Self-Assessment of Non-Compete Clauses: The New Normal

[Pranshu Gupta and Roopam Dadhich are 4^th year B.A.LL.B. (Hons.) students at NALSAR University of Law, Hyderabad]

On 26 November 2020, the Competition Commission of India (‘CCI’) introduced an amendment to the CCI (Procedure in regard to the transaction of business relating to combinations) Regulations, 2011 (‘Combination Regulations’), through which para 5.7 of Form I has been deleted making it non-mandatory for the parties to provide a detailed explanation and justification (its scope, duration and territorial extent) of non-compete clauses (‘NCCs’) while filing for a combination with the CCI.

This post shall discuss the background of NCCs in terms of the legal developments, the stance of the CCI and other courts with respect to reasonableness of NCCs, implications of the recent amendment and the way forward.

Background

According to section 6(2) of the Competition Act, 2002 (‘the Act’), the parties to a combination need to file a notice with the CCI in the form specified under the Combination Regulations. This notice shall be filed in Form I of the Combination Regulations, under regulations 5 and 6, which would include the NCC and other specifications of the proposed combination. This would thereafter be reviewed by the CCI in view of sections 3 and 4 of the Act so that the proposed combination does not cause any appreciable adverse impact on competition.

The purpose of including NCCs in every merger & acquisition (‘M&A’) agreement is to protect the intellectual property, trade secrets, valuable customer relationships and technical know-how possessed by persons related to the target company so that it may not be used to the disadvantage of the acquiring firm following the acquisition, and to save the investment value of the transaction. These provisions are governed by the exception to section 27 of the Indian Contract Act, 1872, which permits contracts restricting a person or an entity from carrying on a similar business where the goodwill is being sold, as long as the restriction pertains only to specified reasonable limits.

Legal Developments

The recent amendment has been introduced after the CCI invited public comments on 15 May 2020 to its proposal to remove non-compete assessment as part of its merger review. The intention is to provide flexibility to the parties in determining non-compete restrictions and reduce the information burden on the CCI by transferring the onus to the parties. Moreover, the rationale was that prescribing a general set of standards for assessment of non-compete restrictions may not be appropriate in modern business environments. Further, this finds congruence to the recently introduced Competition (Amendment) Bill, 2020, under which the current merger timeline is proposed to be shortened from 210 calendar days to 150 calendar days. Also, the phase I review timeline will be reduced from the current 30 working days to 20 working days.

Until 2017, the CCI analysed competition compliance of NCCs within its preliminary review and required parties to undertake appropriate modifications. However, in 2017 the CCI released a Guidance Note wherein the scope of NCCs was specified taking into account its decisions in various cases. Since then, the CCI’s decisional practice evolved and, instead of requiring modification to NCCs, it merely declared NCCs to be “not ancillary” where they were seen as unreasonable. In this Guidance Note, the CCI noted that only an ‘ancillary restriction’, or a restriction that is directly related and necessary for the implementation of a transaction, shall be permitted.

A restriction is considered to be directly related when it is economically related to the transaction and is intended to allow a smooth transition to the post-transaction scenario. The necessity of a non-compete restriction should be assessed in terms of whether, in the absence of such restriction, the transaction can be implemented or whether it will be more onerous on the parties. If it is not directly related and necessary to the transaction, the CCI will approve the combination without approving the non-compete restriction. In such cases, the CCI’s order would state that the non-compete restriction is not “ancillary” to the combination. However, the finding that a non-compete restriction is not in compliance of the Guidance does not mean it infringes the provisions of the Act. Moreover, the standards set forth in the Guidance would not be applied mechanically, and would be applied taking into consideration the facts and circumstances of each case. The Guidance Note released by the CCI is similar to the Ancillary Note released by the European Commission which envisages similar guidelines for assessment of ancillary restraints in merger deals. 

It should be noted that even though the disclosure requirement for NCCs has been done away with through the recent amendment, parties enforcing NCCs will remain responsible to ensure that NCCs are competition-compliant since they can still be assessed under the behavioural provisions (i.e. sections 3 and 4) of the Act. Therefore, parties have to comprehensively self-assess the reasonableness of their NCCs to ensure they are not anti-competitive. For that purpose, the Guidance Note can be a useful tool since it still holds ground, along with an analysis of the past decisions of the courts as well as the CCI.

Judicial Stance

In Orchid Chemicals, the first ever case on NCC, the CCI found the provision on non-compete restrictive of competition, where Orchid Chemicals and the promoter were restricted for eight years and five years respectively from carrying out similar business activities. It was observed that non-compete obligations should be reasonable, particularly in respect of geographical limits, business activities, the duration over which such restraint was enforceable and the persons subject to such restraint, in order to ensure that there is no adverse impact on competition. Pursuant to this observation of the CCI, the parties had to modify the term of the NCC to four years for both the company and the promoter. The parties also modified the NCC to permit research, development and testing of certain new active pharmaceutical ingredients.

In Affle Holdings v. Saurabh Singh, the Delhi High Court upheld a share purchase agreement which restricted the promoter from engaging in a similar business for 36 months. The duration of such non-compete was found reasonable by the court. In Mylan Inc., the CCI did not uphold the NCC and the parties thereby revised it to cover only those products that were produced or sold by the target company, allowing the promoters of the target company to conduct research and development of new active pharmaceutical ingredients. They were also compelled to reduce the non-compete duration from six years to four years. In Crompton Greaves Consumer Electricals, the CCI approved the NCC only when the parties agreed to modify the duration of non-compete from five years to three years.

It is therefore evident that the CCI has in a number of cases compelled parties to modify NCCs on lines of the Guidance which lays down the duration of an NCC for a period of up to two years in case of transfer of goodwill and three years in cases of transfer of goodwill and know-how.  

Concluding Remarks

This seems to be a step in the right direction by the CCI, especially when attracting foreign capital and investments is a major goal for the country. This would have been difficult earlier owing to the onerous formalities of the CCI and its stringent compliance mechanisms. Until now, parties with their counsels’ assistance have already been conducting a detailed self-assessment of non-compete restrictions to ensure compliance of the competition law. However, the CCI while reviewing merger deals has in numerous cases held NCCs to be anti-competitive and non-ancillary, without providing any justification or analysis whatsoever. With this amendment, the process would become more efficient without compromising on the requirement of the parties to undertake a comprehensive anti-trust self-assessment of NCCs in M&A deals.

Some of the aspects that the parties and their counsels can take into account while drafting, negotiating, or agreeing to NCCs are discussed below. First, based upon an assessment of the CCI’s past practice and the Guidance note, the CCI has found a duration of three to four years as competition compliant (except in industries or sectors where customer loyalty to a seller will persist for longer durations or the nature of the know-how transferred justifies an additional period of protection). Second, the restriction should pertain to limited territories or areas, especially when the parties operate in limited regions (say only a few states in India). Third, the concerned business should have a genuine propriety interest. If there are no or very low recent activities, there is hardly any business interest to protect. Fourth, it should not completely restrict the seller from acquiring minor stakes in competing business for investment purposes, given there is no material influence in operations or management. Finally, special caution should be taken while drafting agreements for e-commerce or fintech entities since the geographical boundaries are blurred in such businesses.

– Pranshu Gupta & Roopam Dadhich