China: Non-compete clauses in JV contracts - An analysis from the perspective of the PRC Anti-monopoly Law

Last Updated: 25 August 2013
Article by Liu Cheng, Yu Zhenzhen and Swita Gan

Non-compete clauses ("NCCs") are very often included in joint venture ("JV") contracts in the course of JV establishment. NCCs normally operate to prevent JV parties from engaging in business in competition with the JV entity, for a specified period and within a specified geographical area.

The PRC Anti-monopoly Law i ("AML") came into effect in 2008, and since then PRC competition authorities have issued a number of rules and regulations in connection with the AML. However, none of these rules and regulations (including the AML itself) sets forth specific provisions regarding the regulation of NCCs in JV contracts. As such, this article considers the legality of NCCs under the AML and the basic principles for the negotiation of NCCs in JV transactions.

The nature of NCCs and their legality under the AML

In JV contracts, NCCs are normally structured to restrict competition between the JV parties and the JV (or in some cases between the JV parties alone). Outwardly, these clauses can have the effect of eliminating or restricting competition between actual or potential competitors, as it is likely that the JV parties and the JV entity are such competitors. Despite this, for the following reasons, a NCC in a JV contract should not be deemed a monopolistic behavior and a per se violation of the AML:

First of all, based on the general rationale of the AML, an intent or effect of restricting the overall market competition must be considered for the determination of a monopolistic behavior. In respect of intent, NCCs in JV contracts are normally intended to ensure the JV parties to adhere to the principle of good faith in the course of negotiations, make full use of the JV assets, enable the JV to take advantage of the know-how and goodwill contributed by the JV parties, or protect each JV party interests in the JV from being harmed by the pre-emption rights of another JV party or a third party in relation to transferred know-how or goodwill related to or being developed by the JV. NCCs which purely aim to restrict market competition are quite rare.

In respect of effect, NCCs will often have the effect of restricting competition between the JV parties and the JV or between JV parties. However, to determine whether a violation has actually occurred, it must also be considered whether a competition restriction to the overall market arises and whether, on the contrary, the NCC facilitates the realization of the JV's efficiency.

Secondly, from the observation of AML regimes, NCCs in JV contracts may be reviewed under the PRC merger control regime or Article 13 of the AML in relation to horizontal monopolistic agreements.

From the perspective of the merger control regime, a NCC in a JV contract will be subject to the review by the PRC Ministry of Commerce ("MOFCOM") if the JV transaction triggers the antitrust notification threshold under the AML. According to the amended Notification Form for Concentrations of Undertakings ii, the notifying party should specify whether relevant transaction documents include non-compete arrangements or clauses between the JV parties and/or between the JV parties and the JV entity (if any). In our experience, MOFCOM normally will consider, in the course of their review, whether such clauses are ancillary to transactions. If NCCs are merely ancillary restraints, such clauses will be deemed as having no effect of restricting market competition thus being approved, provided that the transaction itself is determined by MOFCOM not to restrict or eliminate competition and being cleared. Therefore, NCCs are not per se violations of the AML under the PRC merger control regime.

From the perspective of horizontal monopolistic agreements regulation, NCCs may also fall within the scope of monopolistic agreements provided by Article 13 of the AML, as there may be an actual or potential competition relationship between JV parties or in some cases, between JV party and the JV entity. Under Article 13, if the product or service to be provided by the JV is in the same market as the product or service of the JV parties before establishment of the JV, there is a possibility that a NCC may constitute a horizontal monopolistic agreement (e.g. allocation of market or customers). However, for the determination of a horizontal monopolistic agreement, the effect of the NCCs on market competition still needs to be assessed.

  1. Under Article 13, a monopolistic agreement exists where any agreement, decision or other concerted practice eliminates or restricts competition. Also, Article 7 of the Provisions Regarding Law Application in Adjudicating Anti-monopoly Law Civil Disputes iii ("Provisions") provides that, in an antitrust civil litigation, the defendant bears the burden of proving that the five categories of horizontal agreements iv as set forth in Article 13 of the AML do not have the effect of eliminating or restricting market competition. As such, absence of an adverse impact on market competition will rebut the presumption of the existence of a monopolistic agreement. Although such burden of proof may be relatively difficult for the relevant parties, Article 7 of the Provisions makes it clear that horizontal agreements between competitors are not per se illegal, on contrary, the effect of eliminating or restricting market competition needs to be considered for the determination of a NCC constituting a monopolistic agreement.
  2. Furthermore, a recent decision of the Shanghai Higher People's Court regarding the anti-monopoly lawsuit between Rainbow and Johnson & Johnson v also indicated that, according to Article 7 of the Provisions, the effect of eliminating or restricting market competition is an essential factor to be considered for the identification of horizontal monopolistic agreements The Court's position on this matter echoes the view of some government officials. We have heard some government officials who participated in the enactment of the AML expressing the same view that a horizontal agreement would not be per se illegal under the AML, and it is illegal only if it eliminates or restricts market competition.

To conclude, if a NCC is ancillary to and for the purpose of a JV transaction and the JV transaction is subject to the review by MOFCOM, the NCC will be reviewed and assessed with the transaction as a whole under the merger control regime, rather than being deemed as per se illegal. On the other hand, whether the presence of a NCC constitutes a monopolistic agreement will depend on whether it has the effect of eliminating or restricting market competition. This rule is especially important in the context of JVs, as NCCs in JV contracts are normally intended for legitimate commercial reasons. Therefore, the overall effects of a NCC should be delicately considered to assess its legitimacy under the AML.

Likely standards to determine the legitimacy of NCCs in China

Three PRC competition authorities are responsible for regulating competition issues covered by the AML. The Ministry of Commerce ("MOFCOM") is responsible for merger control; the National Development and Reform Commission ("NDRC") is responsible for price-related monopolistic agreements and abuse of market dominance; and the State Administration for Industry and Commerce ("SAIC") is responsible for non-price-related monopolistic agreements and abuse of market dominance. As such, we consider the three authorities all have the power to review NCCs in different circumstances.

Potential approach of MOFCOM

In the case of JV establishment, an appropriate NCC is to some extent necessary for dispelling MOFCOM's concerns in relation to the JV transaction. If JV shareholders engage in competing business with the JV, one of the issues MOFCOM will consider when reviewing the JV transaction and its regulatory compliance is whether JV shareholders will engage in anti-competitive practices, like price fixing, output limitation or customer allocation, with or through the venture after the transaction, as a JV may facilitate information exchange or communication between the JV shareholders (which may originally be independent competitors).

If a JV contract contains a NCC, providing that the shareholders will no longer engage in competing business with the venture, a shareholder could argue that it will exit the relevant market and will not be the competitor of the JV any more; therefore, there is no possibility for JV shareholders and the JV to be involved in a horizontal conspiracy.

However, if a NCC's restriction on competition exceeds the necessary scope, it may still constitute a violation of the AML. For instance, as mentioned above, MOFCOM has begun to evaluate NCCs in JV contracts including its impact on market competition when it reviews transactions subject to notification..

In our experience, if a JV transaction itself does not raise any material competition concerns, MOFCOM is unlikely to individually challenge a NCC, provided that the operative scope of that NCC is not too broad.

Our understanding is that, when MOFCOM reviews a NCC in a JV contract, its focus is whether the NCC is ancillary to the transaction. As there are currently no detailed rules in relation to the NCC review process, we consider MOFCOM may adopt an approach similar to that of the EU. If so, MOFCOM may consider a NCC as an ancillary restraint when the following two conditions are satisfied:

  • The NCC is directly related to the JV transaction; and
  • The NCC is necessary for the realization of the purpose of the JV transaction.

Under the "directly related" test, it is not sufficient that the NCC was entered into in the same context or at the same time as the transaction. Instead, the NCC must be subordinate in importance to the main object of the JV project and intended to allow a sound start-up of the JV after the transaction.

Under the "necessary" test, two detailed requirements should be satisfied: first, to objectively consider whether a NCC is necessary for the accomplishment of the JV transaction ("necessity criterion"); and secondly, to consider whether it is proportional ("proportionality criterion").

  • The necessity criterion is not about making an analysis as to whether, considering the competitive situation of the relevant market, the NCC is indispensable for the success of the JV. Instead, the test considers whether, within the particular context of the JV transaction, the NCC is necessary for realizing the purposes of the JV operation.
  • The proportionality criterion generally requires that the NCC not exceeding what the implementation of the JV transaction reasonably requires. In other words, the parties are obliged to seek other alternative approaches that have the minimum adverse impact on market competition.

Potential approach of NDRC and SAIC

Although we do not know of any current NRDC or SAIC investigations on NCCs in the context of JVs based on publicly available information, we understand the legal basis for NDRC or SAIC determining whether NCCs in JV contracts violate the AML will be Article 13 of the AML regulating horizontal monopolistic agreements, and NDRC or SAIC will consider whether there is an effect of eliminating or restricting market competition.

Also, the competition assessment of a NCC in a JV contract should take into account the JV transaction. After all, such NCCs are not purely non-compete arrangements between completely independent companies. They should not be assessed separately from JV transactions. As such, we believe that NDRC and SAIC should also take into account whether a NCC is ancillary to the JV transaction, i.e. whether it is directly related to the JV transaction and within the scope of necessary to realize the purpose of the JV transaction (provided that the JV transaction itself will not violate the AML). If a NCC exceeds such scope, there will be a high possibility that NDRC or SAIC may deem it as a violation of the AML.

This means that, along with market structure changes, the criteria adopted by NRDC or SAIC on the determination of legality of a NCC in the future remains to be seen. While a NCC is regarded as pro-competitive at the time of the formation of a JV, if market conditions undergo material changes – for example, the JV acquires significant market power in the relevant market – it is possible that NDRC or SAIC may re-assess the effect of the NCC on competition. Therefore, we recommend market participants keep a close eye on market dynamics and revisit the legitimacy of NCCs in JV contracts from time to time on the basis of any material change of competition conditions.

Basic guidelines for negotiating a NCC

Based on the potential approaches of PRC competition authorities towards NCCs outlined above, we suggest that the basic principle for negotiating NCCs in JV contracts be that the non-compete obligation should correspond directly to the products, services and territories covered by the JV agreement, specifically vi:

  1. The geographical scope of a NCC should be limited to the area in which the JV parties offered the relevant products or services before establishing the JV. We understand that the geographical scope could also be extended to territories which the JV parties were planning to enter at the time of the transaction, provided that they had already made necessary investments for evidencing this intention;
  2. The NCC should be limited to products and services constituting the economic activities of the JV. This may include the products and services at an advanced stage of development at the time of the transaction, as well as products and services which are fully developed but have yet to be marketed;
  3. A NCC should not be used for the purposes of protecting one JV party's interest against competition from another JV party in markets other than those in which the JV will be active from the outset; and
  4. The duration of a NCC should normally be the standing period of the JV.

Additionally, as mentioned above, we recommend that market participants continue to review market dynamics, and assess NCCs in light of market situation changes.

Conclusion

In summary, we consider NCCs in JV contracts are not per se violations under the AML. Instead, to determine whether a NCC is illegal under the AML should consider its impact on market competition, i.e. whether it has an effect of eliminating or restricting market competition. We believe that the PRC competition authorities will also adopt the same approach in the process of reviewing or investigating a NCC. However, this does not mean JV parties can agree on a NCC without any limitation. To minimize the potential risk of being challenged by the PRC competition authorities, JV parties should draft the NCCs within the scope of directly relating to and for the purpose of the JV transaction, and revisit it from time to time based on the change of market situation, so as to prevent non-compliance risks.

Footnotes

iDecree of the Chairman of the People's Republic of China ("PRC") No. 68, issued on August 30, 2007, effective as of August 1, 2008.

iiIssued by MOFCOM on June 6, 2012.

iiiIssued by the Supreme People's Court on May 3, 2012.

ivThe five categories of horizontal agreements as set forth in Article 13 of the AML are:

  1. Fixing the price of a commodity;
  2. Restricting the production or sales volume of a commodity;
  3. Dividing a sales market or raw material purchase market;
  4. Restricting the purchase or development of new technology or new equipment; and
  5. Trade boycott.

vThis decision was made by Shanghai Higher People's Court on August 1, 2013.

viIn addition to the following guidelines, as far as we know, under EU competition law, the non-competition obligations between non-controlling parents and a JV are not directly related and necessary to the implementation of the concentration. But under China's AML, there is no rule which differentiates between controlling parents and non-controlling parents in addressing the legality of NCCs. However, based on our experience, MOFCOM is inclined to consider that the interests of controlling parents are consistent with the JV; therefore NCCs between controlling parents and the JV are necessary and unavoidable; while the interests of non-controlling parents and the JV should be independent, then NCCs between them may have the nature of conspiracy and horizontal monopolistic agreements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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