Beware Ambiguity: The Doctrine of Severance in Employment Contracts

In preparing to write about Shafron v KRG Insurance Brokers (Western) Inc, 2009 SCC 6, I prepared myself for a complicated analysis of restrictive covenants in employment contracts. The facts of this case were so detailed, they must have indicated a correspondingly complex legal analysis. I was pleased to discover, however, that the 10-year factual time span, the many renewed employment contracts, and the numerous business dealings undertaken throughout the case would ultimately boil down to one relatively simple question: when can the doctrine of severance be used to resolve an ambiguous term in a restrictive covenant?

Background

The issue arose after Morley Shafron, the owner of an insurance agency business, sold his shares to a company that would then be named KRG Insurance Brokers (Western) Inc. Shafron continued to be employed in the business, and though his employment contract was renewed several times, it always contained a non-competition clause. The nature of this clause provoked the ensuing litigation, because it was ultimately deemed ambiguous.

I will narrow my factual summary down to a few salient points since, as noted, they are quite complex. Though Shafron entered into several employment contracts between 1988 and 1998 with very similar terms and clauses, the 1998 contract was specifically at issue. The contract’s non-competition clause, constituting a restrictive covenant, required that Shafron not, “upon his leaving the employment of the Corporation [KRG Western] for any reason, save and except for termination by the Corporation without cause, 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.” The final four words brought this dispute to the Supreme Court of Canada (“SCC”).

The litigation was put into motion when Shafron left KRG Western’s employment in December 2000, before the expiry of the 1998 contract, to work as an insurance salesman for another agency in Richmond, B.C. In response, KRG Western commenced an action against Shafron, claiming that Shafron was wrongly competing with the company and had breached the restrictive covenant. Though it is not mentioned in the facts, it appears that KRG Western took specific issue with Shafron’s employment in Richmond, which is arguably within the metropolitan area of Vancouver.

The trial judge dismissed the action, finding that the term restricting employment in the “Metropolitan City of Vancouver” was unreasonable, and was neither clear nor certain. The British Columbia Court of Appeal (“BCCA”) reversed this decision, holding that the restrictive covenant was enforceable. Though the “Metropolitan City of Vancouver” was ambiguous, the appellate court applied the doctrine of “notional” severance to the covenant (explained below), which enabled the court to construe the covenant as applying to the City of Vancouver and its contiguous municipalities. Given this definition, the appellate court applied the covenant to Vancouver, the University of British Columbia Endowment Lands, Richmond, and Burnaby, and as such, found in favour of KRG Western.

The SCC Decision

At the SCC, the issue was whether the doctrine of severance or rectification could be applied to resolve an ambiguity in a restrictive covenant in an employment contract, or render an unreasonable restriction in a covenant reasonable. As well, the court was to consider whether Shafron owed fiduciary and equitable obligations to KRG Western and if so, whether they were breached. For the purposes of brevity, and because the second issue was disposed of quickly by the SCC, I will only address the first issue in this post.

The Law on Restrictive Covenants

The SCC began its analysis by summarizing the law on restrictive covenants. In the context of an employment contract, a restrictive covenant precludes an employee from competing with his or her former employer. Such circumstances belie a tension between the freedom to contract and public policy considerations against the restraint of trade. However, the courts have recognized that parties must have freedom to contract, and have created exceptions to the general rule against trade restraints where the restraint is found to be reasonable. A reasonable restraint is one that affords adequate protection to the party in whose favour it is imposed, while not being injurious to the public.

Another important characteristic of a restrictive covenant in an employment context is its relatively narrow freedom to contract, compared to a buyer/seller relationship. The common law has drawn this distinction because, in the context of the sale of a business, a seller is more likely to be able to sell if he can assure a potential purchaser that he will not enter into competition with them. According to the SCC, there are two reasons that justify the rigorous scrutiny of restrictive covenants in employment contracts: there is no payment for good will when the employee ceases to be employed by the employer, and there is often an imbalance in power between employee and employer, in comparison to a buyer/seller.

As mentioned above, a restrictive covenant is upheld as long as it is reasonable. To determine reasonableness, several factors are weighed, including the the geographic coverage of the covenant, the period of time in which it is effective, and the extent of the activity sought to be prohibited. In addition, the terms of the restrictive covenant must be unambiguous; because the reasonableness of a covenant must be proven by the party seeking to enforce it, an unclear covenant will be prima facie unenforceable because that party cannot demonstrate its reasonableness.

The Doctrine of Severance

Lastly, before analyzing the facts of this case, the SCC addressed the doctrine of severance in the context of restrictive covenants in employment contracts. Permissible severance comes in two varieties, both of which have been cautiously applied to render an illegal contract legal: “blue-pencil” and “notional.” “Blue-pencil” severance refers to the striking out an offending portion of a contract, leaving the legal segments intact and without affecting the meaning of the remaining part. “Notional” severance involves the reading down of a contract’s illegal provision to make it legal.

The SCC cautioned that in the context of an unreasonably wide restrictive covenant, the possibility of severance invites employers to draft overly broad covenants due to the prospect of the court severing or reading down any unreasonable portions. In light of the expense of litigation, in which the employee is often at a disadvantage, severance has been viewed as an exceptional remedy.

The SCC then specified what would constitute “exceptional.” While the general rule is that an ambiguous restrictive covenant in an employment contract will be void and unenforceable, blue-pencil severance “may be resorted to sparingly, and only in places where the part being removed is clearly severable, trivial and not part of the main purport of the restrictive covenant.” More notably, the SCC stated that notional severance should not be applied to restrictive covenants in employment contracts, for two reasons.

Firstly, there is no objective rule that can be applied in all cases to render the covenant reasonable, and applying notional severance means that the court will rewrite a covenant in a subjective manner. This creates uncertainty as to what is considered reasonable. Secondly, notional severance invites the employer to impose an unreasonable restrictive covenant, as the court would still enforce it to the extent of what might validly have been agreed to; the employer’s only sanction would be that parts of the covenant would be ignored. The advantageously-placed employer would have no inducement to ensure the reasonableness of the covenant, and the risk that the employee must abide by such an unreasonable covenant would increase. Thus, notional severance does not apply to restrictive covenants in employment contracts.

The Issue at Hand

The foregoing analysis brought the SCC to the issue at hand: whether an unreasonably wide restrictive covenant can be severed to leave in place what the court considers reasonable. The court first surveyed the preceding decisions, also noted above. At trial, on the basis of the evidence, including a confusing explanation of the contemplated spatial area given by the principal of KRG Western, the trial judge found that the restrictive covenant was not clear and certain and dismissed the company’s claim against Shafron. The Court of Appeal agreed with the trial judge that the term “Metropolitan City of Vancouver” was ambiguous, but deviated from the lower court by utilizing the doctrine of notional severance; the appellate court made a finding of what was likely “in the reasonable contemplation of the parties when they made their agreement” to resolve this ambiguity.

The SCC found that the Court of Appeal had not actually applied notional severance, as it did not read down an illegal provision to render it legal. The appellate court was trying to resolve the ambiguity of the covenant’s spatial terms by reading it down according to reasonableness and what the court thought the parties might have intended. As well, the SCC did not think that blue-pencil severance applied in this context, as this remedy is to be applied narrowly. Only trivial or technical aspects of the clause may be severed, as long as they do not form part of the clause’s main purpose.

In this case, the court found that such an excision would be more than just trivial. If the court were to remove “Metropolitan” as requested, only “City of Vancouver” would be left behind, and both KRG Western and the Court of Appeal indicated that something beyond the mere city was intended in the original clause. Because there was no evidence that the parties would have unquestionably agreed to remove this word without varying any other terms of the contract, blue-pencil severance was not applicable.

Finally, the court briefly considered the doctrine of rectification to clarify this term, per KRG Western’s submissions, but held that it was also inapplicable. Under this doctrine, it is necessary that both parties were in complete agreement on the terms of their contract, but in error wrote them down improperly; an inquiry into the parties’ states of mind is not required to determine the error. In this instance, there was nothing to indicate what the parties intended by their use of the term “Metropolitan,” or whether they agreed on an area and mistakenly wrote this down. The court found that they had merely used an ambiguous term in the written contract, which does not give rise to the doctrine of rectification.

In conclusion, the SCC held that the BCCA was in error by rewriting the restrictive covenant to substitute for the ambiguous term “Metropolitan City of Vancouver.” The lower court held that the restrictive covenant was unreasonable, and it was inappropriate for the Court of Appeal to alter the scope of the covenant to attempt to bring it within the realm reasonability. No avenues were left for KRG Western, and they were left to contemplate their lack of clarity. KRG Western’s action was dismissed, the trial judge’s decision was restored, and a harsh lesson was taught by the Supreme Court regarding ambiguity in restrictive covenants.