the overall legal merits and equities that would be brought to bear by a judge. Successful resolution was achieved, both parties recognizing that litigation in many commercial disputes can be a scorched earth policy.
Ron routinely advises partners of law and accounting firms on the strategic management of their withdrawal from professional partnerships. He has done so recently for four separate clients. In the consideration of goals, strategy and tactics, the factors to take into account include whether the partner is leaving voluntarily, or might be expelled, or is being otherwise forced out through the mechanics of reduced compensation, harassment or oppressive conduct. As a general guideline, both the firm and the partner wish to avoid litigation. However, unless managed properly, departures can give rise to lawsuits around transition, the approach to clients, solicitation, competition and the appropriate or unfair use of confidential information. Success must be considered in light of the setting of appropriate goals and getting there without destructive litigation. Litigation itself is the easy part, although more fun for the litigator than the client.
Ron recently successfully resolved a case on behalf of a shareholder, former officer and former director of a privately held company from whom information regarding the anticipated sale of the company had been withheld that directly affected the value of options that he had to exercise in a fixed time frame following his departure from the company.
Although the client may have had no contractual right to the receipt of confidential information that could be expected to have a material impact on the value of the options, the deprivation of that information, known to other directors and officers, was not in accordance with his reasonable expectations and effected a result that was unfair to him. He was deprived of the informational base on which to base the investment decision reflected in the exercise of the options. Although the defendant directors may have had a legal right to act as they did, the exercise of those legal rights was argued to be oppressive. Where parties have worked in close association over many years, equitable fairness trumps strict legal considerations. More specifically, the standard of conduct expected of a director in relation to dealings with a shareholder may vary depending on all the circumstances.
Ron recently was retained to resolve a case raising the enforceability of contractual provisions which determine in advance the financial consequence of breach. Traditionally, if the clause could be construed as a penalty, courts have refused to give effect to it. In general terms, a fixed amount payable in the event of breach would be considered a penalty if it was not a genuine pre-estimate of damage. However, there have been numerous instances where courts have upheld clauses providing a financial consequence for breach, such as the return of settlement funds where a confidentiality clause has been breached. The law on this issue has therefore become difficult to rationalize.
Two recent cases by the UK Supreme Court have attempted to bring a consistent rationale to the analysis and will have inevitable repercussions on Canadian common law. Addressing the argument that the law regarding penalties had become “antiquated, anomalous and unnecessary”, the Court held that the law remained valid but that it had become too artificially applied. To remedy that defect, the Court called for a more nuanced approach to penalties that takes account of the contract as a whole, having regard to all the obligations “primary and secondary” and interpreted against the overall factual matrix.
“The true test [for an unenforceable penalty] is whether the impugned provision is a secondary obligation which imposes a detriment on the contract breaker out of all proportion to any legitimate interest of the innocent party in the enforcement of the primary obligation”.
A clause that simply punishes the party in breach remains unenforceable. The primary concern of the law is to compensate the innocent party for damages suffered as a result of the breach. Compensation is not necessarily the only legitimate interest. There may be a legitimate commercial interest worthy of protection. The court will look at the nature of the innocent party’s right that the impugned clause was intended to secure, such as the enforcement of a restrictive covenant not to compete, and on that basis what appears to be a penalty (because it bears no relationship to actual loss suffered in the event of breach) may in fact be enforceable. That is because the innocent party has a legitimate interest in the performance of the contractual promises of the defaulting party.
A good illustration involves a promise to keep the terms of a settlement confidential: damage flowing from a breach of that promise may be difficult to quantify, but nonetheless, the innocent party may have a legitimate interest in confidentiality and a “penalty” for breach, such as the return of settlement money, may be upheld. The one qualification remains: the “penalty” must not in the circumstances “exorbitant or unconscionable” in relation to the highest level of damages that could conceivably flow from the breach.
Similarly, other payments or withholding of money may be upheld even though they bear no reasonable relation to the measure of loss attributable to the breach. Protection of goodwill is a good example. Often, the court simply cannot assess the precise value of an obligation in relation to the overall value of a contract. In such a case the court can be expected to uphold what appears to be a penalty on the basis that the parties to the contract were the best judges of how the consequence of breach should be reflected in their agreement.
The UK decision has consequences for all commercial contracts, not least the “delay” penalties in construction contracts and “overstaying provisions” commonly applied by parking lots. Whether the decision has added a level of certainty to the enforcement of contractual provisions agreed to by the parties is more debatable. I expect to see more, not less, litigation to arise in this area. And I expect lawyers who draft the contentious clauses will now add a provision that the clause protects the legitimate business interests of the party imposing the clause and that it is neither extravagant nor unconscionable, thereby creating a contractual “estoppel” designed to prevent a party seeking to escape the predetermined and agreed-upon consequences of breach.