Non-compete clause: Legitimate fees or monkey business?

At the heart of this imbroglio lies the philosophical and legal question of the nature of the company and the inter-se rights of the shareholder.

‘Two Cats and a Monkey’ is a classic fable for children that has been passed down from one generation to another through the ages. It is also a story that corporate India has heard and seen before but now seems to have forgotten.

Once upon a time, there were two cats who lived in a village. They were good friends, but they were also rivals, fighting over the bread left by the villagers. One day, the first cat said to the second, “Why do we quarrel? Let us band together and share the bread that the villagers give us." The second cat agreed. They couldn't, however, agree on how the bread would be divided between them. A monkey on a tree nearby was watching them fight. "Why are you fighting?" he asked. I can help you because I have a scale that divides the bread into reasonable portions." Both cats liked the monkey’s advice. The monkey climbed the tree and brought down the scale. He broke the bread into two and put each piece in the pan. He had, however, purposefully divided the bread into unequal portions and said, "Hey, this piece is big; let us make both equal," and after saying this, he took a little bit of the large piece and ate it. In this way, every time the scale became heavy, he broke a little bread from that side and ate it. Both cats were furious, but they waited quietly for the monkey's decision because they did not want to give the other more bread. Finally, only small pieces of bread remained in the scale's pans. The monkey said with a deep sigh, “As you have seen, I have done the hard work of dividing bread, so I must get the wages for my hard work.” Upon saying which, he ate the rest of the pieces of bread. And the poor cats went away with empty stomachs, wondering what exactly had happened.

The colonial managing agency system was a corporate structure that allowed a few partners who set up the agency to control a number of public limited and joint stock companies, despite having a very small shareholding in them. It enabled those with exceptional entrepreneurial skills to promote and run businesses far beyond their financial involvement. However, with limited financial involvement, it was also a system prone to widespread abuse. Managing these companies through long-term contracts gave managing agencies total control and exceptional returns, while investors in the company often got a short shrift. Among some of them, it was also a source of patronage, enabling the funnelling of funds away from the public limited company to their own partner-owned private firms and favourable contracts.

This form of management control was widespread at one point in time, with many of the now-notable names of corporate and industrial India setting up managing agencies. However, deep conflicts of interest emerged over time, and the managing agency system was eventually abolished in 1970.

Merger Of Media Giants

So why are children's fables, managing agency systems, and conflicts of interest suddenly relevant today? The answer lies in the proposed merger of two media giants—one promoter family-controlled and the other a multinational conglomerate—that is currently wending its way through regulatory and legal challenges. The merger is being contested on two key issues. The first concern raised by creditors of the promoter family-controlled media firm is the payment of a "non-compete" fee of approximately Rs 1,100 crore to be paid by the multinational to the promoter family—rather than the merging media firm—in exchange for their agreement not to establish any competing business for a specified period of time. The second, raised by the market regulator, relates to allegations of siphoning of funds from the publicly held company to the benefit of promoter-controlled entities and thereby holding promotor family members ineligible to hold Key Management Personnel (KMP) positions in the publicly listed merged entity for a defined period of time. Unsurprisingly, the “common man” minority shareholder or his rights do not figure anywhere in this picture.

The saga is similar to the managing agency system, with a similar cast of characters and plot. A promoter family with a minuscule equity stake in the publicly traded company drives the merger and, in return, receives disproportionate benefits in the form of hefty non-compete fees and a commitment to allow it to increase its family shareholding in the merged entity in the future. At the heart of this imbroglio lies the philosophical and legal question of the nature of the company and the inter-se rights of the shareholder.

Under Indian common law, every equity shareholder enjoys undifferentiated rights in respect of his ownership of the company to the extent of his proportionate holding vis-à-vis other equity shareholders. In the shareholder democracy of corporate governance, there is no provision for any class of equity shareholder to receive additional financial benefit or remuneration for its entrepreneurial or managerial contribution. Entrepreneurial or managerial contributions are compensated separately through remuneration determined by the company's board of directors for their KMP, a practice that many promoter-driven companies have adopted to distinguish their managerial or entrepreneurial role from their shareholding.

Conflict Of Interest?

In this context, a non-compete clause and subsequent increase in stakes for the promoter family in the merged entity raise issues of conflict of interest and shareholder discrimination.  Its defendants contend that the promoter family's entrepreneurial abilities enabled the company to create value and that they are thus entitled to additional and separate remuneration under the non-compete clause. Critics argue that in order to establish the media company, the company and promoter family raised funds from investors and lenders on the promise of equitable common claims and that any benefits accruing from the company's success should be captured within the company's financial framework and made available to all stakeholders, including creditors and shareholders, rather than the promoter family in its individual capacity.

There is no getting away from the fact that the “non-compete” fees and option for subsequent raising of stakes for the promoter family are riddled with conflict of interest and raise questions about its treatment of creditors and minority shareholders. The situation is complicated further by allegations of fund mismanagement, which prompted the resignation of three board directors in 2019 and which is presently under investigation.

As the case progresses through the legal system, it is hoped that judgments will establish firm principles and guardrails of corporate governance, as well as delineate the rights of equity shareholders, including minority shareholders, corporate creditors, and other stakeholders of the company's artificial but legal entity, in relation to the conflicted private rights and entitlements of promoters arising from their shareholding or management control of that corporation.

And perhaps the “public funds” lender and the “common man” shareholder, unlike the cats in the old fable, will not be left empty-handed once again.

Sandeep Hasurkar is an ex-investment banker and author of `Never Too Big To Fail: The Collapse of IL&FS’. Views are personal, and do not represent the stand of this publication.