Enforcing of non-compete clauses in investment pacts

Shopping online has grown exponentially in India. So it’s no surprise that investments in e-commerce companies have been the trend for the past few years. Notably e-commerce companies which operate and manage online portals for shopping engage several third party agencies, for tasks ranging from developing mobile applications to undertaking marketing campaigns.

Owing to the rise in businesses of the e-commerce companies, it is natural that such third party agencies have witnessed a substantial surge of work, thus attracting investments from private equity (PE) investors and venture capital (VC) funds, as well as foreign entities with similar business looking to establish their presence in India.

Investments are generally made either by subscribing to equity shares of the target company or by purchasing shares from the promoters. The PE/VC investor or a foreign company purchasing the shares of the Indian company buys into the idea and the capability of the promoters, who have been able to nurture the idea into the business. It therefore becomes crucial to negotiate with the promoters so that they cannot start or invest in a similar business for a specific period of time.

In most such transactions, it has been seen that while acquiring the shares of the company in which investment is being made, reasonable restrictions are imposed on the promoters of the investee company in the form of non-compete clauses. In the event of shareholders’ agreements or if the PE/VC investor invests to acquire a majority shareholding of the investee company, the transaction structure generally entails execution of a separate employment agreement with the promoter of the investee company, which inevitably has a separate non-compete clause.

With such non-compete clauses in both, the shareholders’ agreements and the share purchase agreement, as well as the employment agreement, the investor seeks to thwart the promoters of the investee company from forming a competing company. The tricky part though is enforcement of such non-compete clauses.

In terms of section 27 of the Indian Contract Act, 1872, an agreement in restraint of trade and business is void. The exception to section 27, which is of significance in relation to investments based on shareholders’ agreements/share purchase agreements, provides that agreements in terms of which the goodwill of the business is sold are not hit by the prohibition as contained in section 27. Therefore, it is essential while seeking enforcement of non-compete clauses in shareholders’ agreements/share purchase agreements to show that the goodwill in the business has been transferred by the investee company in favour of the investor.

If there is no transfer of goodwill, then enforcement of non-compete clauses in such agreements, no matter how water-tight the clause is, will not be absolute and the investor may not be able to enforce the clause post termination of the agreement. In the case of Percept D’Mark (India) Pvt Ltd v Zaheer Khan and Anr (2006), the Supreme Court of India held that under section 27, a restrictive covenant extending beyond the term of the contract is void and not enforceable

In the case of Affle Holdings Pte Limited v Saurabh Singh and Ors (2015), Delhi High Court, while extending protection to the investor company and restraining the promoter, held that a restriction imposed in the contract was reasonable in view of the promoter having received the total consideration for the shares and, more importantly, having transferred the goodwill in the business. In this case, the petitioners argued the non-compete clause in the employment agreement as well. Though the court granted an injunction in view of the non-compete clause in the share purchase agreement, arguments to enforce the non-compete clause in the employment agreement were rejected as the agreement was terminated.

A non-compete clause in an employment agreement can be enforced so long as the employment agreement – for the present purposes, a separate agreement executed with a promoter of the investee company – is valid and subsisting. Non-compete clauses in an employment agreement once terminated cannot be enforced in view of the prohibition under section 27. Hence, in certain situations, the non-compete clause under the employment agreement may not be available but the clause may be enforced under the shareholders’ agreement or share purchase agreement.

While non-compete clauses are an important means to protect the rights and interests of investors, they are not absolute and must be in conformity with the law and during the subsistence of the contract in order to be enforced.