In India, a non-compete restriction in a M&A transaction is valid only if the transaction involves a sale of goodwill. This article examines whether the goodwill exception is adequate in the context of extant business realities, and the approach taken by Indian regulators.
Non-compete restrictions at Indian law are usually enforceable only during the pendency of a contract. Illustratively, where parties enter into a joint venture or shareholders agreement, non-compete restrictions would, unless deemed unreasonable, be enforceable against the parties so long as they remained joint venture partners or shareholders, as the case may be. Non-compete restrictions which purport to extend beyond the term of a contract are void under Section 27 of the Indian Contract Act, 1872 (Act) except where there has been a sale of goodwill.
The goodwill exception
Indian courts have previously held that the goodwill exception will be available only if the proscriptions on trade are not pervasive and unreasonable, and the goodwill is identifiable, and it is apparent that it is being used.
Where M&A transactions are concerned, the sale of goodwill may be inferred, or apparent, depending on the circumstances. Illustratively, in Affle Holdings Pte Limited v. Saurabh Singh & Others, the Delhi High Court held that a purchase of the entire controlling interest in a target company was, in effect, the acquisition of the business and its goodwill and, therefore, the reasonable non-compete restriction imposed was valid. In the case of a business transfer or slump sale, parties may specify that the goodwill is also being sold and, accordingly, impose a non-compete obligation on the seller.
Difficulties arise where the sale of goodwill is harder to substantiate. Illustratively, in the case of a joint venture company, the goodwill created belongs to the company although its creation may be attributable to the joint venture partners. A joint venture partner seeking to exit may not, therefore, be able to sell any goodwill, and a non-compete restriction imposed on that partner may be void. However, when a joint venture or strategic partner exits, the joint venture entity and, or, the remaining partners may legitimately expect the exiting partner to surrender their interest in the goodwill of the entity and refrain from competing with that entity. Restricting the enforceability of non-compete restrictions to sales of goodwill unduly prejudices parties who may legitimately expect and, or, require non-compete restrictions but may not be able to undertake or demonstrate a sale of goodwill.
The position in other jurisdictions
In the United States, courts have held that, when there has been a sale of goodwill, it would be unfair for the seller to partake in any kind of competition which would have the effect of diminishing the value of the asset that has been sold. In such cases, there must be a clear indication that the parties considered goodwill to be a component of the sale price which would thereby entitle the buyers to ensure protection against competition from the seller. As is the case in the United Kingdom, where an agreement for sale of a business includes goodwill, the seller should be able to get a high price for what they have to sell, and the purchaser is entitled to protect what they are paying for as the business would otherwise be worthless.
The position in foreign jurisdictions indicates that a restrictive covenant in business transaction agreements is more likely to be enforced as the parties are more likely to be on equal footing when negotiating. Although the sale of goodwill enhances the likelihood of enforceability of a non-compete restraint, the restraint remains subject to the reasonability criterion, and where the restraint has been deemed necessary to protect the buyer’s legitimate interests, it will be upheld as enforceable.
Indian regulators and non-compete restrictions
Competition Commission of India
The Competition Commission of India (CCI), India’s antitrust regulator, has, while determining whether a combination will have an ‘appreciable adverse effect on competition within India’, opined that covenants restraining competition must be reasonable. Reasonability is evaluated based on the duration of the restraint, business activities, geographical area, and the persons so restrained.
Additionally, a member of the CCI, M. S Sahoo recognised the significance of ancillary restraints, and noted that such restraints are necessary to ensure the effectiveness of the combination and a reasonable, balanced, and proportionate ancillary non-compete obligation will ordinarily be valid and permissible.
The CCI’s position on non-compete restrictions was further clarified in a guidance note issued in 2017 (Guidance Note) which prescribed certain principles for non-compete restrictions in transactions involving a transfer of goodwill. Restrictions complying with the Guidance Note were deemed to have been approved by the CCI when it approved the relevant combination. The Guidance Note provided, amongst others, that: (i) non-compete restrictions should be reasonably required and economically related to the main combination, and must be aimed at facilitating a smooth transition to the post-combination scenario; and (ii) the implementation of the combination would be more challenging in the absence of such restriction.
Although the Guidance Note was withdrawn on 31 December 2020, this appears to have been to ease parties’ disclosure requirements, and was not indicative of a re-evaluation of the CCI’s position.
Securities and Exchange Board of India
Acknowledging the validity of restrictive covenants in the M&A context, the Securities Appellate Tribunal, Mumbai in Tata Tea Ltd. v. Securities and Exchange Board of India and Anr. observed that taking over a business entails taking over the specific knowledge of the seller’s business and their access to, and possession of, relevant trade secrets. The disclosure or misuse of such secrets is likely to cause irreparable harm to the target company and its continuing shareholders, and “…by virtue of their association with that business, they (out going sellers) are capable of offering competition to the business being taken over. In such cases, it would be legitimate for the acquirer to enter into a non-compete agreement with the promoter sellers if he feels threatened by a lurking fear of competition from them…”.
Separately, the erstwhile Securities and Exchange Board of India (SEBI) (Substantial Acquisition of Shares and Takeover) Regulations, 1997 (Erstwhile Regulations) provided that non-compete fees should be added to the offer price if they exceeded 25% of the offer price. This provision was not restricted to transactions involving a sale of goodwill. In fact, where an open offer fails, the acquirer may not have been able to demonstrate an acquisition of goodwill even though a non-compete restriction was imposed, and fees were paid.
The SEBI (Substantial Acquisition of Shares and Takeover) Regulations, 2011, enacted following the repeal of the Erstwhile Regulations do not interdict the payment of non-compete consideration but merely provide that the offer price would include inter alia the non-compete fees, if any.
In summary
Indian courts and regulators alike appear to agree that non-compete restrictions may be necessary depending on facts and circumstances. In addition to being divorced from commercial and business realities, restricting the enforceability of non-compete restrictions to scenarios in which there has been a sale of goodwill disregards party autonomy.
As a general principle, parties who are competent to contract should be entitled to determine the contractual terms by which they are to be bound, and are the best judges of what is reasonable between themselves. The Allahabad High Court previously observed that “…Section 27 [of the] Act…seriously trenches upon the liberty of the individual in contractual matters affecting trade…”. The Law Commission of India (Commission) in its 13th report has stated that “…there is no reason why a more liberal attitude should not be adopted [with respect to Section 27 of the Act] by acknowledging such restraints as are reasonable not only as between the parties to the agreement but also as regards the general public…”, and recommended that Section 27 of the Act be amended to allow reasonable restraints on trade. However, no such amendment has been made.
The Legislature should consider amending the Act to permit all reasonable restraints of trade instead of restraints where there has been a sale of goodwill. In addition to prioritising party autonomy, this could encourage M&A in India as parties who have paid valid consideration will be better able to protect their interests as they are able to in many Commonwealth jurisdictions and developed countries. Of course, the reasonability of such restraints must be adjudged based on the circumstances, including through an analysis of whether the restraint enables commercial and economic furtherance without causing prejudice to either party.
