[The Viewpoint] Validity of Restrictive Covenants in Contracts

The bedrock of modern-day commerce and trade is based, inter alia, on the relationship between contracting parties, which is governed by the principles of the law of contracts. Technological advancement and globalisation have fostered additional complexities in this sphere, making it incumbent on the parties to protect their legitimate business interests. In a bid to preserve and protect interests such as confidential and proprietary information, ideas and trade secrets, contracting parties often feel the need to include restrictive covenants, impeding the other party from exercising its liberty to use any confidential information or carry out a specific profession, trade or business with any other parties without seeking prior permission from the contracting party. Such restrictive or negative covenants can be of various kinds and include, without limitation, non-compete, non-solicitation and confidentiality clauses.

The inclusion of such negative covenants is either barred or highly restricted in their scope of operations by way of provisions in statutes or through various judicial pronouncements. The Indian Contract Act, 1872 (“Act”), imposes such a restriction on the applicability of negative covenants under Section 27 which stipulates that agreements in restraint of trade are considered void. The aim of Section 27 is to deem unlawful any agreement that prevents or restricts a person from engaging in trade, business, or lawful profession, unless such restriction is valid or reasonable.

The judicial interpretation of whether agreements or covenants are in restraint of trade under Section 27 has evolved over the years. Although the Constitution of India guarantees to every citizen, the right to practice any business, trade or profession, the said right is not absolute. Reasonable restrictions can be placed on such rights in the interest of the public at large. Such restrictions/restrictive covenants have time and again been subject to judicial review and interpretation and the courts have upheld such restrictions depending upon the facts and circumstances of each case. This article aims to analyse the validity of such negative/restrictive covenants, in view of the various judicial interpretations.

The first case in which the need for examining the scope of Section 27 arose was in Madhub Chunder Poramanick v. Rajcoomar Doss and Ors., (1874) before the Calcutta High Court. The Court observed that Section 27 was intended to prevent not merely a total restraint from carrying on trade or business, but a partial restraint as well. In light of this, the court held that an agreement whereby one of the parties agrees to close his business within a particular locality in consideration of a promise by the other party to pay a certain sum of money is in restraint of trade and hence, void.

While there are various kinds of restrictive covenants, the analysis in this article is limited to non-compete and non-solicitation clauses which are some of the most commonly used restrictive covenants in contracts.

A non-compete clause aims at avoiding competition between contracting parties by restraining the other party from pursuing a similar competing profession, trade or business or prohibiting a party from working for a competitor. Such a covenant usually manifests itself in contracts to prevent misuse of trade secrets, confidential information and other knowledge acquired by a party during the term of the contract. Non-compete clauses are also widely used in commercial agreements to protect business interests of parties which may suffer irreparable harm owing to dilution of competitive advantage.

While non-compete provisions find their place in both employment agreements as well as commercial agreements, they have been treated differently by the courts owing to the nature of the relationship between the contracting parties and the consequential losses that may be suffered by the party under the non-compete obligation. Therefore, it is imperative that the validity of non-compete clauses in employment agreements and commercial agreements be dealt with separately.

1. Employment agreements

   A non-compete clause in an employment agreement endeavours to protect the trade secrets, confidential information and business interests of the employer by restricting the employee from competing with the employer or seeking employment with a competing business. Typically, the validity of such a clause may extend till the term of the contract but in some cases, may extend beyond the term of the contract, depending on the nature of confidential information and the skill acquired by the employee during the term of employment.

   In determining whether such a restrictive covenant is in restraint of trade, business or profession, it may be noted that the courts have taken a stricter view with respect to employment contracts as opposed to other commercial contracts. The rationale behind this is that in employment contracts, the employer usually has an advantage over the employee and more often than not, employees are compelled to execute standard contracts, without being provided an opportunity to negotiate their interests. Consequently, the inclusion of such restrictive covenants in the employment contract adversely impacts the ability of the employees to earn a livelihood. Whereas in commercial contracts, the parties are usually at par with each other or at least, are provided the opportunity to negotiate their interests in good faith.

   Thus, the courts have consistently taken the view that restrictive covenants imposed during the period of employment do not amount to restraint of trade under Section 27 of the Act. However, there has been much debate on the validity of post-termination non-compete obligations.

   The Supreme Court dealt with the validity of negative covenants vis-à-vis Section 27 in the landmark judgement Niranjan Shankar Golikari v. The Century Spinning and Manufacturing Company Ltd, where it was observed that negative covenants can be valid as long as the restriction imposed on them is reasonable and they are not against public policy. It was held that the 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/her employer exclusively are generally not regarded as restraint of trade and therefore, do not fall under the ambit of Section 27 of the Contract Act.

   The court, in the above judgement, took a liberal approach in observing that not all post termination non-compete clauses are in restraint of trade and held that, ‘a negative covenant that the employee would not engage himself in a trade or business or would not get himself employed by any 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.’

   In the case of Percept D’Mark (India) Pvt. Ltd. v. Zaheer Khan & Anr, the Supreme Court took a conservative approach while interpreting Section 27 and held that a restrictive covenant extending beyond the term of the contract is void and not enforceable. The court further held that the doctrine of restraint of trade does not apply during the continuance of the contract of employment and it applies only when the contract comes to end. This position was further re-affirmed in Superintendence Company of India (P) Ltd. v. Krishan Murgai.

   In Pepsi Foods Ltd. and Ors. v. Bharat Coca-Cola Holdings Pvt. Ltd. and Ors, the Delhi High Court observed that a covenant restraining an employee from undertaking employment in a similar or competing business, for 12 months post termination of the employment contract, is in restraint of trade. The court held that ‘it is a well settled position that validity of restrictive covenants post termination of agreements, are in violation of Section 27 of the Indian Contract Act and such contracts are unenforceable, void and against the public policy’.

2. Commercial agreements

   As mentioned above, the usage of restrictive covenants is commonly seen in employment agreements due to the exposure of confidential and proprietary information of the employer. However, apart from employment agreements, non-compete clauses are also widely used in commercial contracts where sensitive information is exchanged between the parties, for protecting the business interests of such parties. Accordingly, the principles governing restrictive covenants is applicable even in the case of commercial contracts.

   In Gujarat Bottling Co. Ltd. and others v. Coca Cola and Ors., a franchise agreement contained a covenant restraining the franchisee from performing the same or similar functions for a competitor for the duration of the agreement. The Apex Court held that ‘such a condition restricting the right of the franchisee to deal with competing goods is for facilitating the distribution of the goods of the franchisor and it cannot be regarded as in restraint of trade.’

   Further, the validity of restrictive covenants in a joint venture agreement was examined by the Madras High Court in GEA Energy System India Ltd. v. Germanischer Lloyd Aktiengesellschaft. In this case the parties had entered into a joint venture agreement containing a clause restraining either party from setting up a business similar to that of the joint venture company in India, during or post termination of the agreement. The court observed that the parties have been given liberty to undertake any business they like, however, such a business shall not be prejudicial to the interest of the joint venture business. As such, the restrictive covenant does not envisage a blanket restriction on setting up any business in India. It is not an absolute restriction placed on the parties not to transact any business.

   The Supreme Court has rightly pointed out in the Niranjan Shankar case (supra) that the courts take a far stricter view of covenants in employment agreements than it does of similar covenants between vendor and purchaser or in partnership agreements. An employer, for instance, is not entitled to protect himself against competition on the part of an employee after the employment has ceased but a purchaser of a business is entitled to protect himself against competition per se on the part of the vendor. This principle is based on the footing that an employer has no legitimate interest in preventing an employee, after he leaves his service, from entering the service of a competitor merely on the ground that he is a competitor.

   Notwithstanding the general rule holding that all agreements in restraint of trade are void, the Act specifically exempts agreements not to carry on business, of which goodwill is sold, from the purview of Section 27. This has been upheld by the Delhi High Court in Affle Holdings Pte Limited v. Saurabh Singh where the court examined the validity of a negative covenant which restricted the respondent from engaging in a competing business for a period of 36 months. The court observed that since the respondent acquired a business which was competing with the business of the appellant with the clear intention of acquiring its goodwill, the covenant would fall within the exception envisaged in Section 27 and would not be in restraint of trade.

   While the stance of the judiciary with regard to enforceability of non-compete covenants in employment contracts post termination is well settled, the courts have been flexible when it comes to commercial contracts, paying much heed to the facts and circumstances of each case, to ensure conformity with the principles of fairness and natural justice. Moreover, the validity of such non-compete provisions in different agreements cannot be treated at par and therefore the courts have given due regard to the negotiating power of the contracting parties in determining whether the inclusion of such restrictive covenants would be valid.

A non-solicitation clause is commonly used in employment agreements to restrain an employee from soliciting any of the employer’s clients, suppliers or employees, to the detriment of the interest of the existing employer. Further, complex commercial relations between parties have warranted inclusion of non-solicit covenants in commercial contracts as well. However, the validity and enforceability of such clauses have been dealt with by the courts, depending on the facts and circumstances of each case.

In Wipro Ltd. v. Beckman Coulter International SA, the Delhi High Court examined the validity of a non-solicitation clause in a commercial agreement entered into between the parties. The clause in question placed a bar on the contracting parties from offering inducements to the other party’s employees to give up their current employment and join such other party. However, there was no restriction on the employees of either of the contracting parties from leaving their employment and joining the other party. The court reasoned that since the restriction was put solely on the contracting parties, it had to be viewed more liberally than a restriction in an employment contract. The court in this case held that, ‘a non-solicitation clause does not amount to a restraint of trade, business or profession and would not be hit by Section 27 of the Indian Contract Act, 1872 as being void.’

Similarly, the Calcutta High Court while deciding on the enforcement of non-solicitation between an employer and employee held in Embee Software Private Limited v. Samir Kumar Shaw that if the former employees solicit the customers of the former employer by inducing them to break their contract with the former employer or prevent other persons from entering into contracts with the former employer, such solicitation cannot be permitted.

The Delhi High Court, in Desiccant Rotors v. Bappaditya Sarkar, upheld the injunction granted by the lower court prohibiting the ex-manager of the appellant from soliciting its suppliers, customers and connections, for soliciting business which is in direct competition with the business of the appellant.

The Madras High Court in FL Smidth Pvt. Ltd. v. M/s. Secan Invescast (India) Pvt. Ltd. laid down the following test to determine solicitation and held that, ‘The appellants should prove that the respondents approached their erstwhile customers and only on account of such solicitation, customers placed orders with the respondents. Mere production of quotation would not serve the purpose.’ The court also observed that such clauses may be valid if reasonable restraints are imposed and summarised the following as reasonable restrictions:

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 this 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.

It is commonly observed that one of the primary tests used by the courts to determine the validity of a non-solicit clause in an employment agreement is whether the employer has made out any exceptional case to deviate from the general principle whereby the loss suffered by the employer due to breach of confidentiality obligations of the employee, could not be measured adequately or if measured could/would not adequately place the employer in the same position as if the breach had not occurred. To this effect, the Madras High Court in E-merge Tech Global Services P. Ltd. v. M.R. Vindhyasagar and Ors. held that the non-solicitation clause for a period of 3 years post termination is binding on the employee in order to prevent divulgence of confidential information of the employer.

Although there is no uniformity in law or principle with regard to validity of non-solicitation covenants, a consistent theme that has emerged; wherein the courts generally uphold as valid, such non-solicitation clauses which are included primarily with an intention of preserving legitimate business interests and confidential information of the employer. However, legitimate business interests and confidentiality are not the sole determining factors considered by the courts while assessing the enforceability and validity of such clauses.

Upon review of the catena of judgements laid down by the Supreme Court and various High Courts in this context, the Delhi High Court in the Wipro case (supra), laid down the following guiding principles for ascertaining the validity of restrictive covenants:

1. Negative covenants during the subsistence of a contact, irrespective of the nature of the contract, would not normally be regarded as being in restraint of trade, business of profession unless the same are unconscionable or wholly one-sided.

2. Post termination negative covenants in employment contracts, which restrict an employee's right to seek employment and/or to do business in the same field as the employer would be in restraint of trade and void to that extent.

3. While determining whether a negative covenant is in restraint of trade, business or profession or not, the courts take a stricter view in employment contracts than in other commercial contracts, since in an employment contract, the balance of convenience lies in favour of the employer whereas in commercial contracts, the parties are, more or less, on an equal footing.

4. The question of reasonableness and also the question of whether the restraint is partial or complete is not required to be considered at all whenever an issue arises as to whether a particular term of a contract is or is not in restraint of trade, business or profession.

Although the courts have divergent views on the validity of such restrictive covenants, the emerging trends in the global markets warrant inserting of restrictive covenants in commercial as well as employment contracts, owing to the increasing rate of commercial disputes and litigations. While the enforceability of such covenants has been dealt with in a plethora of cases, the courts have broadly examined such clauses in the light of facts and circumstances of each case, giving due regard to the reasonableness of the restrictions set out in such agreements.

Evidently, the courts in India have upheld that the mere presence of such clauses in contracts does not render the contract void ab initio. However, the judicial principles regarding enforcement of such restrictive clauses vary based on the nature of the agreements, taking into consideration the protection of proprietary information, the reasonability of restrictions imposed and the balance of convenience between the contracting parties.

Chandan P. Kini is a Partner, Nikhil Sharma is a Senior Associate, Sonali Shendge is a Senior Associate and Nidhi Acharya is a Paralegal at Krishnamurthy & Co (K Law).