Sunday, June 12, 2011

Non Compete Fee, Takeover Code: Part 2

In my previous post I had briefly discussed the concept of non-compete fees and the legal issues surrounding it. In this post I shall discuss the prevailing position of law with regard to non-compete fees. The present position of law is clearly articulated in E Land Fashion China Holdings Limited v. Securities Exchange Board of India wherein the SAT while reversing the order of SEBI allowed the acquirer to pay the additional non compete fees to the exiting promoters.


The appellant entered into a share subscription agreement and a share purchase agreement with the target company and its promoters whereby it was inter alia agreed that the appellant would acquire 51% of the equity capital of the target Company at a price of Rs. 75 per share inclusive of a non-compete fee of Rs. 15 per share. The appellant and the target company and its promoters also executed a shareholders agreement. Since, the equity shares acquired by the appellant pursuant to the aforesaid agreements were in excess of 15% of the voting rights in the target company, the provisions of Regulation 10 and 12 of the Securities and Exchange Board (Substantial Acquisition of Shares and Takeovers) Regulation 1997 [Hereinafter “takeover code”] got triggered. Accordingly, the appellant made an open offer to acquire 20% of the voting capital of the target company at a price of Rs. 60 per share. The offer price did not include the additional Rs. 15 which was offered to the promoter group. Thereafter, SEBI directed the appellant to add  the non-compete fee paid to the promoters to the offer price.                                         
SEBI's Contention

SEBI argued that the non compete fee should be added to the offer price as (i) the existing promoters were still continuing to hold substantial shares (post offer shareholding) in the company and that they were not exiting completely (ii) the promoters had the right to appoint two directors and jointly select two independent directors in the company (iii) the shares of the promoters had a lock in period of 3 years i.e. the promoters were not entitled to transfer their shares without the written approval of the acquirer. The crux of SEBI's argument was that the exiting promoters even post offer would continue to hold substantial shares in the company and also control the company. In such a scenario, SEBI argued, it was unlikely that the promoters would totally exit the target company and offer competition.

SAT's Ruling

The SAT allowed the payment of the non compete fee to the promoters of the target company on the ground that the promoters had the experience and expertise to compete with the target company at a future point in time. In arriving at this conclusion SAT heavily relied on its earlier ruling in Tata Tea Ltd. v. Securities Exchange Board of India. In tata tea the tribunal had held that if the payment of non compete is based on a strong business rationale and is not a mere tool to reduce the cost of acquisition to discriminate against the public shareholders, the Board or the tribunal is not entitled to intervene.


It is now fairly well settled that an acquirer is entitled to pay the promoter group of the target company an additional non-compete fee. However the non-compete fee can only to paid when there is a “lurking fear of competition”. The question as to what amounts to “lurking fear of competition” is a factual one and will have to be determined on a case to case basis. Additionally, the validity of a non-compete fee is not dependent on the extent of the threat of competition from the selling promoters i.e. even if the threat is remote it is not open for the Board or even the tribunal to intervene. The Board can intervene only when the non-compete fee is used as a design to reduce the cost of acquisition to discriminate against the public shareholders.

Although the controversy surrounding non-compete fee and the takeover code is clear (at least for the time being), several commentators (here and here) believe that non-compete agreements are in violation of S. 27 of the Indian Contract Act, 1872. The commentators argue that a SEBI Regulation cannot allow what the parliament expressly prohibits.      


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