India: Employment Contracts - Enforcement Of Restrictive Covenants Under Various Jurisdictions

Last Updated: 26 April 2016
Article by Suneeth Katarki and Mini Kapoor

Companies and organizations include "restrictive covenants" in employment agreements, to protect their trade secrets, confidential information and human resources. The restrictive covenants essentially place restrictions and limitations on an employee to deal, solicit or engage with employees, customers, clients of their former organization as well as on the manner in which he/she is permitted to use the information they become privy to during the course of their employment. More often than not most of the employers rely on restrictive covenants in employment contracts to protect themselves from competition, however it is clear from judicial precedents that the right of an employee to employment is more important than safeguarding the interest of an employer. In Desiccant Rotors International Pvt. Ltd. v. Bappaditya Sarkar and Anr. 2006(3)ARBLR118 (Delhi) it is held that "It is this attempt to protect themselves from competition which clashes with the right of the employees to seek employment where so ever they choose and in a clash like this, it is clear that the right of livelihood of the latter must prevail."

The type of restrictive covenants contained in contracts include non-compete, non-solicitation and confidentiality of information and trade secrets. The restrictive covenants are enforceable during the term of the contract. However a lot of these covenants particularly those in relation to non-compete are not enforceable post the employment period. The Indian courts usually take a stricter view of restrictive covenants between employer and employee than it does of similar covenants in other commercial contracts such as partnership contracts, collaboration contracts, franchise contracts, agency/distributorship contracts since in the latter kind of contracts, the parties are expected to have dealt with each other on more or less an equal footing, whereas in employer-employee contracts, an employer has a stronger bargaining power than an employee and it is quite often the case that employees to avoid the risk of not being employed at all sign standard form employment contracts.1

Section 19 (1) (g) of the Constitution of Indian grants every citizen the right to practice any profession, carry on any trade, occupation or business. However, the right to carry on a profession, trade or business is not unrestricted and it can be restricted and regulated by the authority of law. The restrictions have to be reasonable and in public interest.

The Indian courts regard all covenants that impose "restraint of trade" void and therefore such employment contracts fall under Section 27 of the Contract Act, 1872. The principal of "restraint of trade" is not confined to restrain of trade in the ordinary meaning of the word "trade" and includes restrains on the right of being employed.2 The provision of Section 27 of the Contract Act, 1872 is as follows: "Every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void."

The Indian courts do not generally give considerations on whether the restrictions are general or partial or complete, unqualified or qualified, if it is in the nature of restraint of trade, the contract is considered void. The question of reasonableness 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. The Supreme Court in Superintendence Co. of India (P) Ltd. v. Krishan Murgai (1981) 2 SC 246 has held that "neither the test of reasonableness nor the principle that the restraint being partial or reasonable are applicable to a case governed by Section 27 of the Contract Act, 1872, unless it falls within exception I".

A contract in "restraint of trade" is one by which a party restricts his or her future liberty to carry on his or her trade, business or profession in such manner and with such persons as he or she chooses. The Indian courts dislike a restrictive covenant against an employee not to engage in a business similar to or competitive with that of the employer after the termination of his or her contract of employment. No employee can be confronted with the situation where he or she has to either work for the present employer or be forced to idleness.3

The Indian courts have drawn a clear distinction between a restriction in a contract of employment which is operative during the period of employment and one which is operative after the termination of employment. The former restrictive covenants which restrict an employee from engaging himself or herself in a trade or business or provide services of similar nature to another master, which are operative during the term of the contract when an employee is bound to serve an employer exclusively are not regarded as a restraint of trade and therefore do not fall under Section 27 of the Indian Contract Act, 1872. In Niranjan Shankar Golikari v. Century Spinning and Mfg. Co. Ltd (1967) ILLJ740SC the apex court observed that "A similar distinction has also been drawn by courts in India and a restraint by which a person binds himself during the term of his agreement directly or indirectly not to take service with any other employer or be engaged by a third party has been held not to be void and not against Section 27 of the Contract Act, 1872".

This doctrine is not confined to employment contracts but is also applicable to other contracts. The restrictive covenants which are intended for advancement of trade during the sustenance of the contract cannot be regarded as being in restraint of trade. 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 distribution of goods and services through franchise agreements providing for 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."

In India, an employment contract containing restrictive covenants which will be operative post termination of the contract are unenforceable, void and against public policy and since it is prohibited by law it cannot be allowed by the Indian courts. In Pepsi Foods Ltd. and Ors. v. Bharat Coca-Cola Holdings Pvt. Ltd. and Ors. 81 (1991) DLT 122 wherein 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".

In Percept D'Mark (India) Pvt. Ltd. Vs. Zaheer Khan and Anr, 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."

Another form of a negative covenant is non-solicitation, which implies a restriction on a former employee from inducing or encouraging any employees of his or her former employer to terminate his or her employment with or to accept employment with any competitor, supplier or customer of the former employer. In other words it is a covenant which essentially prohibits either party from enticing and/or alluring each other's employees away from their respective employments.4 Depending on the facts of each case if solicitation is proved by the aggrieved party with sufficient evidence, the Indian courts have the tendency to grant an injunction against the defaulting party preventing them from continuing to offer inducements to the other's employees to give up employment and join them.

Moving on to the issue of maintenance of confidentiality of information and trade secrets which an employee becomes privy to during the course of their employment, the Indian Courts may grant an injunction in favour of an employer, preventing an employee from using or disclosing or divulging the confidential information and trade secret relating to the employers business if proved by the employer with sufficient evidence that information which is categorized as "confidential information" and/or "trade secrets" has been shared with an employee during the course of their employment. In order for the information to be classified as "confidential" or "trade secret" it should not usually be within the public domain. Information which can be known to anyone in an employment for a considerable period of time without any special efforts cannot be categorized as "trade secret" or "confidential information". Every information or general knowledge of facts cannot be labelled as "trade secret" or "confidential information".

There are no laws in India that define the term "trade secrets". The human skills which are acquired and developed by an employee during the course of an employment cannot be termed as trade secret and an employer cannot be said to have any proprietary rights over such human skills. For instance in case of a salesman, he/she learns from experience how to deal with different customers, how to sell the product successfully and by the length of his/her experience he/she will gain knowledge of selling points of a product, the rates of the product and quality of the product, he/she may also know the costs and rates of the products. All of these factors cannot be termed as trade secrets. The Bombay High court in Star India Private Limited v Laxmiraj Seetharam Nayak and Anr. 2003(3) Bom CR563 held that "Acquisition of excellence is a very long process in the career of every one. No one else can have proprietary rights or interest in such acquisition of excellence. Such excellence cannot be acquired merely by possessing a trade secret of any one".

The basic principal of the law of confidence is that if someone has received information in confidence he or she shall not take undue advantage or profit from wrongful use or publication of it. Indian Courts typically may intervene and restrain a breach of confidence arising from a contract on the grounds that it is unconscionable for a person who has received information on the basis that it is confidential, to subsequently to reveal that information. Acceptance of information on the basis that it will be kept secret affects the conscience of the recipient of the information.5

In Wipro Limited v. Beckman Coulter International S.A. 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.

The legal position with regard to post-contractual covenants or restrictions has been consistent, unchanging and completely settled in our country. The legal position clearly crystallised in our country 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 express exception contained in Section 27.6 The exception relates to sale of goodwill of a business under an agreement, whereby the Seller agrees to refrain from carrying on similar business within specified local limits as long as the Buyer or any person deriving title to the goodwill from him carries on a like business, provided that the Court considers such restrictions to be reasonable, regard being given to the nature of business. From a practical aspect Promoters of Indian companies agree to non-compete restrictions for a term of 3 (three) to 5 (five) years post-closing of the transaction within specified territorial limits, in the course of an asset sale and acquisition transaction whereby the business of a company is sold along with the goodwill associated with the business.

In United Kingdom, a man is free to commence any lawful trade or calling he chooses to commence, in any place he chooses. Similar to Indian Law, in England any interference with trade and restrains upon liberty of an individual which is injurious to the interest of the state is opposed to public policy. In earlier times any agreement in restraint of trade whether general or partial was void. However with the evolution of trade and commerce the public policy in England has undergone change and is modified by decisions in England. The rule now in England is that restrains whether general or partial are subjected to the test of reasonableness. The restrains whether general or partial are good if they are reasonable with reference to public policy and any restrain on freedom to contract must be shown to be reasonably necessary for the purpose of freedom of trade. The courts in England have to decide whether a contract is in "undue restraint of trade". Similar to Indian Laws, the courts in England take a far stricter and less favorable view of covenants entered into between employer and employee than it does of similar covenants between other business contracts, and accordingly a restraint may not be reasonable as between employer and employee which would be reasonable as between the vendor and purchaser of a business.7

In United States of America, the enforceability of restrictive covenants is a matter of state law and not federal law. Most American jurisdictions subject the restrictive covenants to the test of reasonableness which is similar to the law of England, focusing primarily on 3 (three) aspects (a) the duration of the restriction, (b) the geographic scope of the restriction and (c) the substantive nature of the activity being restricted. Similar reasonability tests are applied to non-solicitation. In the state of California, there is a general prohibition on restrictive covenants which restrict an individual's ability to carry on a business or trade, so restrictive covenants are largely unenforceable in the State of California. The limited exceptions are similar to those under the Indian laws when an individual sells all of his or her business interest in a company or partnership, including the goodwill he or she can enter into a non-compete covenant. However in those limited situations, California courts will enforce a restrictive covenant, only if it is reasonable in terms of duration, geographic scope and substantive scope as set out above. In United States of America, an employer is permitted to protect its confidential information and trade secrets however the information which the employer seeks to protect as confidential information and trade secrets is put to the rigorous test of whether the information which the employer wants to protect is in fact a trade secret or confidential information.8

Footnotes

1. Wipro Ltd. v. Beckman Coulter International S.A 2006 (3) ARBLR 118 (Delhi)

2. Niranjan Golikar v. Century Spinning & Manufacturing Co. Ltd. 1967 (2) SC 1098

3. Wipro Limited v. Beckman Coulter International S.A.

4. Wipro Ltd. v. Beckman Coulter International S.A 2006 (3) ARBLR 118 (Delhi)

5. Zee Telefilms Ltd. and Film and Shot and Anr. v. Sundial Communications Pvt. Ltd. and Ors.

6. Percept D'Mark (India) Pvt. Ltd. Vs. Zaheer Khan and Anr.

7. Gujarat Bottling Company Ltd and Ors. v. Coca Cola Co. and Ors. 1995 (5) SCC 545

8. Page 48 to 56 of Mayer Brown – A global guide to restrictive covenants - Americas

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