In commercial transactions, it is common for one or both parties to provide non-compete undertakings. For example, in a business acquisition, the seller of the business may agree that it will not compete with the business that it has sold, and a clause to this effect may be included in the share purchase agreement or the asset purchase agreement. And in a joint venture, each of the joint venture parties may agree that it will not compete with the joint venture company, and a clause to this effect may be included in the joint venture agreement or the shareholders’ agreement.
Are such undertakings valid and enforceable under the general law and under specific laws such as competition law? If so, what restrictions are imposed on the nature and extent of such undertakings? This article considers the position under the general law in common law jurisdictions, and then examines the position in China, and under competition law.
In answering these questions, the law often needs to make difficult choices between competing priorities. For example, a fundamental principle in common law jurisdictions is freedom of contract; namely, the parties to a contract should be free to determine their mutual rights and obligations.
Another fundamental principle is freedom of trade, under which companies and individuals should have the freedom to carry out trade without unreasonable restriction. The law governing non-compete clauses is an example of an area in which these fundamental principles often come into conflict and the legislators and courts often struggle to achieve an appropriate balance.
Although the focus of this article is on business acquisitions and joint ventures, it should be noted that there are other contexts in which similar issues and challenges arise. These include restrictive covenants in employment contracts, where employees agree not to compete with their employer after leaving their employment.
They also include arrangements that involve exclusive dealings, such as where a customer agrees to deal exclusively with one supplier and not to purchase materials from any other suppliers.
Different names are used to describe such clauses. In common law jurisdictions, they are often called restraint of trade clauses. In the US, they are normally referred to as non-compete agreements or “non-competes”. In addition, the term “non-solicitation clause” is used to describe the situation where a party undertakes not to solicit or recruit employees of the other party, and the term “exclusive dealing clause” is used to describe the situation where a party agrees to deal exclusively with another party.
Traditionally, the common law did not provide much protection to the buyer of a business to protect the business that it had purchased from unfair competition by the seller. Although the common law generally did not permit the seller to solicit customers from its previous business, it did not prohibit the seller from establishing a new business in competition with the business that it had sold. As a result, the buyer started to rely on contractual protection in the form of “restraint of trade” clauses, under which the seller agreed that it would not compete with the business that it had sold for a certain period of time.
For centuries, the common law did not like restraint of trade clauses and considered them to be void on the basis that they were contrary to public policy. This was because they restricted the freedom to engage in trade or commerce, which has always been an important principle of a free society, particularly in the case of employees. However, common law recognised an exception where the restraint was reasonable. The classic statement of the position under common law was made by Lord Macnaghten in a case called Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd (1894):
The public has an interest in every person’s carrying on his trade freely: so has the individual. All interference with individual liberty of action in trading, and all restraints of trade of themselves, if there is nothing more, are contrary to public policy, and therefore void. That is the general rule. But there are exceptions: restraint of trade and interference with individual liberty of action may be justified by the special circumstances of a particular case. It is a sufficient justification, and indeed it is the only justification, if the restriction is reasonable – reasonable, that is, in reference to the interests of the parties concerned and reasonable in reference to the interests of the public…
Lord Macnaghten was a famous member of the House of Lords and one of the judges in the landmark case of Salomon v A Salomon & Co Ltd , which recognised a company’s separate legal personality and the concept of limited liability (for a discussion of this case, see China Business Law Journal volume 3 issue 9: Company or enterprise?).Subsequent cases recognised that a restraint of trade clause will be valid if three criteria are satisfied: (1) there is a valid interest that the party imposing the restraint is trying to protect; (2) the restraint is reasonable; and (3) the restraint is not contrary to the public interest.
You must be a subscribersubscribersubscribersubscriber to read this content, please subscribesubscribesubscribesubscribe today.
For group subscribers, please click here to access.
Interested in group subscription? Please contact us.
A former partner of Linklaters Shanghai, Andrew Godwin teaches law at Melbourne Law School in Australia, where he is an associate director of its Asian Law Centre. Andrew’s new book is a compilation of China Business Law Journal’s popular Lexicon series, entitled China Lexicon: Defining and translating legal terms. The book is published by Vantage Asia and available at law.asia.