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How enforceable are non-compete provisions in investment agreements?

09 January, 2017

Private equity and venture capital investment agreements invariably contain provisions imposing non-compete obligations on the promoters of the investee company. These clauses are in the form of elaborate restrictions, prohibiting the promoters from carrying on any similar or identical business to that of the investee company once they cease to be a shareholder or an employee of such company and for a certain duration of time thereafter.

The question that often arises is how enforceable are these provisions of non-compete against such promoters, who may in many cases be serial entrepreneurs.

The pivotal provision of law on this point is Section 27 of the Indian Contract Act, 1872 (Contract Act), which provides that a contract in restraint of trade is void.

Section 27 of the Indian Contract Act, 1872 provides that every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void. It also has an exception — saving of agreement not to carry on business of which goodwill is sold. One who sells the goodwill of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits, so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business therein, provided that such limits appear to the court reasonable, regard being had to the nature of the business.

The case law on covenants in restraint of trade are as follows:

In the case of Superintendence Company of India (P) Ltd. versus Sh. Krishan Murgai, ((1981) 2 SCC 246) the honourable court held that a negative covenant extending beyond the period of service was void. The court referred to Madhub Chunder versus Rajcoomar Dos ((1874) 14 Beng LR 76) at pp. 85-86, where it had been held that “whether the restraint was general or partial, unqualified or qualified, if it was in the nature of a restraint of trade, it was void”.

Pursuant to the forgoing decisions, the Bombay High Court in Taprogge Gesellschaft MBH versus IAEC India Ltd, (AIR 1988 Bom 157) held that a restraint operating after termination of the contract to secure freedom from competition from a person who no longer worked within the contract, was void. The court in the said matter refused to enforce the negative covenant. 

In the case of Wipro Ltd versus Beckman Coulter International SA (2006 (3) ARBLR 118 (Delhi)) wherein it has been held that negative covenants between employer and employee contracts pertaining to the period post termination and restricting an employee’s right to seek employment and/or to do business in the same field as the employer would be a restraint of trade and therefore, a stipulation to this effect in the contract would be void. No employee can be confronted with a situation where he has to either work for the present employer or be forced to idleness.

The Supreme Court in the case of M/S Gujrat Bottling Co. Ltd & Ors. versus The Coca Cola Co. & Ors., (AIR 1995 SC 2372) has made it amply clear that non-compete clauses operating beyond the term of the contract would not be enforceable as they would have the effect of restraining persons from exercising their right to freedom of trade and would hence be violative of Section 27 of the Contract Act. 

It is, therefore, established law that with regard to employment agreements covenants that prohibit employees from engaging in a business similar to or competitive with that of the employer beyond the term of employment are invalid.

There is, however, no case law on restrictive covenants in investment agreement and in an investor promoter scenario.

The Supreme Court has held in the case of M/S Gujrat Bottling Co. Ltd & Ors. versus The Coca Cola Co. & Ors. (AIR 1995 SC 2372) that, since the underlying principle governing all contracts in restraint of trade was the same, the principle not only applied to contracts of employment but to other contracts as well.

However, in the same case, the Supreme Court discussed the scope of Section 27 of the Contract Act and opined that a covenant in restraint of trade must be reasonable with reference to public policy and must also be reasonably necessary for the protection of the interest of the covenantee and regard must be had to the interest of the covenantor. Contracts in restraint of trade are prima facie void and the onus of proof is on the party supporting the contract to show that the restraint of trade goes no further than is necessary to protect the interest of the covenantee and if this onus is discharged, the onus of showing that the restraint is nevertheless injurious to the public is on the party attacking the contract. The court has to decide, as a matter of law, (i) whether a contract is or is not in restraint of trade, and (ii) whether, if in restraint of trade, it is reasonable.

In light of the aforesaid decision it maybe construed, in our view, that if an investor were to prove that the restraint of trade (i.e. the non-compete clause) is reasonable, the non-compete provision maybe enforceable.

Mini Raman is partner and Savitha M is associate at LexOrbis a corporate and intellectual property law firm. The views expressed are personal and do not necessarily represent the views of the firm.

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How enforceable are non-compete provisions in investment agreements?

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