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Non Compete Clauses and their Validity under Indian Contract Act

by Samyukta Shankar
Non Compete Clauses and their Validity in Indian Contract Act

While law like anything in this world is ever evolving, it is absolutely fascinating that how something created or framed hundreds of years back still governs society. How everything we read today, every law that we see around us was created many years back or has its roots in the past. Speaking of the past, I am reminded of a story of Mr. John Dyer. Dyer probably a sincere but a simple man had once made an earnest promise to his master that he would not exercise his trade in the same town as his  master for six months. Hull J (The Judge of the English Court) on hearing this and having none of it very clearly stated that the condition is against the principles of common law and that if the Master had been present he would have sentenced him to prison.

What started out as a mere promise to not start a similar competing business, went on to lay one of the most important principles that people abide to while framing a contract. While in the Dyer case a rather harsh stance was taken, in 1711 in the case of Mitchell- Reynolds, the court rejected the opinion that agreements in restraint of trade are always void by drawing a line between unreasonable and reasonable restrictions.

Now I am sure that you must be wondering what is the significance of clauses that restrain trade also known as non compete clauses. Let’s take an example. Imagine you started your dream company, that makes customised merchandise. You start this company with the help of a friend, you trust him and share all your business secrets with him. However, as time goes by difference start to arise between you and your friend. As a result of which the friend decides to walk away. It is in exactly such situations that a non compete clause comes into play.

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In essence it refers to those clauses which restrain an employee from entering into a competition of any kind with the employer after the term of employment is over.

POSITION OF THE INDIAN LAW ON NON COMPETE CLAUSES

The position of Indian law on non compete clauses is a bit restrictive and rigid. As per Section 27 of the Indian Contract Act, 1872 “Every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void.”

Which is to say that the Indian law does not recognise or differentiate between complete and partial restraint. Any kind of restraint is considered to be void. The primary reason behind this view is that an employer does not have any legitimate interest in preventing an employee after he leaves the service to join the service of the competitor, merely because he is a competitor.[1]

AGREEMENTS NOT CONSIDERED TO BE IN RESTRAINT OF TRADE

While for a long time the Indian courts applied the above principle, we see that in the case of Brahmaputra Tea Company Ltd. vs Scarth[2] the Court adopted a flexible approach with regards to non compete clauses. The Court held that the condition under which a covenantee was partially restrained from competing after the term was over was invalid. However, the condition by which the employee was bound during his term of employment to not directly or indirectly compete with his employer was held to be valid. The same was acknowledged by the Supreme Court in the case of Niranjan Shankar Golikari v. The Century Spinning And Mfg. Co.[3] Negative covenants that are deemed to be operative during the period of the contract of employment when the employee is bound to serve his employer are usually not considered as restraint of trade and therefore do not fall foul of Section 27 of the Act.

Another exception to Section 27 of the ICA is when the employer restricts employee during his period of employment to not divulge any trade secrets. In the case of Herbert vs. Morris the court observed that trade secrets refers to something peculiar related to the business. It could be formulae, technical know-how or a peculiar mode or method of doing business known only to the employer.  In the case of Ambiance India Pvt. Ltd. vs. Naveen Jain[4], the court held that agreements in restraint of divulging trade secrets are not in restraint of trade during the subsistence of the employment. Similarly in the case of Vfs Global Services Pvt. Ltd. vs. Suprit Roy[5] the Bombay High Courtheld that the effect of such a clause in an agreement is not to restrain a person from exercising a lawful trade or business as long as it is during the period of employment.

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As per Exception 1 of Section 27 of the Indian Contract Act, 1872 an agreement restraining the right to carry on a business of which good-will is sold is not void. Goodwill as stated in the case of Trego vs. Hunt[6] varies and means different things based on the type of business that is being carried out. However, often it is defined as “the sap and life of the business, without which the business would yield little or no fruit. It is the whole advantage, whatever it may be, of the reputation and connection of the firm, which may have been built up by years of honest work or gained by lavish expenditure of money.”

In the case of Le Passage to India Tours & Travels Pvt. Ltd. vs. Deepak Bhatnagar[7] the Delhi High Court, held that to attract the exception under Section 27 the goodwill should be identifiable and must be shown that the person to whom the goodwill has been sold is using the same. Which is to say that if A claims that he sold his goodwill to B, merely showing that he sold the goodwill will not attract the exception. A will have to show that B is actually using the goodwill.

Another caveat in the exception is the phrase “within specified limits”. Which is to say that in order for the exception to be exercisable A will have to show that the restriction is reasonable and subject to reasonable limits geographically.

The Indian Partnership Act, 1932 under Section 11(2) and Section 36(2) also permits agreements in restraint of trade. As per Section 11(2) the partners of a partnership firm can enter into a contract  which prevents them from entering into a competing business. The purpose is to prevent the partner from neglecting his duties towards the partnership while carrying on his own business.

Similarly according to Section 36(2) an agreement can be entered into between the outgoing partner and the remaining partners , that the outgoing partner shall not carry on a business similar to the business of the firm. However, such an agreement will be valid only if the restrictions are reasonable.

It is important to note that agreements in restraint of trade or business are only void to the extent of restraint.

AGREEEMNTS CONSIDERED TO BE IN RESTRAINT OF TRADE

A Garden leave clause refers to a clause as per which the employee is not allowed to work in the workplace or any location for his current employer or any other person. The Garden leave period usually commences from the time that the employee has given a notice period and has ceased to be an employee of the company or place of work. During this period the employee is bound to be paid his salary.

Interestingly the term ‘Garden Leave’ originated in the British Civil Services and was a euphemism for suspension.

While there isn’t a specific statutory provision that bars garden leave clauses, in the case of Vfs Global Services Pvt. Ltd. vs. Suprit Roy[8] the Bombay HC held that  the since the garden leave clause extends beyond the term of employment it is in restraint of trade and therefore void as per Section 27 of the Indian Contract Act 1872. The effect of the clause is to prohibit the employee from taking up any employment during the agreed period post the cessation of the employment.

Other than Garden leave agreements, those agreements that don’t fall under any of the exceptions mentioned above are considered to be in restraint of trade and thereby void. It is also important to note that if it so happens that an agreement was entered into in a different country and such an agreement contained a clause restraining trade or business and was sought to be enforced in India it would be considered to be void. In the case of Taprogge Gesellschaft MBH v. IAEC India Ltd.[9] the Bombay High Court that even if a negative covenant was valid under German Laws the same would not be enforceable under Indian Law as it was against Section 27 of the Indian Contract Act, 19872.

Attempt this quick quiz to test your knowledge on non compete clause!

Results

#1. Is a garden leave clause considered in restraint of trade?

Answer: Yes

#2. Is an agreement restraining an employee during his employment from starting a competing business void?

Answer: No

#3. If A sold the goodwill of his company to B, can A restrain B from setting up a competing business?

Answer: Yes

finish

[1] Kores Manufacturing Company Ltd. vs Kolak Manufacturing Company Ltd 1959 Ch. 108 126

[2] ILR XI Cal 454

[3] 1967 AIR 1098

[4] 2005 (122) DLJ 421

[5] 2008 (2) Bom CR 446

[6] HL 1896

[7] (2017) 391 ITR 207

[8] Supra 5

[9] AIR 1988 Bom. 157

This article has been written by:

Samyukta Content Writer at Kanooniyat.com

To connect with Samyukta on LinkedIn, click here

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