Court endorses non-compete clauses in share acquisitions

By Zakir Merchant and Ashraya Rao, Khaitan & Co
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1915

Restrictive non-compete covenants are common in share purchase and subscription transactions in India. Standard provisions include restrictions on the promoters, sellers or joint venture partners from engaging in competing business for a specified time period. Such provisions are aimed primarily at protecting investment value and business know-how.

Zakir Merchant
Zakir Merchant

However, investors have faced various practical issues in enforcing such provisions because of the broad restriction set out under section 27 of the Indian Contract Act, 1872. Further, Indian courts have frequently refused to enforce post-termination non-compete clauses in employment contracts.

In a welcome development, Delhi High Court in its recent order in Lal Pathlabs Pvt Ltd v Arvinder Singh (2014) acknowledged India’s need for economic development through foreign investment and noted that non-compete clauses are an essential part of mergers and acquisitions in India. The single judge recognized that holding non-compete clauses to be non-enforceable would be a serious impediment to foreign investment.

Legislation

Section 27 of the Contract Act stipulates that an agreement restraining a person from carrying on a lawful profession, trade or business would be void to that extent. An exception to this rule is a person who sells the goodwill of a business to another may be restrained from carrying on a similar business subject to reasonable limits of duration and location as long as the buyer carries on the same business.

In addition, a non-compete agreement may violate section 3 of the Competition Act, 2002, if it causes an appreciable adverse effect on competition in India.

Judicial principles

Courts in India have elucidated various principles in interpreting section 27 of the Contract Act to restrict the validity of non-compete clauses. For example, restrictive non-compete covenants extending beyond the term of a contract are void and not enforceable. The doctrine of restraint of trade applies only after a contract comes to an end and applies to all contracts. Persons can be restrained from carrying on their “trade” if they voluntarily enter into an agreement with that object. The scope of restraint of trade includes master-servant agreements, covenants for the protection of goodwill, exclusive dealing contracts, and price-setting agreements.

While the courts have generally been tolerant where a business is sold since goodwill is associated with the business, non-compete restrictions pursuant to the sale of shares have not been considered favourably.

Shift in the tide?

Recent orders of Delhi High Court in the Lal Pathlabs case and in Affle Holdings Pte Limited v Saurabh Singh (2015) have diverged from the earlier position and validated non-compete restrictions in transactions involving the sale of a controlling stake.

Ashraya Rao
Ashraya Rao

In Lal Pathlabs, the high court held that the exceptions under section 27 of the Contract Act are applicable to the sale of goodwill of any activity, whether labelled as a business, a trade or a profession. Further, the single judge observed that the transaction in the case fell within the exception to section 27 since the documents executed by parties for sale and purchase of shares were intended to cover the sale of goodwill also.

Subsequently, in January 2015, another single judge of Delhi High Court in the Affle Holdings case upheld a non-compete restriction while observing the following: (i) the entire controlling interest of the company was bought with a view to acquire its business along with its goodwill; (ii) substantial consideration was paid for acquisition of those rights and the restriction fell within the first exception to section 27 of the Contract Act; and (iii) the prohibition on engaging in competitive business or commercial activity was reasonable both in time and space and could not be held to be in restraint of trade.

The above orders reflect the changing outlook of the Indian judiciary towards globalization and protecting investment value of stakeholders. Whether the persuasive value of these orders paves the way for similar judgments from other courts in India remains to be seen.

Taking cues from the observations, investors should carefully draft non-compete restrictions with specific considerations in mind, such as: (i) the restrictions being undertaken in lieu of the total consideration received by the seller; (ii) the restrictions being reasonable in terms of duration and geography; (iii) the parties expressly setting out that goodwill is pertinent to the transaction; and (iv) linking post-sale restrictions to the sale consideration instead of employment agreements with individuals. Investors should be mindful that the above orders only deal with share acquisitions involving a 100% stake or a controlling stake in a target company. Investors with minority investments seeking restrictions on promoters would have to consider other ways to protect their value.

Zakir Merchant is a partner and Ashraya Rao is a senior associate at Khaitan & Co. The views of the authors are personal, and should not be considered as those of the firm.

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