Enforceability of Employee Non-Compete Covenants
Introduction
Once an employers’ employee, always an employers’ employee. This is the scenario which every employer resorts to in order to control employee attrition or restricting them from seeking employment with rival competitors or setting up a competing independent business. This is primarily done by incorporating non-compete covenants in the employment agreements. Apart from curbing attrition, employers also impose restrictive covenants to avoid competition and protecting the trade secrets and business connections.
Restraint on trade and employment contracts
In anticipation of having long-term business contribution from the employees, the employers provide substantial resources in training them with specific skills, talent and knowledge. But, in general practice, after gaining the requisite skills, talent and knowledge, employees become more inclined to shift towards more rewarding job opportunities. Thus, to restrict the employees from moving jobs, employers insert typical clauses in the employment agreement which restrict the employees from leaving the job for a fixed period after the training or taking up similar employment for a fixed time period, after they cease to be an employee. Undoubtedly, in such a scenario, the employer and employee have conflicting interests with respect to the negative covenant in the employment agreement which runs the risk of being hit by Section 27 of the Indian Contract Act. The Indian Courts have considered such issues arising under Section 27 and tend to decide in favour of the employees.
Section 27 of the Indian Contract Act, 1872 states that any agreement which restricts a person from exercising a lawful profession, trade or business of any kind is void to that extent. The only exception is in relation to the sale of goodwill, where the buyer may restrict the seller from carrying on similar business within specified local limits. The act does not recognize any other valid restraint on trade, even if such a restraint is reasonable.
Ordinarily, there are three types of agreements in restraint of trade. First, there can be an agreement between master and servant whereby the servant covenants not to set up business on his own account on leaving his service or to enter into employment with a rival firm. Secondly, there can be an agreement between buyer and the seller of a business whereby the seller covenants not to carry on a business which will compete with that of the buyer. Thirdly, there can be an agreement between the traders whereby they contract to regulate their supplies or production or price of articles.
Here, we restrict ourselves to employment contracts only. The legal position appears to be well established with reference to the employment contracts. The broad principles as laid down by Indian courts are:
i) after the expiry of the term of employment, the agreements which prevent an employee from working elsewhere would be restraint of trade, unless there is a proprietary interest of the employer, and
ii) an employee may be restricted from serving any other person or carrying on independent business during the term of employment.
Non-compete during employment
During the term of employment, an employer can legally restrain an employee from competing with it or taking any other employment while the employment contract is in force.
The Hon’ble Supreme Court of India recognized this principle for the first time in Niranjan Golikari vs. Century Spinning and Manufacturing Co Ltd. , where the Court discussed the issues and held that considerations against restrictive covenants are different in cases where the restriction is to apply during the period after the termination of the contract than those in cases where it is to operate during the period of the contract. Negative covenants operative 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 therefore do not fall under section 27. A negative covenant that the employee would not engage himself in a trade or business or would not get himself employed by any other master for whom he would perform similar or substantially similar duties is not therefore a restraint of trade unless the contract as aforesaid is unconscionable or excessively harsh or unreasonable or one-sided.
Though, in one of the rulings of High Court of Calcutta in Shree Gopal Paper Mills Ltd. vs. Surendra K. Ganeshdas Malhotra , it was held that restraints that operate during the term of employment may not be enforceable if they are one-sided and intensely favour the employer. In this case, the plaintiff appointed the defendant to serve for a period of 20 years, during which the defendant could not give his service or advice to any other person or company, nor become interested or engaged in any enterprise or undertaking either alone or jointly with other or any other in any business or trade. The other harsh covenants of the contract were the increase in pay being marginal and the arbitrary power vested with the employer to terminate the plaintiff’s service without notice. In such circumstances, the Court held that the agreement was oppressive, one-sided, and unreasonable. Therefore, the restrictive covenant preventing the employee from working at another place was unenforceable.
Thus, it can be deduced that the non-compete covenant during the term of employment would not attract the doctrine of restraint of trade. The only exception to this would be if the contract and the non-compete covenant thereof is unconscionable or excessively harsh or unreasonable or one-sided.
Non-compete after employment ends
Upon cessation of the employment contracts, the restrictive covenants restricting the employees from working elsewhere or setting up their own business are generally not enforceable. It is seen in some cases that the employers have tried to enforce the non-compete covenant, upon termination of the employment period, on grounds of reasonableness and have also argued that such restrictive covenant should be enforced if it is a partial restraint.
There are several cases in which 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 (the Act), 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.
The principles of Section 27 were rightly summarized by the Supreme Court of India in Percept D’ Mark (India) Pvt. Ltd v Zaheer Khan and Anr. . In this case, the appellant company entered into a Promotion agreement with Zaheer Khan on 01.11.2000 for a period of three years commencing on 30.10.2000 and expiring on 29.10.2003. Clause 31 (b) of the Promotion agreement contained a right of first refusal clause. As per this clause, Zaheer Khan could not accept any offer for endorsements, promotions, advertising or other affiliation with regard to any product or services. If he intended to accept any such offer, he would have to give in writing all the terms and conditions of such third party to the appellant to match such third party offer. The appellant had sent a letter for extension of the Promotion agreement which was not accepted by Zaheer Khan. After the expiry of the Promotion agreement, Zaheer Khan entered into another agreement with Adidas without complying with Clause 31 (b).
The Supreme Court held that under Section 27 of the Act, a restrictive covenant extending beyond the term of the contract is void and not enforceable. The Court further held that if the restrictive covenant is enforced then it would curtail Zaheer Khan’s freedom to enter into fiduciary relationships with persons of his choice and create a compulsion on him to forcibly enter into a fresh agreement with the appellant. This, as such, is a restraint of trade and is void.
Comparative Analysis of Doctrine of Restraint of Trade
It is interesting to look into as to why the Indian Courts feel that no useful purpose would be served in deciding the issue of enforceability of restrictive covenants in line with the English law.
Under English law, the English Courts have held that a man is entitled to exercise any lawful trade or calling as and where he wills. It may be seen that the approach of English courts with regard to enforceability of the restrictive covenants is based upon the following tests, such as:
i) whether a contract is or is not in restraint of trade,
ii) whether, if is in restraint of trade, it is reasonable,
iii) whether, it must protect employer’s propriety interest, such as confidentiality, trade secrets, technical know-how, and
iv) whether, it is against the public policy.
Unlike English law, the Indian courts have taken much stricter and less favourable view towards the enforceability of the restrictive covenants enumerated in the employment contract and has upheld such covenants only in employment contracts during their subsistence, provided the restrictions are reasonable. In so far a commercial contract (other than an employment contract) is concerned, the Supreme Court has held that the question of reasonableness of restraint is outside the purview of Section 27 of the Indian Contract Act. Therefore, the question of reasonableness and also the question whether the restraint is partial or complete are not required to be considered at all whenever an issue arises as to whether a particular term of a contract (other than the commercial contract) is or is not in restraint of trade, business or profession except in the case of sale of goodwill.
Conclusion
When the issue of restraint of trade comes up before the Indian courts for interpretation, the courts invariably compare the Indian position with that of the position under the common law. Under the Indian law, the courts have to follow the statute as worded whereas under English law, the courts follow the common law.
In my considered view, reasonability must be a ground in deciding the doctrine of restraint of trade in all contracts. This would certainly make the Indian position on restraint of trade commercially acceptable. In view of the same, the Law Commission of India in its 13th Report, way back in 1958, strongly recommended that Section 27 be amended, since the constraints that it imposes on Indian business and contracts are commercially undesirable. However, the Government has not taken any action in order to implement the same.
Thus, Section 27 should be amended in a way that the restraint is judged on the test of reasonableness and also provides a window to safeguard the parties’ interest.
About the Author
Mr Rohit Jaiswal, Partner, Singhania & Partners LLP - www.singhania.in
Rohit is a Partner with the firm. He is a lawyer and a company secretary with an experience of more than 17 years. He counsels large number of domestic as well as multinational companies apart from several government companies as well as regulatory authorities. He has acted on several mandates on Public Private Partnership, as well as corporatization or privatization of government arms. He assists Fortune 500 companies on their entry strategy & structuring of their business models.
His practice areas comprise of project finance, corporate & commercial matters, tax, joint ventures & acquisitions with a focus on IT, real estate, roads & power.
Siddharth Dubey, Associate (siddrath.dubey@singhania.in)singhania & Partners LLP - www.singhania.in
Siddharth is an Associate with the firm. He is a part of the corporate group in Delhi and works in the team headed by Mr. Rohit Jaiswal , Partner at S&P. He assists the team in matters relating to mergers & acquisitions, general corporate &commercial and infrastructure
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