"It looks fishy, it smells fishy," host Menaka Doshi declared, opening this week’s episode of The Firm with a scorching observation. The burning question on the minds of panellists BMR Advisors partner Gokul Chaudhri, and FinSec Law Advisors founder Sandeep Parekh: can Sebi interfere with Vedanta’s Rs 50 per share non-compete fee paid to Cairn PLC as part of the acquisition of Cairn India?

According to Vedanta's executive chairman Anil Agarwal: "We felt it absolutely necessary that for us that they don’t compete because they understand lot more than what we understand. It is better to pay them."  With strong arguments on both sides, to understand the issue thoroughly, we begin with an analysis of the law.

Under Section 27 of the Indian Contract Act agreements in restraint of trade are void.  An exception is allowed, however, when in connection with the sale of a business the seller agrees to refrain from carrying on a similar business within specified limits provided such limits appear reasonable to the Court.  

Section 27 has been interpreted through several rulings of the Securities Appellate Tribunal (“SAT”) to allow a non-compete fee to promoter sellers of up to 25% of the purchase price, an illegal premium in most jurisdictions.  

Down to a tea

In Tata Tea (2009) SAT stated an acquirer has the right to protect its investment from competition but acknowledged that SEBI is entitled to rule that a non-compete fee is only a “device to reduce the offer price”.  At the same time SAT limited the ability of the regulators to analyze an acquirer’s perceived threat of dilution stating neither SEBI nor SAT can make a judgment call on such “business decisions”.

In light of the deference afforded to acquirer decisions regarding non-compete fees Chaudhri and Parekh both thought SEBI would not interfere with the payment.  When analyzing the merits of the non-compete fee, however, the guests came to different conclusions.

The argument Doshi posited was whether the non-compete is justified in the first place.  As she noted, the oil & gas industry in India is highly regulated, making the scope for direct competition limited, especially since the non-compete here is only in place for three years.

Chaudhri, an expert in the field of oil & gas, suggested that Cairn India’s minority shareholders were receiving a good deal in absolute terms.  Chaudhri supported his argument by noting that in its mandatory open offer of Rs 355 per share, Vedanta was paying a price equivalent to USD 18 per barrel of proven oil, a valuation he deemed favorable compared to the value per barrel of oil in most global markets.  

Competing with minor interests

Host Doshi countered that such logic was irrelevant in determining whether the non-compete was justifiable, correctly implying that the decision has to be made in light of the necessity of a non-compete and not the price paid to minority shareholders.  
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While Chaudhri admitted that in the context of the resource industry the rationale of non-competes was debatable, he expressly noted that in the present case Vedanta is not yet a major player in the oil & gas industry. Therefore its need to protect its investment was accentuated.  

Countering Doshi’s suggestion that Cairn PLC did not pose a significant threat of competition to Cairn India, Chaudhri noted that there are numerous small players in the field who are capable of being assembled into a business proposition even under the current regulatory framework.  With Cairn PLC influencing these outside players there was a risk to Cairn India that made the non-compete justifiable.

Parekh was more critical of the non-compete, stating that under the circumstances a non-compete fee “reeks of bad corporate governance”.  Pretty harsh, but the argument is valid.  When we are distinguishing between shareholders, principles of equity demand proper justification.  In the case of the non-compete paid to Cairn PLC, Parekh stated his belief that the payment is not justified.  

Parekh, of course, acknowledged case law and specifically the Cementrum case.  In Cementrum, Parekh explained that the non-compete was upheld despite the promoters' repeated demonstration of their incompetence to run the business.  Thus, the non-compete was upheld in a situation where there were few, if any grounds for fears that potential for competition existed.  If Cementrum is taken as a benchmark, as Parekh suggests, it seems unlikely that SEBI will interfere with Vedanta’s payment.

Another argument against the non-compete raised by Doshi is that Cairn PLC continues to hold a significant minority stake of around 10 per cent in Cairn India.

Chaudhri again acknowledged that questions arise as to whether a non-compete is necessary when a shareholder continues to own a significant stake in the business.  Using case law, Chaudhri again dismissed the objection arguing that in the case of Mysore Cement "this point came up for some amount of debate before the regulators and… the regulators actually held it in favour of the transacting parties".

Case-law clear... but wrong?

So it’s not just Tata Tea as both guests pointed out.  Time and again SAT has affirmed that even in dubious circumstances SEBI may not independently decide the validity of the non-compete fee and must instead defer to the acquirer’s decision.  

The episode ended with an interesting aside from Parekh.  Did SAT misinterpret Section 27 of the Indian Contract Act in the Tata Tea case? Parekh seems to think so.

In Tata Tea SAT stated: "The terms of a non-compete have to be decided by the acquirer and the promoter sellers on these business considerations, the Board [SEBI] and this Tribunal have no role to play."  

By stating that the terms of the non-compete is an internal business decision, SAT is implying that it will not look at the payment of a premium alongside the other terms.  The question is, is this just another “business decision” as suggested by SAT or does a non-compete fee in the case where such payment is not justifiable amount to a violation of shareholder’s rights? 

Parekh’s solution: take it to the Supreme Court.  If somebody had “the tenacity to go the Supreme Court and challenge this legal position, I think they will win”, predicted Parekh confidently. 

Click here for a full transcript of the show, which was first aired on Friday 20 August 2010.

This is a new Legally India series that will review and condense the latest episodes of CNBC-TV18's The Firm.