Scope of non-compete clauses in private M&A transactions

It is commonplace for most M&A contracts to contain a provision on the non-compete obligations of a selling entity and/or the promoter(s) of the selling entity post acquisition of a target company by an investor. Such provisions are governed by Section 27 of the Indian Contract Act, 1872 (“Act”), which states that “every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void”. While the provision declares all agreements that restrict a person or an entity from carrying on their profession, trade or business to be void, Section 27 of the Act does provide for one exception under which such agreements would be legally valid. The exception under Section 27 permits agreements restricting a person or an entity from carrying on a business similar to the business of which the goodwill is sold, to be valid, provided that such a restriction only pertains to a specified local limit and so long as the buyer, or any person deriving title to the goodwill, carries on a like business therein. However, the enforceability of such clauses are further subject to the scrutiny of a Court to determine whether the restrictions are reasonable having regard to the nature of business.

For this purpose, it is pertinent to examine certain important judicial decisions in order to understand how the Courts have interpreted the contractual provisions pertaining to restraint of trade while having regard to: (i) the commercial understanding between two parties to an acquisition; and (ii) the need for imposing such a restriction in light of the nature of the transaction. However, the scope of this article has been restriction to non – compete restrictions in private M&A deals or M&A deals of unlisted companies.

In the case of Affle Holdings Pte Limited vs. Saurabh Singh and Others[1], the Delhi High Court had passed an interim order, whereby it was held that a non-compete clause in a share purchase agreement restraining a promoter from engaging in a business similar to that of the target company for a period of 36 months was valid, which was further upheld and confirmed by the Delhi High Court in its judgment dated January 22, 2015. In arriving at this conclusion, the courts had noted that the promoter had received the total consideration for the sale share and had also transferred the goodwill in the business to the investor which is a key requirement under Section 27 of the Act. Another judgment that examined the scope of Section 27 of the Act was the Delhi High Court decision of March 26, 2015 in the case of Arvind Singh and Another vs. Lal Pathlabs Private Limited and Others[2]. In this case, the respondent, i.e., Lal Pathlabs Private Limited had acquired 100% of the shareholding of M/s. Amolak Diagnostics Private Limited and its goodwill from the appellants i.e., Dr. Arvind Singh and another, pursuant to which the appellants were restricted, under a provision in the share purchase agreement, from engaging in any business that was in competition with Lal Pathlabs Private Limited. A single bench of the Delhi High Court had held that such a clause was enforceable and passed an injunction order restraining the appellants from practicing as radiologists or pathologists in the city of Udaipur, India for a period of 5 years. This decision was reversed by the Delhi High Court subsequently on the premise that the activity of a profession is not akin to that of the  business of Lal Pathlabs Private Limited and will therefore not fall within the exception under Section 27 of the Act. Having said that, the court did succinctly note that the appellants will not be able to “overtly or covertly carry on a business of running a Pathlab or an X-ray Diagnostic Centre by forming a venture where the organizational structure has the essential attributes of a business”.

Another important consideration to be taken into account when drafting a non-compete provision in an investment/share acquisition/business transfer agreement would be to ensure that any restraints under the clause do not restrict fair competition in the market. To illustrate, an order passed by the Competition Commission of India (“CCI”) dated December 21, 2012, in relation to the sale of the Betalactum API business of Orchid Chemicals and Pharmaceuticals Limited (“OCPL”) to Hospira Healthcare India Private Limited (“HHIPL”) pursuant to the execution of a business transfer agreement between the two parties, noted that the non-compete clause under the said business transfer agreement was overly restrictive whereby OCPL and its promoter were restricted from undertaking business activities similar to that of the business transferred to HHIPL for a period of 8 years and 5 years, respectively. The CCI had further noted that the non-compete obligations also restricted OCPL and its promoter from undertaking certain other research, development and testing activities and deemed such restrictions to be unreasonable. In view of the above, the parties were required to amend the non-compete obligations under the business transfer agreement in order to ensure that there were no adverse effects on competition by: (a) reducing the restriction period imposed on OCPL and its promoter to 4 years in relation to the domestic market in India; and (b) permitting OCPL to conduct research, development and testing of new molecules. Some other cases examined by the CCI include: (i) Clairant Chemicals (India) Limited / Lanxess India Private Limited [3], wherein the imposition of a non-compete restriction of 5 years on the seller was later reduced to a period of 3 years and consequently accepted by the CCI; and (ii) Advent International Corporation / MacRitchie Investments Pte. Limited / Crompton Greaves Consumer Electrical Limited[4], wherein the CCI had once again approved the transaction only on the modification by way of reduction of the duration of the non-compete on the seller from 5 years to 3 years. In sum, it can be concluded that the CCI assesses non-compete clauses on two parameters, being: (i) that the scope of the non-compete should be reasonable with respect to the business it seeks to curtail and excessive curtailment, beyond the objective commercial necessity of the agreement, is likely to be seen as unreasonable; and (ii) that the duration of the non-compete should balance the commercial necessity of the clause versus the lack of/harm to competition in the market.

While there are judicial precedents that aid in understanding and interpreting the law governing non-compete restrictions in a 100% acquisition, the position in relation to a joint venture agreement in the Indian context continues to remain unclear and ambiguous.

Based on the above, is amply clear that parties to a private M&A deal and its advisors would need to be careful and prudent in drafting a non-compete restriction keeping in mind the: (i) law governing such restrictions; (ii) the various judicial decisions on this point to ensure that such clauses are legal and enforceable in a court of law; (iii) possibility of adherence to such non-compete restrictions from a commercial and practical standpoint; and (iv) applicability of the restrictions to other parties such as an affiliate or relative of a selling entity or its promoter.

Authors:
Vivek Bajaj, Partner
Sampriti Sridhar, Associate

Footnotes:
[1]  OMP 1257/2014
[2]  FAO (OS) 473/2014 & CM No.20860/2014
[3] Case: C-2016/02/373
[4] Case: C-2015/05/270

Date: June 1, 2020