In this article, Ujjwal Ashok discusses the validity and enforceability of non-compete clauses under the Indian Law.
The law outlined in Section 27 of the Indian Contract Act declares all agreements which are in restraint of trade, occupation and business as void unless such an agreement relates to a restraint on carrying on the business of the company whose goodwill has been sold. Any other restraint not falling under this exception is considered as an unreasonable restraint of trade and unenforceable under Indian Law. The Indian law is rigid in this respect and invalidates all restraints, whether general or partial, and neither the test of reasonableness nor the restraint being partial shall apply to a case governed by Section 27 unless it falls within the exception of that Section.
1. Agreements held to be in restraint of trade
a) Agreements containing negative covenant post termination of contract
An agreement in restraint of trade has been defined as ‘ one in which a party(the covenantor) agrees with any other party (the covenantee) to restrict his liberty in the future to carry on trade with other persons not parties to the contract in such a manner as he chooses.[1]Restraint of trade appears to imply that a man contracts to give up some freedom which otherwise he would have had. A person buying or leasing land had no previous right to be there at all, let alone to trade there, and when he takes possession of that land subject to the negative restrictive covenant, he gives up no right or freedom which he previously had.[2] However a post covenant restraint contained in a contract of employment deprives the employee of his right to earn his livelihood and to make a living which is an inalienable right of every individual before he enters into a contract of employment and a restraint in this regarded is accordingly construed by Indian Courts as invalid and unenforceable under Section 27 as it is intended to stifle competition and secure freedom from competition and not to protect the legitimate interest of the covenantee. This principle and the underlying principle and object of Section 27 have been spelt out clearly in a catena of judgements which are as follows:
i. In Wipro Limited v. Beckman Coulter International S.A. [2006 (3) ARBLR 118 Delhi), the Delhi High Court has laid down the four basic commandments of restrictive covenants. These commandments are based on various judgments of the High Courts and the Supreme Court (1) restrictive covenants during the subsistence of a contract would not normally be regarded as being in restraint of trade, business or profession unless the same are unconscionable or wholly one-sided (2) post-termination restrictive covenants between employer and employee contracts restricting 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 therefore void (3) Courts take a stricter view in employer-employee contracts than in other contracts the reason being that in employer-employee contracts, the norm is that the employer has an advantage over the employee and (4) the question of reasonableness as 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.In Krishan Murgai v.
ii. In Superintendence Company of India (AIR 1979 Del 232), the Delhi High Court deliberated over whether a contract of employment, entered into by the appellant with the respondent, which prohibited him from engaging in similar business as that of the respondent, during his employment, and for a further period of 2(two) years after the termination of his employment was violative of Section 27 of the Indian Contract Act,1872. The court held that Section 27 does not distinguish between reasonable or unreasonable restraint of trade and therefore any restraint imposed on the employee after the term of employment, would prima facie be void and unenforceable
iii. In TaproggeGesellschaft MBH v. IAEC India Ltd (AIR 1988 Bom 157), the Bombay High Court held that a restraint operating after termination of the contract to secure freedom from competition from a person, who no longer worked within the contract, was void. The court refused to enforce the negative covenant and held that, even if such a covenant was valid under German law, it could not be enforced in India.
iv. In Pepsi Foods Ltd. and Ors. Vs. Bharat Coca-Cola Holdings Pvt. Ltd. and Ors. [1999 SCC Online Del 530], it has been held that “post termination restraint on an employee is in violation of Section 27 of the Indian Contract Act, 1872. A contract containing such a clause is unenforceable, void and against public policy and since it is prohibited by law it cannot be allowed by the Courts injunction. If such injunction was to be granted, it would directly curtail the freedom of employees for improving their future prospects by changing their employment and such a right cannot be restricted by an injunction. It would almost be a situation of economic terrorism creating a situation alike to that of bonded labour“.
v. In Percept D’Mark (India) Pvt. Ltd. Vs.Zaheer Khan and Anr [(2006)4 SCC 227], the aggrieved respondent had agreed to a right of first refusal in favour of the appellant which extended beyond the term of the agreement, the apex court considered such a contract for personal services to be void and concluded that any restriction extending beyond the term of a contract is clearly hit by section 27 of the Contract Act, and is void. Accordingly the Supreme Court held that “Clause 31(b) contains a restrictive covenant in restraint of trade as it clearly restricts respondent No. 1 from his future liberty to deal with the persons he chooses for his endorsements, promotions, advertising or other affiliation and such a type of restriction extending beyond the tenure of the contract is clearly hit by Section 27 of the Contract Act and is void.“
Example
The employee shall not join any company carrying on a business similar to the business of the Company or carry on any business similar to the business of the Company during the contract of employment and for a further period of (●) years from the termination of the contract of employment.
The above example is a case of a non-compete clause which is unenforceable as it causes the restraint to operate after the termination of employment.
b) Foreign contracts incapable of being performed under Section 27
An agreement that has been made abroad but to be performed in India which is an agreement in restraint of trade under Section 27, shall be void and unenforceable in the Courts of India even if such an agreement is unobjectionable and valid by the lex loci contracts.[3] Thus where a contract of agency contains a restraint by which the agent company (Indian company) is restrained from dealing with other products for a period of 5 years after the termination of agency, the restraint being a negative covenant post termination of the contract, shall attract provisions of Section 27 and will be void and unenforceable under Indian Law even though the agreement was valid under German law. This rule which is applied by the Courts in India finds its origins in English Law.
c) Garden leave clause operating after cessation of employment
A garden leave clause is incorporated in contracts of employment to protect the employer’s latest trade, commercial secrets from being disclosed by the resigning employee or the employee whose contract is being terminated. It seeks to compensate the employee for the notice period, wherein the employee is not required to attend to the service of the employer. However, where a garden leave clause in a contract of employment, prohibits the employee to take up employment after the cessation of the employment it shall attract Section 27 and the clause shall be unenforceable against the employee. Payment of compensation to the employee for the period for which the restraint operates will not be construed by the Court as an extension of the contract as the clause is expressly stated to take effect only after the cessation of employment i.e. the employee serving his notice period and ceasing to be on the rolls of the company. This principle has been enunciated in the case of V.F.S. Global Services Private Limited vs. Suprit Roy [(2008)3 Mah LJ 266]
Example
Upon termination of the contract of employment, the employee agrees not to attend to the office of the employment or join any company carrying on a business similar to the business of the Company or carry on any business similar to the business of the Company for the entire duration of the notice period. The Employee shall continue to receive his entitled remuneration for the notice period. – Enforceable
Upon termination of the contract of employment, the employee agrees not to attend to the office of the employment or join any company carrying on a business similar to the business of the Company or carry on any business similar to the business of the Company for the entire duration of the notice period and for a further period of (·) years from the cessation of employment i.e. when the employee ceases to be on the payroll of the company. The Employee shall receive his remuneration on a __ (prorated basis) for the entire duration of the notice period and the further period of (·) years thereafter from the date of termination of employment. – Unenforceable
II. Agreements not held to be in restraint of trade
The Supreme Court has held that a restraint on trade, whether general or partial, may be good if shown to be reasonably necessary for freedom of trade. A restraint reasonably necessary for the protection of the covenantee must prevail unless some specific ground of public policy can be clearly established against it. It has been further held by the Supreme Court that restrictions that are to operate only while the employee is contractually bound to serve his employer are never regarded as being in restraint of trade, at common law, or under Section 27. Therefore, where a clause imposes a partial restraint, prohibiting the employee from performing services in the same area of business, as that of the employer, during the stipulated period of the agreement, such restraint would not violate Section 27.A covenant in restraint of trade must be reasonable in reference to the parties concerned and in reference to the interest of the public.[4] Cases of agreements imposing restraints not being a restraint of trade under Section 27 are as follows:
a) Negative covenant during the subsistence of the contract
A negative covenant in a contract of employment which is operative for the term of the contract of employment will not attract the provisions of Section 27. The very purpose of a restraining the employee from joining a competing business, trade or profession during the contract is to ensure the employee’s performance and fulfilment of the terms of a legally binding contract entered into with the employer. In this regard, it is important to understand the difference in the intention of an employer incorporating a negative restraint operative during the term of the employment as opposed to the intention of the employer incorporating the negative covenant to be operative post termination of employment.
The purpose of the employer imposing a negative covenant after cessation of the employment is to secure freedom from competition from a person who no longer works within the contract. It is intended to prohibit the employee from profiting out of the skill acquired during the period of his employment with the employer. As opposed to this, the purpose of an employer imposing a negative covenant operating during the contract of employment is to ensure the employee’s performance and fulfilment of the terms of the contract. Thus, it is clear that when a direct link can be established between the purpose of the employer in imposing the restraint and the need to ensure the performance of the contract, the court considers the restraint valid. However where no direct link can be established between the purpose of the employer imposing the restraint and the contract entered into and where the sole intention of the employer appears to be to secure the freedom from competition, the restraint is regarded as unfair exercise of the employee’s bargaining power and held to be unreasonable, invalid and unenforceable under Section 27.
A negative covenant in a franchise agreement prohibiting the franchisee from dealing with competing goods during the subsistence of the contract is for the advancement of the trade and facilitating the distribution of the goods of the franchiser and not to secure freedom from competition and such a restraint is construed as valid and enforceable under Indian Law. In this regard, in Gujarat Bottling Company Ltd and Ors. v. Coca Cola Co. and Ors. 1995 (5) SCC 545 it has been held that “There is a growing trend to regulate the distribution of goods and services through franchise agreements providing for the grant of franchise by the franchiser on certain terms and conditions to the franchisee. Such agreements often incorporate a condition that the franchisee shall not deal with competing goods. Such a condition restricting the right of the franchisee to deal with competing goods is for facilitating the distribution of the goods of the franchiser and it cannot be regarded as in restraint of trade.”
Example
The employee shall not at any time during the contract of employment and prior to cessation of employment with the Company join any company which is carrying on a business similar to the business of the Company or carry on any independently any business which is similar to the business of the Company. – Enforceable
b) Negative covenant to protect the trade secrets and business connections
A clause prohibiting an employee from disclosing commercial and trade secrets is not in restraint of trade as the intention of the restraint is to afford protection to the legitimate interest of the covenantee in guarding the trade secrets, business connections in relation to the business of the company and does not restrain the employee from carrying on any lawful trade, occupation or business. Further in one case – V.F.S. Global Services Pvt. Ltd Vs Mr. Suprit Roy, 2008(2) Bom CR 446, the Bombay High court established the principle that a restraint on the use of trade secrets during or after the cessation of employment does not tantamount to a “restraint of trade” under Section 27 of the Act and therefore can be enforceable under certain circumstances.
c) Non-Compete Agreement to protect the goodwill of the business being sold (Ambit of Exception 1 to Section 27)
Even as regards a sale of business between the vendor and purchaser of business, a non-compete agreement to not carry on the business of the company sold shall not be permitted where the sole intention of the restraint is to secure freedom from competition and not to protect the goodwill of the business sold. Where the business carried on by the buyer of the business has no connection with business of the seller, the non-compete agreement to restrain the seller of the business to not carry on similar business shall be construed as a restraint intended to limit competition and not to protect the goodwill of the business sold to the buyer and will be rendered invalid and unenforceable by the court.
This principle can be better explained by enunciating the principle laid down in the case of Vancouver Malt & Sake Brewing Co v Vancouver Breweries Ltd. A company licensed to manufacture beer and liquor confined its business to produce sake – Japanese liquor made from rice. Thereafter the company entered into an agreement wherein its business was sold to another wine and beer manufacturing company. The company was restrained from carrying on the business of manufacturing wine and beer for a period of 15 years. It is to be seen here that, the Company not having engaged in the business of manufacturing beer did not possess any goodwill to be sold and thereby protected by the buyer in the form any restrictive covenant. The goodwill of the company was only in regard to the Company’s business of manufacturing sake, which was expressly excluded from the terms of the sale. Therefore a restrictive covenant of this nature only intended to prevent any possible competition by the company in the manufacturing of beer and not to protect the goodwill of the seller.
To protect the goodwill of the business sold to the buyer, the seller can be restrained within certain territorial or geographical limits and the limits must be reasonable. Reasonableness of restrictions will depend upon many factors, for example, the area in which the goodwill is effectively enjoyed and the price paid for it.[5] In the case of Chandra Kanta Das v. Parasullah Mullick[6], it has been held that a covenant or running a ferry for only a few months in competition with the long-established business of the covenantee was held to possess goodwill for the purpose of restraining him from carrying on that business for three years.
Tax Implications on Non-Compete Fees paid for Business Acquisition
Under Section 27 of the Indian Contract Act, only in the instances of the sale of a business where the goodwill of the company is also being sold can a non-compete agreement be enforced against the seller of the business by the buyer for the protection of the goodwill of the business. However, the restriction must appear to be reasonable to the Court as regards the local limits to which the restraint operates and the buyer or any person deriving title to the goodwill from him, must carry on a like business therein. Goodwill is an intangible asset, whose tangibility can be recognized in terms of its brand value and repute enjoyed in the market acquired through years of experience acquired in the concerned industry. Thus if the fair value of a company is Rs.100 Crores and the value of its assets is 50 Crores, the balance 50 Crores is attributable to goodwill accruing from the experience and reputation of the company in the industry. Hence the price paid by a prospective buyer over and above the value of the Company’s assets will constitute a payment towards the goodwill enjoyed by the Company. In this regard, on a business acquisition, the buyer also incurs a substantial expenditure in acquiring the goodwill enjoyed by the seller of the business and it is to protect this goodwill that a non-compete agreement is entered into between the buyer and seller of the business.
1. Tax Implications on the Seller of the Business
The tax treatment of non-compete fees received by the seller of the business can be understood better by the principle set out in the case below.
The ITAT, in Ramesh D. Tainwala’s case [7] had observed that if the agreement to refrain from indulging in competition is part and parcel of the agreement for transfer of a business and the transferor agrees not to indulge in competition, then it can be said that right to carry on same or similar business was transferred along with the business.
To fulfil this requirement is essential to attract the exception under Section 28(v) (a) of the Income Tax Act, 1961 which exempts any income tax from being paid on amounts received in lieu of the right to carry on business being transferred by the seller of the business. Further to attract Section 28(v) (a), the seller of the business must not merely sell its shareholding but also an ongoing business being carried on by the seller. It has been held by the Income Tax Appellate Tribunal in a judgment [8] that Section 28(v) (a) would be attracted where the assessee was carrying on a business and not merely had the right to conduct business.
2. Tax Implications on the Buyer of the business
Under the Indian tax regime, the buyer of the goodwill of a business is not accorded with any tax protection upon acquisition of a business. As held by the Delhi High Court in a judgment[9] dated November 5, 2012, the non-compete fees paid by the buyer to acquire the non-compete right (asset) is treated as a capital expenditure and not a revenue expenditure as by restraining the seller having a substantial market share in the business acquired from carrying on a similar business, the buyer stands to benefit by having a substantial market share in the business and acquires a commercial advantage for the period for which the non-compete operates. This is seen as a capital expense under the Indian tax regime. Further it has also been held that, the non-compete right being acquired by the buyer, cannot be regarded as an intangible asset as in the case of intellectual property rights such as patents, trademarks and copyright as the intellectual property rights are enforceable against the whole world and not just against the seller of the goodwill of the business.
Trading Combinations
It has been held that an agreement between manufacturers not to sell their goods below a stated price, to pay profits into a common fund and to divide the profits in certain proportions, is not avoided by Section 27, and cannot be impeached as opposed to public policy under Section 23, even though it is likely to limit competition and keep up the prices.[10] Thus where associations of traders have entered into a combination where it was agreed to do business only with those who became members of the association and where fines would be imposed for any breach of conditions by the members, such a trade combination cannot be considered as a restraint of trade. The object of the association is to regulate competition and not to restrain competition wherein the members were not coerced into not doing business with anyone else. Every prospective member had the option to choose to become a member and subsequently comply with the conditions or enter into business with another trader and therefore any indirect damage caused to the trade rivals in the bargain will not be attributable to the trade combination being in restraint of trade.
Solus or Exclusive Dealing Agreements
Solus Agreements are in the nature of vertical agreements which take place between firms in different levels of the supply chain such as manufacturers and distributors, manufacturers and consumers, suppliers and retailers etc. Thus where a manufactures enters into an agreement to sell all of his salt or all of his goods to a consumer for a fixed period, such an agreement is an example of a solus agreement and will fall outside the scope of Section 27 of the Indian Contract Act, 1872. The negative stipulation in respect of the buyer in such an agreement is to not buy the goods from any other manufacturer during the subsistence of the contract, and such a negative stipulation is ancillary to the main object of the contract i.e. ensuring the manufacturer has a certain market for the product of his labour and therefore in advancement of the manufacturers trade. Therefore, the negative stipulation is not prejudicial to the legitimate interest of the parties concerned and ensures that there is no obstruction to the due course of trade.
Employment Bond
In the context of Indian Law, it is a settled position that non-compete agreements imposing restraints operating post termination of employment will not be enforced by Courts. However in certain situations by requiring the employee to enter into an employment bond with the employer, the employer can make the employee compensate the employer in the event of a breach of the employment bond i.e. when the employee after agreeing to serve the employer for an agreed period in return for the employer providing the employee with specialized training at the employer’s cost (provided the term is reasonable in the opinion of the court) has terminated the contract and not honored the terms of the bond. In such a case, the employer is entitled to a reasonable compensation for the costs incurred on training the employee not exceeding the amount of the bond. Although the employment bond cannot compel the employee to work with the employer it acts as a deterrent and protects the employer in the event of any breach. It also ensures the employee only terminates the employment as a last resort being aware of the consequences viz. need to pay the compensation. Thus the terms of the bond create a restraint which can cause the employee to think twice before terminating the employment due to the onus of having to pay compensation. The ultimate aim of the employer in this manner can be achieved without it being unenforceable, provided the terms of the bond are reasonable and the employee signs the agreement acting out of free will and consent. By resorting to an employment bond, the employer can achieve the following two objectives:
- Compensation for breaching the bond can cause the employee to honour the term of the bond and refrain from terminating his employment;
- Even where the employee commits a breach of the bond, the employer can be reasonably compensated by seeking civil remedies before the appropriate civil court
In the case of Sicpa India Limited V. Shri Manas Pratim Deb, the Plaintiff had entered into an employment bond with the Defendant, under which the Defendant had agreed to serve the plaintiff for a period of three years or make a payment of Rs. 2, 00,000. The Defendant left the services of the Plaintiff after serving for a period of 2 years and in the same period, the Plaintiff had incurred expenses on the Defendant amounting to Rs. 67,995. Upon giving due regard to duration of employment of the Defendant and the total costs incurred by the Plaintiff, the Court ordered the Defendant to pay a compensation of Rs. 22,532 to the Plaintiff, thus providing the Plaintiff what was in the opinion of the Court an adequate remedy
III. Rationale of the judiciary in interpreting Section 27
a) Courts take a stricter view of covenant between master and servant as compared to covenant placed in commercial contracts
Why do the Courts in construing whether a restraint is restraint of trade adopt a stricter approach in respect of employer-employee contracts as opposed to partnership contracts, collaboration contracts, franchise contracts, agency/distributorship contracts and commercial contracts? Essentially, because a contract of employment involves a master-servant relationship, wherein the employer has a stronger bargaining power over the employee whereas in the case of other commercial contracts both the parties are of equal strength and standing in the market.Moreso, a negative covenant after cessation of the employment is intended to secure freedom from competition and prohibit the employee from using the skills acquired during his employment for pursuing better economic prospects. As regards a contract between a vendor and purchaser of business both parties have an equal say at the time of negotiation and in the event of any disagreement at the time of negotiation, one of the parties may simply opt out and negotiate with another party on like terms. In the case of an employee who at most times will be required to sign standard form contracts, however prejudiced against him they may be, the employee has a job to lose by not signing on the dotted line. This disparity in the employer- employee relationship allows the employer to dictate terms to the employee and comply with unreasonable restraints in a contract. For this reason, a negative covenant in a contract of employment is interpreted much more strictly and in favour of the employee by the Indian judiciary to see to it that the bargaining power of the employer has not been unfairly exercised to the detriment of the employee’s interest.
However, the Court shall uphold restraints against the employee to protect the proprietary rights of the employer such as trade secrets, confidential information but where the restraint is to prevent the employee from joining a competing business at the risk of business loss caused by the exiting employees knowledge, skill and experience acquired during the course of the employment with the employer, the court shall invalidate such restraints as every employee shall be entitled to utilise the skill and expertise acquired during his employment for his best interests and a denial of such right shall impinge on his to right to earn a livelihood and right to live a dignified life.
IV. Non-Compete Clause and the Securities Exchange Board of India Act, 1992
In the event of an acquisition of a company by another person/group of persons/company, it is understood that the acquirer takes over substantial control of the shares, business, and voting rights of the company being acquired. This makes it necessary and imperative for the acquirer to enter into a non-compete agreement with the company/person/group of persons whose shares and goodwill of the business it’s acquiring to prohibit them from carrying on a business similar to the business of being of the company being sold to the acquirer. To enforce the non-compete agreement, the Court shall ascertain it’s reasonableness in terms of the duration of the restraint, area in which the goodwill is effectively enjoyed and whether the territorial restriction in this regard is justified and whether price paid for protection of the goodwill is commensurate with loss that would be suffered by the seller of the business.
In carrying out such transactions involving acquisition and takeover of a business enterprise it must be kept in mind that the jurisdiction of Securities Exchange Board of India Act,1992 (“SEBI”) shall be triggered if the non-compete fees paid to the seller of the business is in excess of 25% of the offer price, offered to the public shareholders. According to Rule 20(8) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, where the non-compete fees shall be in excess 25% of the offer price, the non-compete fees shall be added to the offer price. This rule was adverted to and applied in a recent ruling [11]where Sebi had erred in taking jurisdiction involving an acquisition of a target company by another corporate body, where the non-compete fees did not exceed 25% of the offer price. The rationale behind introducing this rule was to disallow the acquirers from paying a token consideration amount for acquisition of shares and an excessive non-compete fees which actually constituted a major share of the actual consideration of the acquisition agreed to at the time of negotiation. By resorting to this approach, the acquirer got away with paying a token amount as consideration for the transaction to the promoters and public shareholders to whom it would be required to make an offer of the same kind in terms of price per share, made to the promoter. Thus with the introduction of Rule 20(8) of the SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 1997, SEBI has reduced the elbow room for the acquirers to resort to lowering the cost of acquisition by paying an excessive non-compete fees.
It has been held by the Supreme Court that in order to determine the eligibility of entities being paid a non- compete fees by the acquirer, the eligibilities of the entities are to be considered as a whole. Thus, where a few entities are not carrying on the business of the company sold and are not a possible competition to the acquirer, the non-compete agreement in its entirety shall be regarded as a sham and not only as regards the specific ineligible entities.
V. Non-Compete Clause and the Competition Act, 2002
In drafting a non- compete clause regard must be had that the clause does not have an appreciable adverse effect on competition within India. Section 3 of the Competition Act prohibits and makes void any anti-competitive agreement that in respect of production, supply, distribution, storage, acquisition or control of goods or provision of services, causes or is likely to cause an appreciable adverse effect on competition within India.
Appreciable adverse effect on competition in India would mean acts, contracts, agreements or combinations which are prejudicial to public interest and unduly obstruct the due course of trade. In all such cases where a non-compete clause in agreements involving sale of business contain a restraint denying the public the fruits of labour and which are prejudicial to the interest of the public, the combination will not be allowed to take effect by the Competition Commission of India (“CCI”) in terms of powers enshrined to the CCI under Section 31 of the Competition Act. It is in this vein that CCI in its recent decision accepted modifications in relation to the non-compete obligations entered into between parties to the combination. In respect of the non-compete obligations entered into between the parties, CCI opined that the non-compete obligations in relation to the business transfer agreement constituting the combination must be reasonable. Reasonableness has to be ascertained in terms of i. the duration over which such restraint is enforceable and ii. the business activities, geographical areas and person(s) subject to such restraint, in order to ensure that such non-compete obligations do not result in an appreciable adverse effect on competition[12]
In this case, the non-compete clause imposed a restriction upon one of the parties and its promoter to not carry on the same business of the transferred entity for five years and eight years respectively. Additionally, the non-compete clause imposed a restriction upon the party from conducting research, development and testing of Penem (including Carbapenem) and Penicillin API’ (Active Pharmaceuticals Ingredients) for injectable formulations. In the opinion of the CCI, the restriction regards duration to not carry on business was unreasonable and to not carry on research and development of the product which was not existent worldwide would be prejudicial to public interest and obstruct due course of trade and therefore cause the appreciable adverse effect in competition within India. It was in line with CCI’s opinion that modifications were carried out, pursuant to which the proposed combination was approved by the CCI under Section 31(1) of the Competition Act.
VI. Contrasting Non-Compete under Indian law with law in the U.S.A. and U.K
a) Non-Compete Law in the U.S.A
The law as regards the enforceability of restrictive covenants in the United States of America varies from state to state and is not a matter of federal law. Unlike the law stated under Section 27 of the Indian Contract Act which regards all agreements in restraint of trade as void, the Courts in most of the American jurisdictions apply the test of reasonableness in determining the enforceability of non- compete agreements which are also similar to the law in England. This test of reasonableness takes into account three factors, them being:
- Duration of the restriction
- Geographic scope of the restriction
- Substantive nature of the activity being restricted
The law on restrictive covenants in California differs on this count and follows the principle envisaged under Section 27 of the Indian Contract Act i.e. Restrictive covenants operating post termination of the employment are void and unenforceable except in the case where there is a sale of interest in the business or goodwill in order to protect the goodwill acquired by the buyer from the seller. Even where cases are covered under such an exception, the test of reasonableness explained above shall be applied in enforcing such a restrictive covenant. The law in the United States permits employers to protect the confidential information and trade secrets post termination provided that the employers can prove that the nature of information for which restriction is sought can indeed be classified as either a) confidential information or b) a trade secret.[13]
It is interesting to note that the Courts in the United States are more often than not inclined towards enforcing non-compete clauses even in cases where they do not meet the test of reasonableness by adopting these two approaches: a) Blue Pencil Doctrine and b) Rewriting the Offending terms.
For instance if the terms of the non-compete clause restrict the employee working in Seattle from engaging with any competing business situated within Seattle and the whole of U.S.A. post termination of employment, the Courts (such as in North Carolina) shall by adopting the blue pencil doctrine, delete the offending terms i.e. the “United States of America” and render the non-compete clause enforceable within Seattle. However, where the terms of the non-compete clause are such that its duration is considered unreasonable and excessive, the Courts (such as in Washington) do resort to a reformative approach whereby they rewrite the term of duration they find excessive e.g. 7 years and let the duration extend to two years so as to make the non-compete clause enforceable.
b) United Kingdom
The treatment of the non-compete law by the Courts in the United Kingdom is similar to the approach followed by the judiciary in the United States in that the Courts apply the test of reasonableness in determining whether the non-compete clause can be enforced or not. In enforcing a negative covenant, the Courts place importance on whether such a restraint is necessary to protect the legitimate business interest of the employer. In light of this, the UK Court of Appeal passed a judgment [14] dated February 2007, wherein it upheld a non-compete clause operating for a period of 12 months after the contract of employment. In this case, a non-compete clause operating for a period of 12 months was inserted by the insurance broker in relation to the contract of employment of its managing director. The managing director after terminating the employment with insurance broker instituted court proceedings in respect of the validity and enforceability of the non-compete clause. The Court of Appeal passed an eye-opening judgment and upheld the restraint by relying on the following principles:
- In cases where it is difficult to ascertain the confidential information covenantee exposed to the covenantee, a non-compete clause operates as the most satisfactory restraint in addition to a non-solicitation and confidentiality clause as the same are difficult to police and the covenantee might as well not solicit the clients directly but direct others to do so.
- Nature of the employment i.e.stature of the managing director naturally exposed him to information relating business strategy, business development, business operations and information which would amount to trade secrets and be of continuing interest to any competitor and merit satisfactory protection by way of a non-compete clause.
In drafting a non-compete clause in the U.K., a careful approach is a must as unlike some of the Courts in the USA, the UK Courts will not adopt the reformative approach in rewriting and making good the terms of the covenant they find unenforceable. If a covenant contains particular words or clauses that render it unenforceable, the court can delete them if the remaining words would still make sense i.e. the blue pencil doctrine, but it will not make substantive revisions.
However, in general, the Courts in the U.K. are not in favour of enforcing restrictive covenants operating beyond the termination of employment unless a clear case of the need to protect a legitimate interest can be shown by the covenantor. In this respect, the most hassle-free alternative to enforcing restrictive covenants in the U.K can be by incorporating a “garden leave” clause in the contract of employment. More so, as all employees in the UK have a notice period (and executives often have a 6 to 12 month notice period), a garden leave shall ensure the employees while remaining on the payroll of the Company do not attend the employment and gain access to any of the latest trade secrets, confidential information concerning the business and the clients of the covenantor. As such, it is easier to enforce the garden leave clause in the U.K (and thereby prevent the executive from working for a competitor) than enforcing a restrictive covenant
VII. Contrasting Non-Solicitation with Non-Compete
Non-compete clauses are restrictive covenants which prohibit the employee from joining any other competing business during and/or after the contract of employment.
Non Solicitation clause is engrafted into a contract to bar the former employee from inducing the customers and employees of the former employer to his own benefit.
a) Why the Courts are more liberal in enforcing the non-solicitation clause
Non-Compete and Non- Solicitation clauses are enforceable during the subsistence of the contract and till the cessation of the contract of employment. However, where a non- compete clause cannot be enforced beyond the term of employment, the non-solicitation clause can be enforced under limited circumstances depending on the facts and circumstances of the case. The Court’s adopting a more liberal stance in enforcing non-solicitation clauses as opposed to non-compete clauses is because of two reasons mainly:
i. It poses no restriction on the former employee’s constitutional right to earn a livelihood by causing the former employee to surrender his economic mobility and does not prohibit the former employee from joining a competing business or organization in the advancement of polishing the skills acquired under the training of the former employee
ii. It does not prohibit the former employee from joining a competing business or organization in advancement of polishing the skills acquired under the training of the former employee
It is for this reason that it has been held that the 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[15].
b) Judicial Pronouncements on enforceability of non-solicitation clause post termination of contract
i. The Madras High Court in this judgment[16] considered the enforceability of non-solicitation clause operating beyond the contract of employment. The court held that in order to enforce a non-solicitation clause it is imperative to show that the employee has solicited the customers of the former employer and the customers have gone on to place orders in furtherance of the employee’s act of soliciting the former employer’s customers. In the absence of evidence to show the same, no remedy/damages can be claimed by the former employer. In principle, the employee should have by his solicitation of the former employer’s customers, caused them to break the contract with the former employer and enter into contracts with the employee or his new employer.
ii. In a landmark judgement, [17]the Delhi High Court enforced a non-solicitation clause post termination of the contract entered into between a company and its Canvassing Representative/ Distributor. Under the terms of the non-solicitation clause envisaged in the contract, the contracting parties were restrained from soliciting and alluring the employees of the other party for a period of two years from the termination of the contract. The Respondent Company had pursuant to the termination of contract issued an advertisement stating their interest to recruit employees who have had previous experience of dealing with the company with whom the petitioners have had the experience of dealing with. The advertisement was clearly hinted to induce and lure the employees of the Petitioner Company to enter into a contract with the Respondent Company and the act was construed as an act of soliciting the employees of the Petitioner Company in violation of the non-solicitation clause. In enforcing the non-solicitation clause, the Court had specifically stated that the contract was not of an employer – employee and as such restraint was upon the contracting parties and not the employees.
iii. In another judgment[18], the Calcutta High Court held that an employee of the former employer shall not cause the customers of the former employer to break their contracts with the former employer or prevent the customers from entering into contracts with the former employer. It was held that in the absence of a non-solicitation clause, a solicitation by the employee which damages the business of the former employer shall still constitute a tort. In this case, the exiting employees had prior to terminating their employment with the employer, incorporated a company which they joined after terminating their contract of employment. This company incorporated by them carried on the same business as that of the former employer and the employees had access to information which would constitute trade secrets of the former employer. In view of the same, the Courts in order to protect the legitimate interest of the former employer ruled in favour of the restraint of non-solicitation.
iv. In another judgment[19], the Delhi Court by an order of injunction restrained the Defendant from soliciting the suppliers, customers and employees of the Plaintiff for a period of two years from the date of termination of the Agreement. In this case, the Defendant joined the Plaintiff Company as a sales manager and was as such privy to the information relating to the sales strategy, client lists, trade secrets which were for the exclusive knowledge of the Plaintiff and which would be of continuing interest to any competitor. As per the obligation agreement, the Defendant was restrained from associating with customers, suppliers and employees of the Plaintiff Company for a period of two years after termination of employment. In contradiction to this understanding, the Defendant joined a third party which was a direct competitor to the business carried on by the Plaintiff company i.e. sale and marketing of similar products. Therefore the Plaintiff company was at the risk of having its trade secrets (in relation to sales strategy, technical know how) let out to its competitor as the same would be of continuing interest to the competitor to the detriment of the Plaintiff business. The court considered the same in ruling in favour of enforcing non-solicitation.
VIII. Contrasting Non-Disclosure with Non-Compete
Even in the absence of any non-confidentiality agreement or secrecy agreement entered into between the employer and the employee, the employee owes a duty of fidelity to his employer to not divulge confidential information to any third party during the contract of employment. Even post termination of employment, the judiciary has in several cases enforced secrecy agreements and non-confidentiality agreements operating beyond the termination of employment. In all such cases the nature of the confidential information which was sought to be protected was in the nature of trade secrets which would be of continuing interest to the direct competitor and as a result damage the business of the former employer. In enforcing non-confidentiality agreements post termination of employment, the Courts take into consideration whether the information for which protection is sought is information intended to belong exclusively to the knowledge of the former employer or whether such information/skill has been acquired by the employee through the employee’s own efforts and experience in the industry. To accord protection to information of the latter kind would be enforcing a restraint which is intended to stifle competition and not in the advancement of trade and would be hit by Section 27 of the Indian Contract Act. However unlike non-compete agreements intended to operate post termination of employment which are void under Indian Law, the Courts accord a more liberal construction to enforcing non-confidentiality agreements by taking into account the legitimacy of the business interest for which protection is sought and whether such information if divulged to a third party who is a direct competitor can be utilised to the former employer’s detriment.
a) Judicial Treatment of Non-Confidentiality Agreements
In a judgment[20] passed by the Kolkata High Court, the Petitioner, an organizer of travel trade shows entered into a Non-Disclosure agreement with the Respondent for a period of 6 months in anticipation of entering into a joint venture agreement with the Respondent on a later date. As per the terms of the Non-Disclosure Agreement, the Respondents were restrained from disclosing the confidential information for a period of 2 years from the date of the termination of the Non-Disclosure Agreement. The nature of information for which the Petitioner was seeking protection related to 1) marketing strategy, 2) customer base, 3) costing and 4) profitability of organizing travel trade shows. Subsequently, when the parties failed to conclude the negotiations, the Petitioner prayed for an order of injunction from the court to prevent the Respondent from utilizing the confidential information for a period of 2 years from the date of termination of the Non-Disclosure Agreement. The High Court held that “Business information such as cost and pricing, projected capital investments, inventory, marketing strategies and customer lists may qualify as trade secrets” and passed an order of injunction restraining the Respondent from sharing any information concerning the marketing strategy and customer base received from the Petitioner for a period of 2 years from the date of termination of the NDA thereby enforcing the secrecy agreement post termination. In enforcing the NDA post termination, the Court also relied on the principle that “a person who has obtained confidential information cannot use it as a springboard for activities detrimental to the person who has made the confidential information”. In determining what shall constitute confidential information the court relied on the rule laid down in an English case [21]which states that an information can only be said to be confidential information when it has been made by the maker who has applied his brain and produced a result which cannot be produced by another without going through the same process.
In another judgment [22]passed by the same High Court, the respondents were injuncted from divulging the confidential information which was in the nature of trade secrets possessed from the Plaintiff Company. The Plaintiff Company was engaged in the manufacturing and sale of technologically advanced highly engineered products and equipment for power and process sector industries. The Respondents, ex-employees of the company held senior positions in the Plaintiff Company and were as such exposed to trade secrets in the nature of product pricing, technological database, clientele database, queries concerning specific client, needs and demands of clients in relation to specific projects and other confidential information which were in the nature of trade secrets. During the course of employment of the respondents, the Plaintiff amended the human resource policy by which the respondents were restrained from disclosing and divulging confidential information to any third parties. The Respondents pursuant to the termination of their employment formed a business competing directly with the business of the Plaintiff. The Respondents were further guilty of transferring the confidential information contained in the computer database of the Plaintiff during the course of employment and utilising the said confidential information containing client specific information in order to solicit and meet the needs and demands of the concerned client to entice and lure the client to break the contract with the Plaintiff and only transact business with the Respondents. The Court in order to prevent a genuine case of apprehended breach of confidentiality made by the Plaintiff and depriving the Plaintiff Company of their competitive advantage acquired over a period of time, directed the Respondents to restrain from divulging the details, confidential information to a third party and acting as a sales agent for the customer of the former employer. In passing this order the Court applied the following rationale- “A trade secret or a business secret may relate to financial arrangement, the customer list of a trader and some of the information in this regard would be of a highly confidential nature as being potentially damaging if a competitor obtained such information and utilized the same to the detriment of the giver of the information. Business information such as cost and pricing, projected capital investments, inventory marketing strategies and customer’s lists may qualify as his trade secrets. The Courts need to find out if the information that was acquired during the course of their employment are now being used as the spring board to enable the said respondents to exploit such database in the course of their business”
In concluding, it can be seen that non-compete agreements are, on the whole, not enforced by Indian Courts, except if they are brought within the exception to Section 27 of the Indian Contract Act. However, even here it is for the beneficiary of the non-compete to establish that the clause meets the test of reasonableness. On the other hand, there is a growing and genuine concern for employers wanting to enforce non-compete agreements to protect their proprietary data. Given the evolution of technology and the critical role it plays in modern business, the “blue pencil” approach followed by U.S. and U.K. courts would go a long way in meeting some of these concerns. It is in this regard that amendments can be made to the law enshrined in Section 27 of the Indian Contract Act, to allow reasonable restraints to operate post termination of employment.
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References
[1] Petrofina (Great Britain) Ltd. Vs. Martin, [1966] Ch 146 per Diplock LJ, at 180, [1966] 1 All ER 126, at 138, [1966]2 WLR 318
[2] Esso Petroleum Co. Ltd. Vs. Harper’s Garage (Stourpore) Ltd. supra; cited with approval in Cleveland Petroleum Co. Ltd. v. Dartstone Ltd., [1969]1 WLR 116, [1969]1 All ER 201, [1969] 1 WLR 116
[3] Taprogge Gesellschaft mbH v. IAEC India Ltd.
[4]Niranjan Shankar Golikari v. Century Spinning and Mfg. Co. Ltd.
[5] Damodar Laxman Lele v Kashinath Waman Lele,(1906)9 Bom LR 312
[6] (1921) 48 IA 508
[7] [2011] ITAT 9545
[8] Mrs Hami Aspi Balsara Vs. ACIT, 126 ITD 100(Mum)
[9] Sharp Business System Vs. The Commissioner of Income Tax – III [ 2012 SCC OnLine Del 5639]
[10] SB Fraser & Co. v. Bombay Ice Manufacturing Co. Ltd., (1904) ILR 29 Bom 107
[11] I.P Holding Asia Singapore Private Limited & Anr. Vs. Securities and Exchange Board of India [(2015)2 SCC 68
[12] CCI order dated 21st December 2012
[13] Page 48 to 56 of Mayer Brown – A global guide to restrictive covenants – Americas
[14] Thomas Vs. Farr Plc and Hanover Park Commercial Limited [2007] EWCA Civ 118, [2007] IRLR 419
[15] Wipro Limited v. Beckman Coulter International S.A. MANU/DE/2671/2006: 131(2006) DLT 681
[16]M/s. FLS midth Pvt. Ltd. v M/s. Secan Invescast [2013-1-L.W. 830]
[17] Wipro Limited Vs. Beckman Coulter International S.A.[2006 SCC OnLine Del 743]
[18] Embee Software Private Limited Vs. Samir Kumar Shaw & Ors.[2012 SCC OnLine Cal 3094]
[19] Desiccant Rotors International Private Limited Vs. Bappaditya Sarkar[ 2009 SCC OnLine Del 1913]
[20] Fairfest Media Ltd.Vs. ITE Group PLC[2015(2) CHN 704]
[21] Saltmen Engineering Co.Vs. Campbell Engineering Co. Ltd.[ 1963(3) All ER 413]
[22] Hi Tech Systems & Services Ltd. Vs. Suprabhat Ray & Ors. [ Air 2015 Cal 261 ]
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