Competition restrictions in sale contracts can cause a lot of problems

The common practice when acquiring a company is to add a clause which restricts competition. Such a clause prescribes that during a certain time period after the sale and in an agreed field of activity, the seller will not compete neither with the company being sold or the acquirer. These kinds of agreements are automatically not prohibited, however they are often on the borderline of being in contradiction with competition law. Entrepreneurs themselves often consider competition restrictions rational as the restrictions guarantee the value of their investments. In reality such restrictions seldom find the need for application. Is it therefore reasonable to claim that competition restrictions are necessary?

Recent developments in the practice of the European Commission (EC) indicate that common agreements, which are drafted to protect the investments and the investor in general, might not be permitted under competition law. In January 2013 the EC adjudicated on an important matter concerning the sale contract between international phone operators Telefónica and Portugal Telecom. With that transaction Telefónica became the sole shareholder of Vivo, a Brazilian company. Before the aforementioned contract, the parties to the contract had a shared control over the particular company. Part of the sale contract was an agreement which stated that Telefónica and Portugal Telecom would not compete between themselves on the markets of Spain and Portugal as of September 2010 to the end of 2011. By its own initiative the EC commenced an investigation to explore the matter. In light of the investigation Telefónica and Portugal Telecom terminated the restrictive agreement approximately 4 months after its initiation. What was the issue? In the sale contract the parties had knowingly agreed that they would avoid each other’s domestic markets for one and a half years after the sale. However, such a restriction wasn’t justified, because it signified a serious restriction of the development of the telecommunications markets. Neither of the parties was in need of such a restriction as the acquired company was of Brazilian origin, thus not active in Europe. Furthermore, nothing indicated that in the case Telefónica or Portugal Telecom would in fact compete with each other, than the acquirers’ investment wouldn’t be secured. Even more, the EC nor the Estonian Competition Authority haven’t generally considered grounded restrictions to competition on the activity of the seller.

When agreeing on competition restrictions, parties must ensure that such restrictions would be directly related to the transaction, grounded and necessary for the enactment of the transaction itself. Furthermore, the restrictions must safeguard the interests of the acquirer not the ones of the seller. It should be added that although the duration of competition restrictions is generally allowed up to 3 years, in some cases that period could be shorter (e.g. up to a year) or longer (e.g. up to 5 years). In the case cited above, the parties agreed to a restriction with duration of one and a half years and applied it only for 4 months. However the penalty for establishing such a restriction was substantial in regard of the duration of the restriction. Namely, the fine for Telefónica was EUR 70 million and for Portugal Telecom EUR 13 million. The EC explained that such a substantial penalty was set due to the importance of the infringement to the nature of competition law. In the practice of the EC, this case is of significant importance given the circumstances of the case and the magnitude of the penalties. Thus, competition restrictions established in sale contracts can be considerable violations of competition law.