Validity of Non-Compete agreements
Author
Adv. Ajit R.Powar
Published on 30.06.2022
Business competition and trade wars are not new and no more limited to ethical practices of providing quality products and good marketing strategies with the backup of a good sales team. Often organisations cross the ethical line to get access to their competitor’s confidential information to get an edge over them. The most common practice of gathering information is through the employees. To put a break to the dissemination of confidential information in the interest of their business, employers take commitments from employees in the contract of employment restricting certain rights of employees in the form of Non- Compete, Restrictive or Negative Covenants.
Such non-compete, restrictive or negative covenants applicable during the period of employment have been held valid by the courts unless unconscionable, excessively harsh or unreasonable, however, post employment negative covenants have been more or less commonly held to be in restraint of trade being against public policy. Therefore this thin line differentiating valid covenants and invalid covenants in restraint of trade plays an important role for employers in initiating action against employees and for employees in their defense against the employer’s actions.
Though invoking such clauses and initiating action against employees would require necessary evidence in the hands of the employer, such clauses do play a role in controlling employees from divulging confidential business information and in getting injunction orders from courts restricting any such attempts on the part of the employees. At the same time it is important for employees to be aware of their rights in relation to the doctrine of restraint of trade and not get bogged down by such restraints in their contract of employment which are invalid in most cases.
Non-compete clauses as popularly known, are restrictive covenants or negative covenants in a contract of employment. Negative covenants in a contract of service are ones by which an employee is precluded from engaging himself in any trade or business or getting himself employed by another master for whom he would perform similar or substantially similar duties, these are covenants by which an employee agrees to refrain from doing certain things which would otherwise be within his right to do like exercising any lawful profession, trade, business or getting employed in a place of his choice. In most cases, these covenants are applicable during the term of employment and in many cases are incorporated to cover even post-termination period. These clauses are generally incorporated in the terms of service to protect intellectual property rights and confidential information of the business as they safeguard the interest of the employer by precluding the employee from divulging confidential information and knowledge shared with him such as trade secrets, manufacturing processes, etc. as differentiated from the general knowledge and experience that he might gain while in course of employment. Such restrictive covenants also cover non-solicitation and confidentiality agreements limited to a reasonable period of time.
Such restrictive, negative or non-compete clauses are treated as void by courts under section 27 of Indian Contract Act, which reads as -“Agreement in restraint of trade, void – every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void
Exception 1.—Saving of agreement not to carry on business of which goodwill is sold.—One who sells the goodwill of a business may agree with the 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 the business”.
While these restrictive covenants are accepted by the courts so long as they are reasonable and not unconscionable depending on the facts prevailing the courts have also invalidated in many cases such clauses for being in restraint of trade and against public policy. It is not that in all cases such restrictions are treated in restraint of trade under section 27, rather a distinction has been consistently drawn by foreign precedents and precedents of the courts in India between restrictions applying during the period after termination of a contract of employment and those in cases where they are to operate during the period of the contract of employment. Negative covenants which are operative during a contract of employment when an employee is bound to serve his employer have been generally not regarded as invalid for being in restraint of trade and therefore have not been held to fall under section 27 of the Contract Act, unless the contract is unconscionable or excessively harsh or unreasonable or one-sided.
While negative covenants applicable beyond the contractual period of employment have been consistently held to be invalid at the same time such post-employment negative covenants for protecting confidential information or non-solicitation agreements for a reasonable time have stood the test of validity. However, the discussion on whether the negative covenant is conscionable or reasonable is a never-ending one, and the observations of the Supreme Court and High Courts certainly help us in understanding the trend of judicial pronouncement and the law on the point.
In Niranjan Shankar Golikari vs Century Shipping and Mfg. Co. Case way back in 1967, which was a case for injunction by the employer during the existence of a contract of employment to restrain the employee from continuing in employment with its competitor, the Supreme Court of India after considering various Indian and foreign precedents which were based upon the settled position of law on the point held that “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 unless contract is unconscionable or excessively harsh or one-sided”. Such covenants are not necessarily in restraint of trade, but could be in furtherance of trade or contract of employment and to protect the interest of the employer, as observed by Calcutta high in Court Brmahaputra Tea company case “ An agreement to serve a person exclusively for a definite term is a lawful agreement, and it is difficult to see how that can be unlawful which is essential to its fulfillment, and to the due protection of the interest of the employer while agreement is in force.”. In other words, how can a negative covenant be held as unlawful which is introduced in the contract of employment solely for the fulfillment of the positive covenant of the employee (which is lawful) to serve the employer exclusively for a definite term.
The court further held that “there is nothing to show that if the negative covenant is enforced the appellant would be driven to idleness or compelled to go back to the respondent company”. As a rule, the courts do not accept any negative covenant which would lead to idleness of the employee nor do courts seek to compel persons against their will to maintain continuous personal relations rather it is settled law that courts do not enforce specific performance of contracts of personal service. Accordingly, negative covenants resulting in idleness or compelling the employee to go back to the employer for work would be invalidated for being unreasonable, unconscionable or harsh. We can thus infer from the above observation that a negative covenant applicable during the course of employment has to be conscionable and not harsh or one-sided in order to be valid for seeking an injunction to restrain an employee. In case the negative covenant is harsh or unconscionable or one-sided, the said clause would be a valuable defense for the employee against any such injunction.
A similar view has been taken by the Supreme court in Gujarat Bottling co.ltd. Vs Coco cola : “the court is however, not bound to grant an injunction in every case and an injunction to enforce a negative covenant would be refused if it would indirectly compel the employee either to idleness or serve the employer”.
Efforts have been made to convince that post-contractual period covenants if reasonable or for a limited period or area would fall outside the prohibition of section 27. However, the legal position is that while construing the provisions of section 27 of the Contract Act, neither the test of reasonableness nor the principle of restraint being partial is applicable, unless it falls within the express exception provided in section 27 which is in respect to sale of goodwill of the business. As has been held in another landmark Judgment of the Supreme Court in the case of Superintendence Co.Ltd Vs Krishan Murgai,1980 “There is nothing in the wording of section 27 to suggest that the principle stated therein does not apply when the restraint is for a limited period only or is confined to a particular area. Such matters of partial restrain have effect only when the facts fall within the exception to the section.
A contract which has for its object a restraint of trade is prima facie void. Section 27 of the Contract Act is general in terms and unless a particular contract can be distinctly brought within the exception 1there is no escape from the prohibition. We have nothing to do with the policy of such a law. All we have to do is take the words of the contract Act and put upon them the meaning which they appear plainly to bear”.
In Niranjan Golikari Case supra the Court also considered the decision of Calcutta High Court in Gopal paper mills vs Malhotra which was a case of a negative covenant enforceable during the period of employment. In which the period of contract was as much as 20 years. The contract gave the employer an arbitrary power to terminate the services without notice if the employer decided not to retain the employee during the three years of apprenticeship or thereafter if the employee failed to perform his duties to the satisfaction of the employer. The employer in the case had absolute desecration to decide whether the employee failed to perform his duties and the employer’s certificate that he did not, was to be conclusive between the parties. It was held that such a contract would fall in the class of contracts held void being one-sided.
The judgment of Calcutta High Court in Bramhaputra tea company vs Scrath was also considered with approval by the Supreme Court which was a case of negative and positive covenant. In the said judgment the court held to be good in law that part of the covenant by which the employee bound himself during the term of his agreement not to directly or indirectly, compete with his employer, However, the part of the covenant under which the employee was partially restrained from competing with the employer after the term of his engagement was over with his former employer was held to be bad.
Both the Judgments of the Supreme Court in Niranjan golikari case and Superintendence Co.ltd case were considered by later judgment of Supreme Court in Gujarat bottling company ltd. vs Coco-Cola where it was observed “ The court has to decide as a matter of law 1 ) whether the contract is or is not in restraint of trade, 2) whether, if in restraint of trade, it is reasonable. The court takes a far stricter view and less favorable view of covenants entered into between employers and employee than it does of similar covenants between vendor and purchaser or in partnership agreements and accordingly, a restraint may be unreasonable as between employer and employee which may be reasonable as between vendor or purchaser of a business”. Accordingly, the courts have drawn a distinction between contracts of employment and commercial contracts while applying the test of reasonability before granting any such injunctions.
The reason why courts have a different approach to covenants between employers and employees can be best explained in the word of the Hon’ble Supreme court of India in Superintendence co.ltd case supra “ It is well settled that employees covenant should be well scrutinized because there is inequality of bargaining power between the parties; indeed no bargaining power may occur because the employee is presented with a standard form to accept or reject. At the time of the agreement, the employee may have given little thought to the restriction because of his eagerness for a job; such contracts tempt improvident persons, for the sake of present gain, to deprive themselves of the power to make future acquisitions, and expose them to imposition and oppression”.
Garden Leave
In order to protect against the prohibition under section 27 of the Contract Act the companies have now come up with ‘Garden leave’ provisions in their contracts of employment. It refers to a provision under which despite the termination of employment, whether by resignation or removal by the employer, the employer continues to pay him his full salary for a stipulated time as compensation in order to prevent him from reporting to a competitor for work. Such a provision of a Garden leave operative beyond the contractual period of employment would also be treated as unreasonable. However, exceptions in some cases have been followed by the courts. In the case of Garden leave the employers need to observe some safeguards in their clause like adequate compensation, the garden leave should be applicable to a reasonably small duration, preferably the employee stays on the company’s roll till the garden leave is over. However one should bear in mind that courts in India will be very cautious in validating such clauses.
Conclusion :
While recommendations have already been made for the amendment of Section 27 as the section is to quite an extent harsh on employers whose only interest is to protect their trade secrets from being divulged. A decision on such recommendations is not an easy one for the legislators knowing the weak bargaining capacity of employees and their need to seek immediate alternative employment after termination, while at the same time changes are certainly required with the growing complex business relations.
Employers certainly require taking all steps to protect their confidential information and it would always be advisable to limit the applicability of these negative covenants only to the contractual period. While doing so one needs to be very careful in drafting such clauses as they have to stand the test of not being unreasonable, impartial, or unconscionable. Some exceptions to the doctrine of agreements in restraint of trade have been taken in the case post-contractual negative covenants, like in the case of garden leave clauses however the number of such cases are way too low and based on facts of those cases, and therefore cannot be followed as a rule.
Adv. Ajit R. Powar
The contents of this article are the views and opinions of the author on the subject matter. The readers are expected to take expert advice based on the facts and circumstances of their case.
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