Non-Compete Clauses in Employment Contracts

Non-Compete vis-à-vis Contract Act

A very fine line divides the issues that fall within the sphere of: (a) the principle of the freedom to contract, and (b) restraint of trade. A non-compete clause by its very nature falls on the periphery.

Section 27 of the Indian Contract Act, 1872 (the “Contract Act”) provides: “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.”

Therefore, the Indian Courts have consistently refused to enforce post-termination non-compete clauses in employment contracts, and have held them as: (a) “restraint of trade” and impermissible under Section 27 of the Contract Act, and (b) void and against public policy as it deprives an individual of his or her fundamental right to earn a livelihood. The principles of Section 27 of the Contract Act were aptly summarized by the Supreme Court in Percept D’ Mark (India) Private Limited vs. Zaheer Khan[1], wherein the Supreme Court observed that under Section 27 of the Contract 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.

As a general principle, confidentiality, non-competition and non-solicitation agreements will be enforceable during the term of the employment. However, upon termination of employment, many of the provisions of the employment contract including non-compete clause are rendered unenforceable by Court, even if the provisions are reasonable in scope and duration, subject to certain exceptions. One of the few instances in which non-compete clause will generally be enforceable is in the context of the sale of a business, where the owners of the business agree to a non-compete in exchange for consideration for the goodwill associated with the business. To be enforceable, the non-compete clause will need to be reasonably limited in time and scope, and consideration will need to be attributed to the goodwill in the transaction. Similarly, a non-compete clause in a joint venture or partnerships in which shareholders/partners mutually agree not to compete with each other on certain terms and conditions, which include time and geographic restrictions, will generally be enforceable in India[2].

In the case of M/s Gujarat Bottling Company Limited vs. Coca Cola Company[3], the Supreme Court summed up the law relating to the issue of a restrictive covenant with reference to its earlier judgments. Keeping in view the need to balance the employer’s interests with the right to livelihood  of the employee, the Supreme Court  held that, “a negative covenant which is operative during the period of the contract of employment when the employee is bound to serve his employer exclusively is generally not regarded as restraint of trade and therefore will not fall within the purview of Section 27 of the Contract Act”. Thus, a negative covenant which has the effect of ensuring that the employee does not engage himself in a trade or business or would not agree to be employed by any other master for whom he would perform similar or substantially similar duties, is not a restraint of trade unless the contract is unconscionable or excessively harsh or unreasonable.

The Supreme Court in the Gujarat Bottling case[4] noted the ratio of an earlier decision in Superintendence Company of India (P) Limited vs. Krishan Muragi[5], wherein it was laid down that “the doctrine of restraint of trade never applies during the continuance of a contract of employment; it applies only when the contract comes to an end”. The Court finally came to the conclusion that while there is no legal bar against a clause of the above nature from being included in an employment contract for the period during which the employee continues to be in the employment of the employer, however, any clause which has the effect of causing such restriction to continue after the contract of employment has come to an end, could attract the provisions of Section 27 of the Contract Act.

From the aforesaid decisions of the Indian Courts, it may reasonably be concluded that clauses in employment contracts which stipulate that the employee shall not take up a similar position with a competitor of the company albeit for a restricted period after the termination of the contract of employment is, in all likelihood, liable to be struck down. However, given the developed social, legal, and corporate circumstances, and the requirement for confidentiality and integrity of employment, the Indian Courts have been inclined towards giving some regard to the non-compete agreements. In the case of Niranjan Shankar Golikari vs. Century Spinning and Manufacturing Company Limited[6], the Supreme Court observed that “restraints or negative covenants in the appointment agreements or contracts may be valid if they are reasonable”. So far as the term ‘reasonable’ is concerned, in general understanding it means ‘according to reason’. Whatever a reasonable man would do using common sense and knowledge, under the given circumstances, will account as reasonable. Therefore, the test of reasonability depends on the facts and circumstances of each case.

Conclusion

The law relating to restriction on employment and confidentiality has been well settled in India by judicial pronouncements. While the Courts have opined that restraints or negative covenants in the employment contract may be valid in certain circumstances if such restraints are reasonable, it is a settled position till date that an employee can, while he continues to be in employment, be restricted from working outside his scope of employment, and for other organizations. However, once he leaves his employment or his services are terminated, he cannot be restricted from working for a competitor or for any other employer doing business on lines similar to the earlier employer. This is founded on the basis of the provisions of Article 19(1)(g) of the Constitution of India and Section 27 of the Contract Act, which stipulate that an Indian citizen has a fundamental right to practice any profession, or to carry on any occupation, trade or business and any restriction on such means of livelihood is prohibited.

  The views and opinions expressed in this article belong solely to the author and do not reflect the position of Tatva Legal Hyderabad.  

[1] AIR 2006 SC 3426

[2] See FL Smidth Pvt. Ltd. vs. Secan Invescast (India) Pvt. Ltd., 2013 (1) CTC 886

[3] AIR 1995 SC 2372.

[4] Id.

[5] AIR 1980 SC 1717

[6] 1967 SCR (2) 378