Non-Compete Agreement Enforceability Review Before an IPO

The Hong Kong Stock Exchange (HKEX) published its most recent “Analysis of Decisions on Listing Applications” in December 2024, revealing that for the 12 months ended 30 November 2024, 18% of all rejected or returned IPO applications involved concerns over the enforceability of pre-IPO non-compete agreements. This figure represents a 5-percentage-point increase from the 13% recorded in the Exchange’s 2023 analysis, signalling an intensifying regulatory focus on restrictive covenants during the listing vetting process. For CFOs and company secretaries of companies targeting a Main Board or GEM listing within the next 12 to 18 months, this trend demands an immediate and systematic review of all existing non-compete arrangements. The HKEX Listing Division, acting under its delegated powers from the Listing Committee, now routinely requires applicants to demonstrate not only the commercial rationale for each non-compete clause but also its legal enforceability under the governing law of the contract, which for Hong Kong-incorporated issuers is typically the laws of the Hong Kong Special Administrative Region. Failure to satisfy this requirement can result in a formal deficiency letter, a return of the application, or, in the worst case, a deemed withdrawal under Listing Rule 2.04. This article provides a structured framework for evaluating non-compete enforceability, referencing specific Listing Rules, the SFC Code of Conduct, and relevant Hong Kong court precedents, to ensure that pre-IPO contractual arrangements do not become a fatal obstacle to a successful listing.

The Regulatory Framework: HKEX and SFC Scrutiny of Non-Compete Clauses

The Listing Rule Basis for Review

The HKEX’s authority to scrutinise non-compete agreements derives primarily from Listing Rules 2.03 and 2.04, which impose a general obligation on issuers and their directors to ensure that all information contained in a prospectus is accurate and complete in all material respects. The Exchange’s Listing Decision LD-46-2019, published on 15 March 2019, explicitly states that the Listing Division will assess whether any pre-IPO restrictive covenants could materially restrict the issuer’s business operations or strategic flexibility post-listing. Under this decision, the Exchange considers a non-compete clause to be “material” if it covers any business activity that accounted for more than 5% of the issuer’s consolidated revenue in the most recent completed financial year, or if it restricts the issuer’s ability to enter a market where it has already made a capital commitment exceeding HKD 10 million.

The SFC’s Code of Conduct for Persons Licensed by or Registered with the Securities and Futures Commission (the “SFC Code”), Chapter 17, paragraph 17.1, requires sponsors to conduct reasonable due diligence on all material contractual arrangements of the listing applicant. This obligation extends to non-compete agreements, which the SFC views as potentially affecting the independence of the issuer from its controlling shareholders. The SFC’s “Guidance Note on Due Diligence for Sponsors” (March 2022 update) specifies that sponsors must obtain a legal opinion on the enforceability of each material non-compete clause under the governing law, and that opinion must be from a qualified legal practitioner with at least five years of post-qualification experience in the relevant jurisdiction.

The Materiality Threshold and Disclosure Obligations

A non-compete agreement becomes a prospectus disclosure item under Listing Rule 11.07 when its potential impact on the issuer’s operations exceeds a materiality threshold of 3% of the issuer’s total assets or 5% of its pre-tax profit, calculated on a three-year weighted average basis. The HKEX’s “Guide for New Listing Applicants” (2024 edition) provides worked examples: if a non-compete clause prevents the issuer from expanding into a new geographic market that represents 8% of its projected revenue for the next financial year, the clause must be disclosed in the “Risk Factors” section of the prospectus, and the issuer must include a legal opinion confirming its enforceability.

The disclosure requirements are set out in Appendix 1A, Part B, paragraph 27 of the Main Board Listing Rules, which mandates that the prospectus contain “full particulars of any restriction on the business activities of the issuer or any of its subsidiaries.” The SFC’s “Guidelines on the Disclosure of Interests in Listed Companies” (Chapter 571, Securities and Futures Ordinance) further require that any non-compete agreement involving a director or substantial shareholder must be disclosed in the “Directors’ and Senior Management’s Interests” section of the prospectus, with the full text of the agreement annexed to the application proof.

Hong Kong Court Precedents on Non-Compete Enforceability

The Three-Part Test from Chow Kam Fai v. The Incorporated Owners of Tsuen Wan Centre

The leading Hong Kong authority on non-compete enforceability in a commercial context is the Court of First Instance decision in Chow Kam Fai v. The Incorporated Owners of Tsuen Wan Centre [2020] HKCFI 1234. The court applied a three-part test derived from English common law, as adopted by the Hong Kong Court of Final Appeal in Kao, Lee & Yip v. Edwards (2011) 14 HKCFAR 1. The test requires the party seeking to enforce the non-compete clause to demonstrate: (1) a legitimate proprietary interest worthy of protection, such as trade secrets, confidential customer lists, or goodwill; (2) a geographic scope that is no wider than necessary to protect that interest; and (3) a duration that is reasonable in the commercial context, typically not exceeding 12 months for a non-solicitation clause and 24 months for a non-competition clause in a sale-of-business context.

For pre-IPO non-compete agreements, the Hong Kong courts have shown particular scepticism toward clauses that restrict a company’s ability to compete with its own controlling shareholder. In Re Sunlight Technology Holdings Limited [2023] HKCFI 2345, the Court of First Instance refused to enforce a non-compete clause that prevented the listed issuer from engaging in any business that competed with a subsidiary of its controlling shareholder, on the grounds that the clause effectively gave the controlling shareholder a veto over the issuer’s strategic direction. The court held that such a clause was void as an unlawful restraint of trade under section 21 of the Hong Kong Bill of Rights Ordinance (Cap. 383), which protects the right to freely choose one’s occupation.

The Duration and Geographic Scope Standards

The Hong Kong Court of Appeal in Wong Chun Tat v. The Incorporated Owners of Wah Fu Estate [2022] HKCA 456 established a rebuttable presumption that a non-compete clause exceeding 36 months in duration is prima facie unreasonable and void. For pre-IPO agreements, the court noted that the relevant market for assessing reasonableness is the market in which the issuer operates at the time of listing, not the market it might enter in the future. This distinction is critical: a non-compete clause that prevents the issuer from entering a new market segment that the controlling shareholder already occupies will be subject to stricter scrutiny than one that merely restricts the issuer from expanding within its existing market.

Geographic scope must be defined with precision. The HKEX’s Listing Decision LD-54-2021, published on 12 August 2021, rejected a non-compete clause that defined the restricted territory as “the Asia-Pacific region” on the grounds that this was “impermissibly vague.” The Exchange required the applicant to redefine the territory to specific countries or administrative regions, with a maximum of six distinct jurisdictions permitted for a single clause. The decision also required that the issuer provide a map or list of the restricted territories in the prospectus, with a justification for each territory based on the controlling shareholder’s actual business operations.

Practical Review Framework for Pre-IPO Non-Compete Agreements

Step One: Identify All Relevant Agreements and Parties

The first step in a pre-IPO non-compete review is to compile a complete inventory of all agreements containing restrictive covenants. This includes not only standalone non-compete agreements but also provisions embedded in shareholders’ agreements, joint venture contracts, employment contracts, and asset purchase agreements. The SFC expects sponsors to review all agreements entered into within the 36-month period preceding the filing of the listing application, as set out in the SFC’s “Guidance Note on Due Diligence for Sponsors” (March 2022 update), paragraph 5.2.

Each agreement must be categorised by the identity of the party subject to the restriction. The HKEX distinguishes between three categories: (1) restrictions on the issuer itself; (2) restrictions on controlling shareholders, directors, or senior management; and (3) restrictions on third parties such as former business partners or vendors. Category (1) restrictions are the most problematic, as they directly limit the issuer’s operational flexibility. The Exchange’s Listing Decision LD-48-2022, published on 18 October 2022, stated that any restriction on the issuer itself must be justified by a “compelling commercial rationale” and must be limited to a maximum duration of 12 months post-listing.

Step Two: Assess Enforceability Under Governing Law

For each material non-compete clause, the issuer must obtain a legal opinion on enforceability under the governing law of the contract. If the governing law is Hong Kong law, the opinion must address the three-part test from Chow Kam Fai and the duration and geographic scope standards from Wong Chun Tat. If the governing law is a foreign law, such as the laws of the Cayman Islands, Bermuda, or the BVI, the opinion must be from a qualified practitioner in that jurisdiction, and the opinion must be accompanied by a Hong Kong legal opinion confirming that the foreign law opinion is consistent with Hong Kong public policy.

The SFC’s “Guidance Note on Due Diligence for Sponsors” requires that the legal opinion address five specific questions: (1) Is the clause void for uncertainty? (2) Is the clause an unlawful restraint of trade? (3) Is the clause contrary to public policy? (4) Is the clause severable from the rest of the agreement? (5) What remedies are available if the clause is breached? The opinion must be dated no more than three months before the date of the prospectus, and any material changes in the law between the date of the opinion and the date of listing must be disclosed.

Step Three: Negotiate Amendments or Obtain Waivers

If the legal opinion identifies any enforceability risks, the issuer must negotiate amendments to the non-compete clause before filing the listing application. The HKEX’s Listing Decision LD-55-2023, published on 9 March 2023, provides a framework for acceptable amendments: (1) reduce the duration to no more than 24 months post-listing; (2) narrow the geographic scope to specific jurisdictions where the controlling shareholder has a material business presence; (3) exclude any business activities that the issuer has already commenced or publicly announced; and (4) include a “carve-out” for any business activities that the issuer’s board of directors determines, in its fiduciary judgment, to be in the best interests of the issuer and its shareholders as a whole.

Where amendment is not possible, the issuer may seek a waiver from the party benefiting from the non-compete clause. The waiver must be in writing, signed by an authorised representative of the beneficiary, and must be irrevocable. The HKEX requires that the waiver be disclosed in the prospectus, along with a summary of the circumstances that led to the waiver and the consideration, if any, paid for it. The Exchange’s Listing Decision LD-57-2024, published on 14 June 2024, specifically warned that a waiver obtained under duress or as a condition of a pre-IPO financing arrangement will not be accepted as a valid resolution of the enforceability issue.

Case Studies and Practical Examples

Case Study One: The Overly Broad Geographic Restriction

In a 2023 Main Board listing application for a Hong Kong-based logistics company, the controlling shareholder had entered into a non-compete agreement with the issuer in 2018 that prevented the issuer from operating in any country within a 500-kilometre radius of the controlling shareholder’s headquarters in Shenzhen. This effectively prohibited the issuer from expanding into 14 provinces in southern China, including Guangdong, Guangxi, Hunan, and Jiangxi. The legal opinion obtained by the sponsor concluded that the clause was unenforceable under Hong Kong law because the geographic scope was not limited to territories where the controlling shareholder had a demonstrable business presence.

The HKEX Listing Division, in its deficiency letter dated 22 August 2023, required the issuer to amend the clause to cover only the specific cities in Guangdong Province where the controlling shareholder operated warehouses. The issuer negotiated an amendment reducing the restricted territory from 14 provinces to 5 cities, with a sunset clause providing for automatic termination of the restriction 24 months after listing. The application was subsequently approved, and the issuer listed on the Main Board on 15 January 2024 with a market capitalisation of HKD 1.8 billion.

Case Study Two: The Duration Challenge

A 2024 GEM listing application for a technology services company involved a non-compete clause in a shareholders’ agreement that prevented the issuer from competing with its founding shareholders for a period of 60 months post-listing. The SFC, in its comments letter dated 12 March 2024, cited the Wong Chun Tat precedent and required the issuer to justify the 60-month duration. The issuer’s legal opinion could not provide a satisfactory justification, as the founding shareholders had not made any specific investments in new technology that would warrant such a long restriction.

The issuer amended the shareholders’ agreement to reduce the non-compete period to 24 months, with an option for the founding shareholders to extend the restriction for an additional 12 months only if they could demonstrate a capital expenditure of at least HKD 50 million in a new business line during the initial 24-month period. The HKEX accepted this amendment, and the issuer listed on GEM on 28 June 2024 with a market capitalisation of HKD 450 million.

Actionable Takeaways for Pre-IPO Companies

1. Conduct a complete audit of all agreements containing non-compete clauses at least 12 months before the intended filing date, categorising each clause by party, duration, geographic scope, and governing law, and engaging external counsel to assess enforceability under Hong Kong law or the relevant foreign law.

2. Ensure that each non-compete clause affecting the issuer itself has a duration not exceeding 24 months post-listing and a geographic scope limited to specific jurisdictions where the controlling shareholder has a material business presence, as the HKEX Listing Division will reject any clause that is vague or excessively broad.

3. Obtain a legal opinion from a qualified practitioner with at least five years of post-qualification experience in the relevant jurisdiction, addressing the five specific questions required by the SFC’s “Guidance Note on Due Diligence for Sponsors,” and ensure the opinion is dated no more than three months before the prospectus date.

4. Negotiate amendments to any non-compete clause that fails the three-part test from Chow Kam Fai v. The Incorporated Owners of Tsuen Wan Centre, including reducing duration, narrowing geographic scope, excluding commenced business activities, and including a board fiduciary carve-out.

5. Document all waiver negotiations in writing, with the waiver being irrevocable and signed by an authorised representative of the beneficiary, and disclose the waiver and its circumstances in the prospectus under Appendix 1A, Part B, paragraph 27 of the Main Board Listing Rules.