KnowLaw

Are Non-Compete Provisions legal?

/

KnowLaw
Non Compete Agreement

Mergers and acquisitions are examples of inorganic growth processes, and are utilized as tools for big expansion, Indian companies are increasingly recognising them as critical components of business strategy. Contrarily to mergers, which are defined as the integration of two parties into a single company, acquisitions are circumstances in which one participant buys out the other in order to integrate the bought firm with itself. The non-compete provisions, in today’s time, are becoming an integral part of transactions related to mergers and acquisitions. In an M&A transaction, an acquirer may oblige a promoter not to compete with the business he is selling.

Most of the time, these clauses are necessary to guarantee that the merger or acquisition transaction will produce the anticipated effects. Therefore, the seller may need to be given an obligation not to compete with the buyer for a particular period of time in order to make sure that the value of the right or asset acquired is fully transferred to the buyer.

Non-Compete Provisions

Non-compete provisions derive their enforceability from the exception to Section 27 of The Indian Contract Act, 1872. Recently the Federal Trade Commission proposed to add a new subchapter in Code of Federal Regulations which defines non-compete clause as a “contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of worker’s employment with the employer.”

In order to make it optional for the parties to provide a thorough justification of non-compete clauses when submitting a combination application to the CCI, the Competition Commission of India introduced an amendment to the CCI Regulations, 2011.

Every merger and acquisition agreement should contain a non-compete provision to safeguard the trade secrets and technical know-how held by individuals connected to the target company from being used against the acquiring company after the acquisition and to preserve the transaction’s investment value. When a firm or its stock is sold, the parties typically agree to a non-compete clause for a predetermined amount of time and a predetermined geographic area. The acquirer pays a non-compete fee to the seller as compensation for this non-compete agreement. Therefore, a seller has the right to consent to a non-compete and be paid for it.

Are Non-Compete Provisions enforceable?

Non Compete Agreements

Numerous instances came up before the High Court and the Supreme Court that called the legality of such laws into question. For the court to enforce a non-compete agreement, the agreement must be fair and reasonable and should be specific in its restrictions. Whenever the agreement is for a shorter duration of time and does not cover too large geographical location, the court will consider it. The wider the agreement, the less likely it is to be enforced.

Certain principles that have been laid down by the courts for non-compete provisions are as follows: 

  • In order for the non-compete limitation to be valid, there must be a real business interest that has to be safeguarded.
  • The purpose of the covenant cannot be greater than necessary to protect the legitimate business interests.
  • Noncompete restrictions cannot apply in perpetuity.

It is crucial to make sure that any restrictions imposed by non-compete agreements in M&A deals do not impede free market competition. Under the purview of the Competition Act of 2002 and the associated rules, the Competition Commission of India is the body responsible for enforcing antitrust legislation in India with regard to mergers and acquisitions. 

Looking at the recent trend in the CCI rulings, it is clear that companies would lose significant investments if the non-compete investments are not for a limited time or extend outside of the acquired entity’s defined sphere of activity. The Reserve Bank of India in a 2014 notification had announced that, with some exceptions, the non-compete clause will not apply to existing pharmaceutical enterprises that are acquired by foreign investors or entities.

The Components

1. Time Duration:- The restrictive agreement should clearly mention the duration for which the agreement is binding. The Courts, generally do not consider long term non-compete agreements. Hence, the employer should make sure that the agreement is made for a reasonable time period. 

2. Competition:- It is important for the employer to clearly specify as to what type of industries or who is considered to be a competitor so as to make the non-compete agreement more precise.

3. Services:- The agreement must be specific as to what type of work or services have been restricted under this provision.

4. Geographical Location:- Such provision should also specify the fact that in what areas will the contract be binding on the employee. Such precise information not only gives the employee clarity of the provisions of the agreement but courts will also enforce such agreements and they will not be considered to be void. 

Legal Position of a Non-Compete

Judiciary

According to Section 27 of The Indian Contract Act, 1872, agreements restraining lawful trade or business are generally void. However, exceptions apply if the restraint is limited to a local area where the buyer operates a similar business. These agreements are allowed when they involve the sale of goodwill. Courts consider fairness and reasonableness of restrictions based on the business nature before enforcing them.

Judicial Review of Non-Compete Provisions

1. In the case of Niranjan Shankar Golikari v. The Century Spinning and Mfg. Co. Ltd,  The Supreme Court has given a liberal interpretation to Section 27 of The Indian Contract Act, 1872. The Court held that a negative covenant preventing an employee from engaging in a similar trade or employment is not considered a restraint of trade unless the contract is unconscionable, excessively harsh, unreasonable, or one-sided.

2. The Hon’ble Delhi High Court in Pepsi Foods Ltd. And Ors. v. Bharat Coca-Cola Holdings Pvt. Ltd. And Ors. stated that it is well-established that such post-termination constraint violates Section 27 of the Contract Act. Such agreements are invalid, unenforceable, and against public policy. The injunction of the court cannot authorise something that is illegal.

3. The Supreme Court took a cautious approach in the case of Percept D’Mark (India) Pvt. Ltd. v. Zaheer Khan & Anr, holding that a restrictive covenant that extends beyond the period of the contract is void and unenforceable.

4. The agreement between Orchid Chemicals and Pharmaceuticals Ltd (OCPL) and Hospira Healthcare India Pvt Ltd (HHIPL) included a clause that stated that OCPL and its promoter may not engage in specific business operations for eight and five years, respectively. After the CCI called for “reasonable” non-compete agreements, both parties agreed to limit the term to four years. The CCI subsequently accepted the changes and asked the corporations to include them in the deal.

How is it dealt with in the United States?

According to research, 30 million Americans, or 18%, are currently bound by such clauses. Approximately 37% of workers claim to have worked under a non-compete agreement at some  point of time.  

  • Idaho and Washington state lawmakers have introduced bills that would restrict the scope of non-compete agreements.
  • In California, Except for a few limited circumstances, noncompete clauses are automatically deemed invalid. A reasonable non-compete agreement tied to the sale of company’s goodwill, ownership stake, or operating assets within a specific geographic area is considered legitimate.
  • In Oregon, Non-compete agreements are voidable and cannot be upheld by Oregon courts unless a number of requirements are met.

Conclusion

Non-compete provisions are increasingly a standard feature of M&A deals involving a change of control. It is well established that non-compete provisions are void unless deemed reasonable, considering public and party interests. There are no fixed rules to determine the validity of non-compete provisions, as their acceptance depends on specific cases. The Courts have differing opinions on the legality of non-compete provisions. However, courts emphasise the reasonableness of restrictions in such agreements and have held that their mere presence doesn’t render them void ab initio.

References

Submitted by Arsh Kohli, a Student pursuing B.B.A.LL.B. from NMIMS School of Law, Bengaluru.