Enforceability of restrictive stipulations in employment contracts

Labour law issues are in the Concurrent List contained in the Seventh Schedule to the Constitution of India. This means that both Parliament and State Legislative Assemblies have the power to legislate with respect to labour issues. Consequently, the various State Legislatures have modified the Statues passed by the Parliament and these modifications to Central Legislation must be ascertained depending on the States in which a company has an office.

Every employer in India is required to furnish an employee with an employment contract referred to as the ‘appointment letter’, which sets out the terms and conditions of employment. As a good corporate practice, an employment manual should be adopted and incorporated by reference in the employment contract/letter of appointment signed and accepted by the employee, which should be handed over to the employee at the time of signature of the employment contract.

Generally, employees learn information regarding the business of their employer during their course of employment, which an employer would like to conceal. In an outsourcing industry, employees are carrying on tasks, which are critical to functioning of the client’s business. In order to prevent an employee from working for a competitor or disclosing confidential information to the competitors, the standard price is to include restrictive stipulations in an employment contract.

Restrictive stipulations play a pivotal role in protecting a business from potential threats to its confidential information, customer base or workforce stability arising from the post-termination activities of former employees. The restrictive stipulation may apply either during the term of employment or thereafter.

The validity of a stipulation is assessed by reference to the relevant circumstances at the time it is entered into, rather than at the time the employer wishes to enforce it. Customarily, it is difficult to argue that wording which makes a stipulation impermissibly wide can be deleted or “severed” from the rest of the clause, so as to make it enforceable.

Restrictive Stipulations as a Restraint on Trade

Section 27 of the Contract Act provides that every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind is, to that extent, void. There is an exception for an agreement not to carry on a business of which the goodwill is sold. In interpreting restrictive stipulations applicable during the term of employment and those applicable after the employment has been terminated, Indian courts have distinguished.

Restrictive Stipulations During Period of Service

It is well settled that any restriction operating during the subsistence of the employment contract does not attract Section 27 of the Indian Contract Act, 1872 unless the contract is one-sided, for example, if the employer can arbitrarily dismiss the employee. Negative stipulations operating during the period of the contract of employment when the employee is bound to serve his employer exclusively are generally not regarded as restraint of trade and do not fall under Section 27 of the Indian Contract Act, 1872. However, if the employer wrongfully dismisses the employee, this constitutes the repudiation of the contract, which relieves the employee of the restrictive stipulation.

The Hon’ble Supreme Court of India, in the judgement of NS Golikari v Century Spinning and Manufacturing Co Ltd, observed that the restraints on trade, whether general or partial, might be good if they are reasonable. It then drew a critical distinction between restraints applicable during the term of the contract of employment and restraints applicable after the employment period. A stipulation that an employee shall devote his whole time to the employer and shall not, during the term of contract serve any other employer would normally be enforceable.  The Hon’ble Supreme Court Concluded that a negative stipulation applicable during the employment period is not a restraint on trade unless the contract is unconscionable or excessively harsh or one sided.

Post-Service Restrictive Stipulations

The stipulations restraining employees from joining competitors after the termination of employment are the post-service restrictive stipulations. Restrictions in this category might also prevent an ex-employee from starting a competing business or advising a consanguine or a friend, who is in a similar line of business.

As discussed above, under Section 27 of the Indian Contract Act, 1872, all agreements in restraint of trade are void, except in the case of sale of a business with its goodwill. While the Common Law Rule applied in England and the US has been widening so that the courts only have to consider in every case whether the restraint is reasonable, Indian Law applies the old rigid rule. The Law Commission has recommended that the Section 27 of the Indian Contract Act, 1872 be amended to permit reasonable restrictions on the right to carry on trade but the section remains un-amended to date.

Post-termination restrictive covenants, specifically, the restrictions on working for a competitor and on disclosure of confidential information were recently upheld by the Madras High Court in 2005 in the Office Tiger Case (129 Company Cases 192) which did not consider the Section 27 of the Indian Contract Act, 1872. This case must be considered as an aberration from the long line of case law on post-termination restrictive covenants. It is indisputably well-settled that neither the test of reasonableness nor the principle that a partial restraint of trade may be reasonable, are relevant to interpreting the Section 27 of the Indian Contract Act, 1872 unless the exception to it applies.

It is quite clear in law that an employer cannot restrict the right of the employee to work for a competitor or set up a competing business after the term of his employment. This is a critical issue, particularly in view of the high turnover rates, which plague the outsourcing and BPO industry.

Remedies for Breach of the Restrictive Stipulations

Under Indian Law, the remedies provided for the infringement of restrictive stipulations are:

1. Injunction, i.e., preventing the third party from using trade secrets. Remedy in the form of injunction can be sought if an employer has reason to believe that an employee has breached the post-service restriction.

2.  Return of the Confidential Information to the Employer

3.  Compensation for Damages Caused to the Employer

4.  Section 72 of the Information Technology Act, 2000, also provides for the penal consequences of any breach of confidentiality and privacy.

For the remedies, the employer will need to show some loss resulting from the infringement of the restrictive stipulations.

By: Navin Kumar Jaggi & Aashna Suri