Non-compete restrictions are an integral part of employment contracts. However, non-compete restrictions are often also found in agreements for a complete sell-out by promoters of a company. In simple terms, a person undertaking ‘non-compete’ obligations promises not to undertake a business or work similar to that of the entity for which the employee is working or which the promoter has sold out.
Enforceability of non-compete clauses under the Indian Contract Act
Although commonly sought, non-compete clauses in agreements are unenforceable in terms of Section 27 of the Indian Contract Act, 1872 (the ‘Contract Act’) as such restrictions are considered to be a restraint on the right of a person to carry out his/her lawful profession, trade or business.
However, there is an exception to Section 27 of the Contract Act, where a non-compete restriction is placed on sellers at the time of sale of their business and where such sale of business is along with goodwill and where such restriction is applicable within reasonable specified local limits.
Non-compete restrictions on sellers are permitted in the aforesaid cases and their enforceability in these circumstances is at the discretion of the courts. Non-compete restrictions during an employee’s course of employment have over the years been recognised and are permitted.
Through this article, we aim to discuss promoter-related non-compete obligations which typically require a promoter not to engage in any competing business in any capacity upon sale of business along with goodwill. The prohibition is all-encompassing and covers any form of association of the promoter with any competing business i.e. in the capacity as shareholder or partner or consultant etc., including indirect association with any competing businesses as well.
To what extent are non-compete restrictions enforceable?
A second and important aspect is that of consequences of a breach of such non-compete obligations. A test of enforceability of non-compete restrictions would also mean a test of enforceability of the consequences of breach of such restrictions (as documented in the agreement), since these would also have to stand the test of reasonableness.
Consequences of any breach of non-compete obligations would be in the form of either a claim for damages (amounts) or suit for injunction (implying that the party that has breached the non-compete obligation will be required to cease all competing activities).
Recent ruling on non-compete restriction on promoters
The above mentioned issue regarding the enforcement of a non-compete clause has sparingly come before judicial authorities. In a recent Delhi High Court order dated January 22, 2015 passed in the matter of Affle Holdings Pte. Ltd. v. Saurabh Singh and Ors, the petitioner had bought the entire controlling interest in the company from the promoters after paying substantial consideration with a view to acquire its business along with its goodwill.
Considering that substantial consideration had been paid by the petitioner to the promoter under the Share Purchase Agreement, the court was of the view that the matter would fall within the preview of Exception 1 to Section 27 of the Contract Act and it was held that non-compete restrictions on the promoter not to engage in a competing business for a period of 36 months was not void.
Safeguards for promoters
The Contract Act does not specify any set parameters to determine whether the non-compete restrictions imposed on a promoter are reasonable. The reasonability of such restrictions would be scrutinised only when a dispute arises, which would thereafter be evaluated and decided by the court on a case-by-case basis.
Also, since there are very few judicial proceedings initiated in relation to the exception to Section 27 of the Contract Act, it is difficult to elaborate on the accepted principles for a non-compete clause under such transactions.
While non-compete restrictions usually form part of obligations that promoters undertake at the time of their exit from the company, it is also important for the promoter to ensure that the obligations which are being sought from him/her are acceptable from a commercial perspective. When the promoter agrees to undertake non-compete obligations under an agreement, he should factor in certain aspects of such obligations considering that he will be required to adhere to such obligations for a specified duration of time
Therefore, not only will the period for which the non-compete obligations continue to bind the promoter be important, but there are also a few other safeguards within the non-compete clauses which the promoter should consider and negotiate with the counter-party which include:
Scope of non-compete — are relatives and affiliates also expected to adhere to non-complete clauses?
In some cases, a non-compete obligation is not only required to be adhered to by the promoter, but also by his relatives and affiliates. To what extent such a scope can be accepted would depend on the ability of the promoter to ensure that such persons/entities comply with the non-compete obligations. Promoters need to be mindful of the consequences which flow from a breach of non-compete obligations. To ensure that there is no breach in the entire duration when the non-compete restriction applies, it then becomes imperative to limit the non-compete clause only to those relatives/entities which the promoter would be in a position to ensure will comply with these obligations.
Given the wide ambit of the non-compete restrictions which prohibit the association of a promoter with any competing business, it becomes important for the promoter to identify carve-outs to which such non-compete restrictions would not apply. These carve-outs could be in:
- The nature of any existing ventures in which the promoters are interested
- Any non-significant investments made by promoters in businesses that may be competing in nature etc.
Identification of such interests and disclosing them to the acquirer and also detailing these in the agreement would be critical to ensure that the promoter has the flexibility to continue being associated with such ventures.
Non-competes for startups
A non-compete in case of startup companies is along the same principles. Also, when startups receive funding, apart from the usual obligations in relation to the business which the promoters are required to adhere to, the promoters of startups are also required to devote their full time and attention to the startup company and which can be found in the form of non-compete restrictions, of a nature similar to that discussed above.
It would be important for promoters to ensure that the provisions with respect to non-compete restrictions are considered by the promoters carefully before accepting the same. Promoters must carefully study the implications non-compete restrictions may have on them post the sale of their business and during the course of their association with companies they are associated with. It would also be important for the promoters to carefully analyse the downside of acceptance of an absolute non-compete restriction and also ensure that if there any exceptions which can be carved out to dilute the implications of such non-compete provisions, then they should be looked into.
(Disclaimer: The views and opinions expressed in this article are those of the author and do not necessarily reflect the views of YourStory.)