A non-compete covenant is a contract, or a clause in a contract, limiting a party from competing with the business or trade of another party. Most commonly such covenants are entered into between employers and their employees, or between companies during a transaction involving transfer of business or goodwill.
Legal Status of Non-Compete Covenants
Section 27 of the Indian Contract Act, 1872 (“ICA”) provides the test for determining the legality of non-compete covenants in India. Section 27 of the ICA states that “every agreement by which any one is retrained from exercising a lawful profession, trade or business of any kind, is to that extent, void.” The only statutory exception to this is an agreement not to carry on business, of which goodwill is sold.
An agreement in restraint of trade has been identified as one in which a party agrees with any other party to restrict his liberty in the future to carry on trade, business or profession, with other persons who are not parties to the contract in such a manner as he chooses. Non-compete clauses have therefore, time and again, been regarded by courts in India, as restrictive clauses, which undermine a party’s freedom to engage in trade. A literal interpretation, of Section 27 invalidates all non-compete covenants, irrespective of their reasonableness, or consideration paid for such covenants. In an employment situation however, such clauses are usually held to be valid during the period of employment, but invalid post-termination.
In Krishan Murgai v. Superintendance Company of India, 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 years after the termination of his employment was violative of Section 27 of the ICA. 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.
In Star India Pvt. Ltd. v. Laxmiraj Seetharam Nayak & Anr, the Bombay High Court had to determine whether an injunction could be granted in furtherance of a negative stipulation, in the nature of a non-compete clause, in an employment agreement. The Bombay High Court held that the injunctive relief sought would not be granted where its effect would be to compel the employee to continue in the services of the employer, against his will.
In Taprogge Gesellschaft MBH v. IAEC India Ltd, 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.
Exceptions to the Rule
Restraint imposed on freedom of trade and business, has been recognised as valid in certain circumstances.
The first of such circumstances is contained in the statutory exception to Section 27, which provides that, if a party sells the goodwill of his business to another he can agree with the buyer that he will not carry on a similar business within the specified local limits. As per Section 27, “one who sells the goodwill of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits; so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business therein, provided that such limits appear to the Court reasonable, regarding being had to the nature of the business.”
In such cases, courts will generally grant suitable injunctive remedies, to prevent a contracting party from carrying on a trade or business, the goodwill of which has been transferred by him for good consideration.
The second exception has been carved out by courts, by subjecting Section 27 to a less literal construction, and pertains to employment relationships. In the case of Niranjan Shankar Golikari v. Century Spinning & Mfg. Co., the Supreme Court held 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.
As far as post-termination employment restraints are concerned, it has been reiterated time and again, that in order to restrain an employee from joining a competitor, the onus would be on the employer to prove that there is actual theft of confidential and proprietary information, and that the loss of trade secrets, or the disclosure of trade secrets to the competitor has caused or is likely to cause damage/loss to the employer. Even in this case, it is likely that courts would only restrain the employee from disclosing any confidential/proprietary information to the competitor, but may not necessarily prohibit him from joining the competing organisation. In any event, the burden of proof in such cases is on the employer, and is very high.
The third exception relates to the restrictions on a franchisee’s right to deal with competing products during the subsistence of the franchise agreement. In M/S Gujarat Bottling Co. Ltd. v. The Coca Cola Co., the Supreme Court held that some terms of commercial contracts have passed into the accepted currency of contractual or conveyancing relations, and aim at promoting trade and business. Such terms due to their nature and purpose cannot be said to enter into the field of restraint of trade. In this case, the Supreme Court held that a negative stipulation in a franchising agreement, restraining the franchisee from dealing with competing goods, during the subsistence of the franchising agreement, could not be regarded as restraint of the franchisee’s right to trade.
The need for change
Although the need to protect contractual autonomy and liberty has been repeatedly expounded by Indian courts, non-compete clauses have been consistently held to be invalid, by virtue of Section 27 of the ICA. Under the present statutory framework, a company is almost paralyzed in terms of preventing an employee with access to confidential information and intimate knowledge of its trade secrets, from moving to a competitor.