Non Compete Clauses and The Indian Contract Act, 1972

A non-compete clause or a covenant not to compete is a term used in contracts under which the employee agrees to not pursue a similar profession, trade or business in competition against the employer. Apart from the regular employment agreements, such covenants are also at times included in the agreements relating to sale of goodwill of business or professional practice, employment exit and other exclusive dealings and service arrangements.

The Indian Contract Act, 1872, which provides a framework of rules and regulations, governing the formation and performance of a contract in India deals with the legality of such non-compete covenants. It stipulates that an agreement, which restrains anyone from carrying on a lawful profession, trade or business, is void to that extent. Under section 27 of the Indian Contract Act, 1872 agreements in restraint of trade are void.

Agreement in restraint of trade is defined as the one in which a party agrees with any other party to restrict his liberty in the present or the future to carry on a specified trade or profession with other persons not parties to the contract without the express permission of the latter party in such a manner as he chooses. Providing for restraint on employment in the employment contracts of the employees in the form of confidentiality requirement or in the form of restraint on employment with competitors has become a part of the corporate culture.

Section 27

Every agreement by which anyone is restrained from exercising a lawful profession or trade or business of any kind, is to that extent void.

Exception: One who sells goodwill of a business with a buyer to refrain from carrying on a similar business, within specified local limits so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business therein provided that such limits appear to the Court reasonable, regard being had to the nature of business.

Although the section states that all agreements in restraint of any profession, trade or business are void, the current trend as per various judicial pronouncements leads to the conclusion that reasonable restraint is permitted and does not render the contract void ab initio. Reasonableness of restraint depends upon various factors, and the restraint in order to prevent divulgence of trade secrets or business connections has to be reasonable in the interest of the parties to ensure adequate protection to the covenantee. The above section implies that to be valid an agreement in restraint of trade must be reasonable as between the parties and consistent with the interest of the public.

Therefore two terms need to be defined:

1. What is public policy?

2. What is “reasonable”?

PUBLIC POLICY

The concept of public policy is illusive, varying and uncertain. The term ‘Public Policy ’ is not capable of a precise definition and whatever tends to injustice of operation, restraint of liberty, commerce and natural or legal rights; whatever tends to the obstruction of justice or violation of statutes and whatever is against good morals can be said to be against public policy.

It has been held that the concept of public policy is capable of expansion and modification.[1]

The Supreme Court observed in in Gherulal Pathak v. Mahadeodas Maiya[2]

“Public policy is a vague and unsatisfactory term and calculated to lead to uncertainty and error and when applied to decision of legal rights it is capable of being understood in different senses. It is the province of the judge to expound this law only. They have become a part of recognized law, and we are therefore bound by them. There are several decisions of the courts which lays down a general rule as to what is an agreement opposed to public policy and what is not. These, though provide guidelines as to defining ‘public policy’ cannot be used as a sure shot rule”.

Agreements opposed to public policy:

There are several moral, legal, ethical constraints. Some case laws help to understand what an agreement in restraint of public policy is.

If an agreement is  such that it tends to injure public interest or public welfare it is against public policy [3]

Where there is an agreement between the parties that a certain consideration should proceed from the accused person to the complainant in return for the promise of the complainant to discontinue the criminal proceedings is clearly a transaction as opposed to public policy[4]

 Agreements Not Opposed to Public Policy:

A contract for manning, running, operating, repairing and maintenance on hire for three vehicles was entered into between parties. The contracts inter alia provided that the employer shall have the right to terminate the contract after expiry of one year without assigning reasons. It was held that such a stipulation was not unconscionable or opposed to public policy[5]

Hence using these guidelines courts can deduce what is public policy as it has not been appropriately defined in any case law. 

WHAT IS REASONABLE?

As defined by the dictionary reasonable means – according to reason.

Hence whatever a reasonable man would do, using commonsense and knowledge, under the given circumstances, will account as reasonable. Therefore the test of reasonability depends on the facts and circumstances of each case.

 Where services are performed under an agreement that the remuneration shall be to the discretion of the employer, the question whether the employer has the right to determine whether any remuneration at all shall be paid, so that his decision is a condition precedent to any claim or merely has the right to fix the amount of the remuneration, is a question of construction and intention in each particular case.[6]

Reasonable restrictions can be placed in the following ways:

1. Distance: suitable restrictions can be placed on employee to not practice the same profession within a stipulated distance, the stipulation being reasonable.

2. Time limit: if there is a reasonable time provided in the clause then it will fall under reasonable restrictions.

3. Trade secrets: the employer can put reasonable restrictions on the letting out of trade secrets.

4. Goodwill: There is an exception under section 27 of the Indian Contract Act on the distribution of goodwill.

NON COMPETE CLAUSES UNENFORCEABLE IN INDIA

With the increase in cross-border trade and an enhanced competitive climate in India, confidentiality, non-compete, and non-solicitation agreements are becoming increasingly popular, especially in the IT and technology sectors. An increasing number of outsourcing and IT companies are including confidentiality, non-compete, and non-solicitation clauses in agreements with their employees, with terms ranging from a few months to several years after the employment relationship are terminated. The companies claim that such restrictions are necessary to protect their proprietary rights and their confidential information.

Indian courts have consistently refused to enforce post-termination non-compete clauses in employment contracts, viewing them as "restraint of trade" impermissible under Section 27 of the Indian Contract Act, 1872, and as void and against public policy because of their potential to deprive an individual of his or her fundamental right to earn a livelihood.

There are various case laws that will clear out the situation in India:

Supreme Court of India in Percept D' Mark (India) Pvt. Ltd v Zaheer Khan [7] observed that under Section 27 of the Act a restrictive covenant extending beyond the term of the contract is void and not enforceable. The court also noted that the doctrine of "restraint of trade" is not confined to contracts of employment only, but is also applicable to all other contracts with respect to obligations after the contractual relationship is terminated.

In a 2009 decision by the New Delhi High Court in Desiccant Rotors International Pvt Ltd v Bappaditya Sarkar & Anr [8] involved a senior marketing manager at a manufacturer of evaporative cooling components, products and systems. As part of his employment agreement with Desiccant, the manager agreed that for two years following the termination of his employment, he would be bound by a covenant with Desiccant that would require him to keep Desiccant's matters confidential, and that would prevent him from competing with Desiccant and soliciting Desiccant's customers, suppliers and employees. Expressly embodied in the employment agreement was an acknowledgment by the manager that he was dealing with confidential material of Desiccant, including: know-how, technology trade secrets, methods and processes, market sales, and lists of customers. After a few years of employment, the manager resigned and-notwithstanding the terms of his old employment agreement-within three months of his resignation joined a direct competitor of Desiccant as country manager in charge of marketing and started contacting customers and suppliers of Desiccant. In injunctive proceedings against the manager by Desiccant, the High Court reiterated the principles embodied in Section 27 of the Act and the individual's fundamental right to earn a living by practicing any trade or profession of his or her choice. Brushing aside any argument by Desiccant that the restrictive covenants were primarily designed to protect its confidential and proprietary information, the High Court ruled that in the clash between the attempt of employers to protect themselves from competition and the right of employees to seek employment wherever they choose, the right of livelihood of employees must prevail. However the High Court did allow an injunction against the manager prohibiting him from soliciting Desiccant's customers and suppliers to stand in effect.

Similarly, in a 2007 decision in V.F.S. Global Services Ltd. v. Mr. Suprit Roy [9]

The Bombay High Court held that a fully paid three-month "garden leave" agreement with a senior manager did not renew the employment contract and constituted a "restraint of trade" unenforceable by V.F.S. However, relief for breach of non-solicitation obligations was denied on the basis of vagueness of the relief claimed.

In Superintendence Company of India vs Krishan Murgai [10]

The Supreme Court held that a contract, which had for its object a restraint of trade, was prima facie void. The company, with its head office at Kolkata and branch office at New Delhi, carried on business as valuers and surveyors. It had established a reputation and goodwill in its business by developing its own techniques for quality testing and control and possessed trade secrets in the form of these techniques and clientele. Mr Murgai was employed as branch manager of the New Delhi office. One of clauses of the terms and conditions of employment placed him under a post-service restraint that he would neither serve any other competitive firm nor carry on business on his own in similar line for two years at the place of his last posting; and the restriction would come into operation after he left the company. When he was terminated from service, the employee started a business on similar lines. When the matter came for appeal, the Supreme Court held that under Section 27 of the Indian Contract Act, 1872, a service covenant extended beyond the termination of the service was void.

In Star India Pvt Ltd. V. Laxmiraj Seetharam Nayak [11],

The Bombay High Court held that an employer has right to terminate the contract of employment on the ground of misconduct; hence, it cannot be said that the employee had absolutely no right to resign from the employment on account of better prospects or other personal reasons. It was observed by the court that merely because for some time the employer might face some inconvenience, the employee concerned cannot be forced to come back for the pleasure of the employer or to satisfy the ego of the higher-ups of the contemplated competition in the market.

In Sandhya Organic Chemicals P.Ltd v. United Phosphorous [12],

The Gujarat High Court held that a service covenant extended beyond the termination of the service is void. It was held that an employee could not be restrained for all times to come to use his knowledge and experience which he gained during the course of employment either with the employer or with any other employer. It was also held that the principles laid down by the English Courts on common law and equity will not be applicable in view of Section 27 of the Indian Contract Act.

In Lalbhai Dalpatbhai and co. v. Chittaranjan Chandulal Pandya[13],

The Division Bench of the Gujarat High Court consolidated all the fundamental principles concerning the negative stipulation in the contract of service during the service period and after the service period. The Bench dealt with the problem with utmost clarity and great vision. In fact, this should be a guiding judgment on the point. While considering the freedom of contract and the freedom of occupation, they laid down the fundamental principle that the freedom of contract must yield to the freedom of occupation in public interest.” The Bench said that it must be seen whether the enforcement of the negative stipulation is “reasonably necessary for the protection of the legitimate interests of the employer. If it is not going to benefit the employer in any legitimate manner, the court would not injunct the employee from exercising his skill, training and knowledge merely because the employee has agreed to it.”

In M/S Gujarat Pottling Co.Ltd. & Ors vs The Coca Cola Co. & Ors on 4 August, 1995[14]

The Supreme Court exhaustively reviewed the law relating to the validity of the contracts containing a negative covenant in commercial agreements. In paragraph No. 14 of the agreement entered into in the year 1993 between the parties in Gujrat Bottling Company's case provided that the Bottler would not manufacture, bottle, sale deed or otherwise be connected with the products, beverages of any other brands or trademarks/trade names during the subsistence of the agreement including the period of one year notice of termination. The 1993 agreement between the parties in that case was construed by the Supreme Court to be an agreement of a grant of franchiser by Coca Cola as a franchiser to Gujarat Botting Co. (GBC) as a franchisee whereby the GBC had been permitted to manufacture, bottle and sell beverages covered by the trade marks in the area covered by the agreement. The Supreme Court was required to consider whether the negative stipulation contained in paragraph No. 14 of the 1993 agreement being in restraint of trade was void under provisions of section 27 of the Contract Act. The Supreme Court noted that in England in earlier times, all contracts in restraint of relaxed and it became a rule that a partial restraint might be good if reasonable although a general restraint was void. The distinction between the general and partial restraint was subsequently repudiated and the rule, in England, now is that restraints whether general of partial may be good if they are reasonable and any restraint of freedom of contract must be shown to be reasonable to be valid. The principle that agreement in restraint of trade is void is a common law principle applicable in England while it has a statutory recognition under section 27 of the Indian Contract Act, 1872. While construing the provisions of section 27 of the Contract Act, the High Courts in India have held that neither the test of reasonableness nor the principle that the restraint being partial or reasonable are applicable to a case governed by section 27 of the Contract Act, unless it falls within the exception. The Law Commission in its 13th report has recommended that the provision (section 27 of the Contract Act) should be suitably amended to allow such restrictions and all contracts in restraint of trade, general or partial as were reasonable in the interest of the parties as well as public. No action is, however, been taken by the Parliament on the said recommendations (See paragraph No. 23).

However the court has upheld the non compete principle where is it reasonable:

In the case The Supreme Court of India in Niranjan Shankar Golikari v. The Century Spinning and Manufacturing Company Ltd [15]. observed that restraints or negative covenants in the appointment or contract may be valid if they are reasonable. A restraint upon freedom of contract must be shown to be reasonably necessary for the purpose of freedom of trade. The court held that a person may be restrained from carrying on his trade by reason of an agreement voluntarily entered into by him with that object. In such a case the general principle of freedom of trade must be applied with due regard to the principle that public policy requires the utmost freedom to the competent parties to enter into a contract and that it is public policy to allow a trader to dispose of his business and to afford to an employer an unrestricted choice of able assistance and the opportunity to instruct them in his trade and its secrets without fear of their becoming his competitors. Where an agreement is challenged on the ground of its being in restraint of trade, the onus is upon the party supporting the contract to show that the restraint is reasonably necessary to protect his interests. Once, this onus is discharged by him, the onus of showing that the restrain is nevertheless injurious to the public is upon the party attacking the contract.

Hence the non-compete covenants used in agreements can be categorized into in term and post term covenants. In an employment contract, the basic interests of the employer which are required to be protected include trade secrets and business connections and other such confidential information. In case of restraints in contracts of employment the nature of business and employment is relevant in assessing the reasonableness of restraints. An employee owes a duty to the employer to not disclose to others or use to his own advantage the trade secrets or confidential information which he had access to during the course of employment and he could be restrained from or sued for divulging or utilizing any such information in his new employment. But once again, he cannot be prevented from taking up the employment. Also, the employer cannot prevent the use of employee’s knowledge, skill or experience even if the same is acquired during the course of employment. Restrictive covenants are different in cases where the restriction is to apply during the period after termination of the contract than in those cases where it is to operate during the period of the contract.

Negative covenants operative during the period of contract of employment when the employee is bound to serve the employer exclusively are generally not regarded as restraint of trade and do not fall under Section 27 of the Indian Contract Act,1872. A negative covenant, one that the employee would not engage himself in a trade or business or would not get employment under any other employer for whom he/she would perform similar or substantially similar duties, is not a restraint of trade unless the contract is unconscionable or excessively harsh or unreasonable or one sided

CONCLUSION

It is well established by the various case laws decided in the courts of India that ‘non compete’ clauses that extend after the termination of employment are not enforceable in India. It is stated clearly in section 27 of the Indian Contract Act, 1872 that agreements in restraint of trade are void. In the garb of confidentiality, an employer cannot be allowed to perpetuate forced employment, as it is hit by Section 27.

Even though these clauses are valid in foreign countries, the laws and judicial interpretations of other countries will hardly have any effect on Indian courts if the statutory laws of this country are unambiguous. Post term restrictive covenants have been held invalid through various judicial pronouncements. An employer is not entitled to protect himself against competition on the part of an employee after the employment has ceased. However, a purchaser of a business is entitled to protect himself against competition per se on the part of the vendor and it has been upheld that a employer has no legitimate interest in preventing an employee after he/she leaves his service from entering the service of a competitor merely on the grounds that the employee has started working with a competitor, unless the same leads to misuse or an unauthorized disclosure of confidential information, which has been provided to the employee during his course of employment

Article 21 of the Constitution of India guarantees the live to livelihood and since it is a fundamental right it is held to be inviolable. This makes the enforcing of non compete clauses in India even more of a difficult task.