Validity of Employment Bonds in India – The Blog of Daksh Pandit

In contracts of employment, often certain clauses are inserted in the agreement which are in the form of negative covenants that bind the employee to the company for a particular period of years and debars the employee for such period from seeking employment in another firm which is carrying on a similar trade practice to his current employer. Such clauses are inserted to protect the interests of the employer who, during the course of the employment contract, has imparted training and knowledge upon the employee who in turn gets sensitized to the trade secrets, confidential information, and technical know-how of the company. Therefore, in order to prevent the trade secrets falling in the hands of the competitors, clauses of such nature are inserted in the contract which-

Restrains the employee, during the term of his employment contract from joining a competitor firm or any other firm for that matter or engaging in any business activity whether directly or indirectly other than that of the employer company.
Restrains the employee from divulging any confidential information, trade secret or technical know-how of the company to any competitor firm carrying on a similar trade practice.

Agreements casting restraints upon the liberty of a person to practise a profession of his choice are generally called Agreements in restraint of trade and are governed by the doctrine of restraint of trade which is embodied in Section 27 of the Indian Contract Act 1872 [“the Act”] reproduced herein below:

“27. Agreements in Restraint of Trade, Void-

Every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void.

Exception 1.—Saving of agreement not to carry on business of which goodwill is sold.—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, regard being had to the nature of the business.”

Section 27 of the Act categorically stipulates that an agreement in restraint of lawful profession, trade or business is void except for the cases falling in the exception 1 thereof. Negative covenants in an agreement which act as a restraint and impinges upon the autonomy and liberty of a person to practice a profession of his choice are to be examined on the touchstone of the Section 27 of the Act. Not to mention that freedom of profession is a fundamental right granted to all the citizens of the country enshrined in Article 19(1)(g) of the Constitution of India.

In contracts of employment, usually, an employee does not have any bargaining power and the immediate need of employment takes precedence over the exercise of scrutinizing the terms of the employment contract and in no time an employee finds himself bound to the company for a particular period of years envisaged in the Agreement. That is why, the courts have repeatedly held that employment contracts containing negative covenants impinging upon liberty of an employee to seek employment elsewhere, ought to be carefully scrutinized as there is inequality of bargaining power between the parties. As a matter of fact, the employee is accorded with no bargaining power whatsoever because the employee is presented with a standard form of contract to accept or reject. Such contracts “tempt improvident persons, for the sake of present gain, to deprive themselves of the power to make future acquisitions and expose them to imposition and oppression.” The Courts, therefore, view with disfavor a restrictive covenant which restrains an employee from engaging in a business similar to or competitive with that of the employer after the termination of his contract of employment.¹

Doctrine of Restraint of trade is based upon public policy of the country and if the terms of the employment contract are such that instead of acting in furtherance of trade, the terms prohibit it or operate in a counterproductive manner to the detriment of the employee, the same would naturally run afoul of Section 27 of the Act and the public policy of the country. In England, however, the rule is that, restraint, whether partial or general is not considered bad in law, unless such restraint is shown to be reasonable and necessary to protect the interests of the employer.However, the position of law in India is settled in this regard by a catena of judgments whereby the Courts have concurrently held that neither the test of reasonableness nor the principle that restraint being partial is reasonable, are applicable to a case governed by Section 27.² Therefore, the Courts in India do not have to venture into fact finding whether the restraint embodied in the negative covenant in the contract is reasonable, all the Courts have to see is that whether such restraint is impinging upon a person’s freedom of choice to practice a lawful profession of his choice. When an agreement is challenged on the ground of it being a restraint on trade, the onus is upon the party supporting the contract to show that the restraint is reasonably necessary to protect its interests. Once, this onus is discharged, the onus of showing that the restraint is nevertheless injurious to the public is upon the party attacking the contract.³

Doctrine of Restraint of trade never applies during the continuance of a contract of employment and only comes in operation when the contract comes to an end.⁴ In India, a contract containing a negative covenant stipulating that during the term of the employment of two years the employee shall not take service with any other employer or be engaged by a third party is held to be a contract which is not in restraint of trade but in furtherance of it and therefore, not hit by Section 27 of the Act. However, a negative covenant in an employment contract stipulating that after termination of employment, the employee is not to take employment for a period of two years with a direct competitor firm, is held to be an agreement in restraint of trade and directly hit by Section 27 of the Act. Therefore, an agreement to serve a person exclusively for a definite term is a lawful agreement, unless it shown that the contract is unconscionable or excessively harsh or unreasonable or one sided.⁵

It is noteworthy that as per the Specific Performance Act, 1963, contracts of personal service or contracts which are based upon personal qualification of parties and require regular supervision by the courts, are not enforceable in law. Furthermore, Section 41(e) of Specific Performance Act specifically states that an injunction cannot be granted to prevent the breach of a contract, the performance of which would not be specifically enforced. However, Section 42 of the Specific Performance Act categorically provides for enforcement of a negative covenant in a contract and empowers to court to grant an injunction to perform a negative covenant. The position of law with respect to validity of restrictive clauses in the agreement is hereby explicated hereinbelow with reference to landmark judgments on the subject.

Case Laws

1. Niranjan Shankar Golikari Vs The Century Spinning and Mfg. Co. Ltd. ⁶

The Appellant entered into an employment contract dated 16.03.1963 with the Respondent company, the terms whereof, interalia stipulated that the Appellant would be bound to serve the company for a period of five years during which period, the Appellant shall not take employment with any other company and shall not divulge any information, instruments, documents, trade secrets, technical-know-how etc. of the company. The Appellant, however, before the expiry of five years, negotiated with a competitor firm a higher salary and joined that firm after submitting his resignation to the Respondent Company within a period of two years of his employment. The Respondent company filed a suit seeking an injunction restraining the Appellant from serving in any capacity whatsoever or being associated with any person, firm or company including the competitor company that the Appellant had mischievously joined, till 15.03.1968 i.e. till the expiry of five years of his employment contract with the Respondent company. The trial court granted injunction which was later affirmed by the High Court and finally challenged before Supreme Court by the Appellant.

The Supreme Court drew a distinction between restraints that are applicable during the term of the contract of employment and restraints that apply after the termination of contract. The former are not hit by Section 27 of the Act, while the latter squarely fall within the edifice of Section 27 of the Act, and thus void. Since in the present case, the contract prohibited the employee during the term of the contract of five years from joining a rival firm or divulging any confidential information or trade secret, the court noted that negative covenants operative during the period of contract of employment when the employee is bound to serve his employer exclusively are generally not regarded as restraint of trade and therefore do not fall under Section 27 of the Contract Act. The court upheld the findings rendered by the High Court and Trial Court and dismissed the Appeal.

2. Superintendence Company of India Pvt. Ltd. vs Krishan Murgai⁷.

The Respondent was employed by the Appellant company as the Branch Manager of its New Delhi office on terms and conditions contained in letter of appointment issued to him, clause 10 whereof placed the Respondent under a post-service restraint that he shall not serve any other competitive firm nor carry on business on his own in similar line as that of the Appellant company for two years at the place of his last posting.

“10. That you will not be permitted to join any firm of our competitors or run a business of your own in similar lines directly and/or indirectly, for a period of two years at the place of your last posting after you leave the company.”

After a certain period of years, the Appellant terminated the employment of the Respondent, who, thereafter, started his own business und ethe name and style of the Appellant company viz. “Superintendence and Surveillance Inspectorate of India” on lines identical with or substantially similar to that of the Appellant company. Being aggrieved, the Appellant filed a suit for injunction in Delhi High Court for carrying on a similar business to that of the Appellant till the expiry of two years envisaged in clause 10 of the Agreement. The Ld. Single judge granted injunction on the basis that the negative covenant, being in partial restraint of trade, was reasonable inasmuch as it was limited both in point of time (two years) as well as the area of operation (New Delhi, his last posting) and, therefore, was not hit by Section 27 of the Act. The Ld. Single judge also held that the expression “leave” in clause 10 was not confined to voluntarily leaving of the service by the Respondent but was wide enough to include termination of his services by the appellant company. On appeal, the said order of the Single judge was reversed and challenged before the Supreme Court by the Appellant.

The Supreme Court, after referring to a catena of judgments including Niranjan Shankar Golikari (supra) held as follows:

The question whether an agreement is void under Section 27 must be decided upon the wording of that Section. There is nothing in the wording of Section 27 to suggest that the principle stated therein does not apply when the restraint is for a limited period only or is confined to a particular area. Such matters of partial restriction only fall within the exception to the Section 27.
It is immaterial whether the restraint was general or partial, unqualified or qualified, if it is in the nature of restraint of trade, it is void and such contract is unenforceable.
A service covenant extended beyond the termination of the service is void. In the present case clause 10 effectively operated and travelled beyond the termination of contract by casting restraints upon the Respondent for a period of two years after the contract is over, from joining a rival company.
If there is any ambiguity in construction, it must receive a narrower construction than wider. The court held that the Ld. Single judge was wrong to accord a wider interpretation to the expression “leave” in clause 10 and holding that the same would take within its sweep even the case when the employment contract is terminated by the employer/Appellant.

In view of the above ratio, the Supreme Court dismissed the Appeal.

3. Gujrat Bottling Co. Ltd. and Ors vs Coca Cola Company and Ors⁸

This is one case which saw the giants of soft drinks industry, viz. Pepsi and Coca Cola come head-to-head against one another. The dispute emanated from an agreement dated 20.09.1993 [“the 1993 Agreement”] between the Gujrat Bottling Co. [“GBC”] and Coca Cola whereby Coca Cola permitted and authorized GBC, upon the terms contained in the said agreement, to bottle, sell and distribute the beverages known and sold under the trademarks “Gold Spot”, “Thums up”, “Limca”, “Maaza” and “Rim Zim” owned by Coca Cola. Paragraph 14 of the said agreement contained a negative covenant casting restraints upon GBC viz.

“The Bottler covenants that the Bottler will not manufacture, bottle, sell deal or otherwise be concerned with the products, beverages of nay other brands of trademarks/trade names during the subsistence of this Agreement including the period of one year’s notice as contemplated in paragraph 21”

As per paragraph 21 of the said agreement, parties could terminate the agreement upon giving 1 year’s written notice. Subsequently, another agreement was executed between the parties on 30.04.1994 [“the 1994 Agreement”] whereby Coca Cola granted to GBC a non-exclusive license to use the aforementioned trademarks in relation to goods prepared by GBC from concentrates or syrup supplied by Coca Cola. The terms of the 1994 agreement enabled parties to terminate contract by giving a 90 days’ notice unlike the 1993 Agreement which provided 1 year’s notice. In 1995, the majority of shareholding of GBC was transferred to Pepsi, which gained a controlling power over the affairs of GBC, pursuant to which, GBC, on 25.01.1995 sent a notice to Coca Cola under cl. 17 of the 1994 Agreement, terminating the said agreement, by interalia stating that the 1993 Agreement stands replaced by the 1994 Agreement and that the termination period under the 1993 agreement stands reduced to 90 days after the execution of the 1994 agreement. Pepsi, by taking over GBC sought to achieve a dual purpose, viz. reduce the production capacity of beverages bearing trademarks held by Coca Cola by denying use of the plants of GBC for manufacture of those products and to increase the production capacity of Pepsi products by making available the plants of GBC for manufacture of Pepsi products.

On receiving the notice, Coca Cola filed a suit in Bombay High Court seeking a permanent injunction restraining GBC from dealing with Pepsi during the notice period of one year of 1993 Agreement. The Bombay High Court granted interim injunction restraining GBC from manufacturing, bottling, selling the products or dealing with anyone other than Coca Cola. In Appeal, the Division bench made the injunction absolute. Being, aggrieved, GBC filed an Appeal before the Supreme Court. One of the questions that arose for consideration before the Supreme Court was whether paragraph 14 fell within the mischief of Section 27 of the Act, being in restraint of trade. The Court inter alia held as follows-

The restriction imposed by paragraph 14 was operative only during the subsistence of the term of 1993 agreement and as such the stipulation was not in restraint of trade so as to attract Section 27 of the Act.
The nature and scope of 1993 and 1994 agreement are different and by no means, it can be construed that the 1994 Agreement replaced the notice period of 1993 Agreement from 1 year to 90 days especially in the absence of any consensus ad idem to the effect between the parties.
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 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 above terms, the Supreme Court dismissed the Appeal filed by GBC and upheld the orders of Bombay High Court.

4. Sandhya Organic Chemicals Pvt. Ltd. Vs United Phosphorous Ltd. and Ors.⁹

In this case the Plaintiff had invented a new methodology to produce his material in a certain way which proved to be time saving and much more profitable for the Plaintiff. The Defendant was employed with the Plaintiff and as per the terms of his employment, the Defendant was not allowed to divulge, or publish, during the tenure of his employment with the Plaintiff or subsequently any confidential or secret information, including the methodology invented by the Plaintiff for production of its materials. After some time, the Plaintiff terminated the services of the Defendant for loss of confidence, and immediately after termination of his service, the Defendant joined a competitor company working in same lines as that of the Plaintiff and started manufacturing material using the methodology and secrets he had come in possession of while being employed with the Plaintiff. The Plaintiff filed a suit for injunction for restraining the Defendants from using the methodology invented by the Plaintiff in production of their material. The Ld. Trial Judge granted injunction in favour of the Plaintiff, thereby restraining the Defendants from using the new process/methodology invented by the Plaintiff for production of their material and from selling such products in the open market or secretly and from divulging, any information, documents to any other person, corporation, etc. The matter finally came up for consideration before the High Court which inter laia held as follows-

The stipulation in the agreement casts restrains on the defendant which travels beyond the termination of the Agreement which is ex facie void in terms of Section 27 of the Act.
The Defendant cannot be restrained at all times from using his knowledge and experience which he has gained during the course of his employment with the Plaintiff especially in view of the fact that the Defendant is a qualified person having experience of working in a number of companies.
The Defendant Nos 1 and 2, whom, the Defendant No. 3 joined after termination of his service with the Plaintiff, were already using the same methodology invented by the Plaintiff as can be discerned from evidence on record. Therefore, the Plaintiff has failed to prove his case in this regard, more so, in view of the fact, the Plaintiff did not get its invention/methodology registered with the appropriate authorities.

5. Ambience India Pvt. Ltd vs Naveen Jain¹⁰

The Employment agreement dated 30.08.2003 executed between the parties stipulated a clause whereby the Defendant/employee, after termination of his contract, was restrained from divulging any trade secret of the Plaintiff for a period of three years and further restrained from taking any employment or deal with the Plaintiff’s present or past customers for a period two years after termination of his contract. The employee terminated the contract and joined a customer of the Plaintiff. The Plaintiff filed a suit seeking ad interim injunction before Delhi High Court, to restrain the Defendant/employee from continuing in the employment of its customer and to divulge trade secrets. The Court held as follows-

An employee, after termination of his agreement with his employer is free to pursue his own business or seek employment with someone else. However, during subsistence of his employment, the employee may be compelled not to get engaged in any other work or not to divulge trade secrets to others. In such a case restraint order may be passed as such cases do not run afoul of Section 27 of the Act. Since in the present case the restraints embodied in the negative covenant travelled beyond the termination of the Agreement, the same were found to be illegal in terms of Section 27 of the Act.
A trade secret is some protected and confidential information which the employee has acquired in the course of his employment. However, routine day-to-day affairs of employer which are in the knowledge of many and are commonly known to others cannot be called trade secrets. If the defendant, on account of his employment has learnt some business acumen or ways of dealing with the customers, the same do not constitute trade secrets or confidential information, the divulgence or use of which should be prohibited.

6. Percept D’Mark Pvt. Ltd. vs Zaheer Khan¹¹

The case involved a celebrity contract dated 01.11.2000 executed between former Indian National Team Cricketer Zaheer Khan and the Appellant company whereby the Appellant agreed to provide player management and social media/marketing services to the Respondent. The Contract was to subsist for a period of three years commencing from 30.10.2000 and expiring on 29.10.2003.

Clause 31(b) of the Agreement stipulated a right of first refusal to the Appellant which entitled the Appellant to be given an opportunity to match any third-party offer made to the Respondent before Respondent was permitted to enter into a contract with the third party. If the Appellant failed to match the third-party offer, only in that scenario, the Respondent was free to enter into contract with the third party. On 29.07.2003, the Appellant issued a letter of intent to the Respondent intimating therein its wish to extend the contract for a further period of 5 years. However, the Respondent, on 10.09.2003, categorically informed the Appellant that he has no desire to renew/extend the contract beyond the stipulated date i.e. 29.10.2003. After the contract ceased to operate by efflux of time, the Respondent entered into a contract with Adidas on 20.11.2003. Being aggrieved, the Appellant filed a Section 9 Petition under the provision of Arbitration and Conciliation Act, 1996 before the Bombay High Court, seeking interim measures to restrain the Respondent from entering into any agreement with Adidas or any third party without complying with the covenants under clause 31(b) of the Contract. The Ld. Single Judge granted injunction, which was later reversed by the Division bench, on appeal, which found clause 31(b) void under Section 27 of the Contract Act. The said order was challenged before the Supreme Court by the Appellant which held as follows-

Clause 31(b) constitutes an unlawful restriction on the Respondent and a compulsion on him to forcibly enter into a fresh contract with the Appellant even though he has fully performed the previous contract, and is, therefore, a restraint of trade which is void under Section 27 of the Contract Act.
Under Section 27 of the Contract Act-

A restrictive covenant extending beyond the term of the contract is void and not enforceable.
The doctrine of restraint of trade does not apply during the continuance of contract for employment. It is applied only when the contract comes to an end.
This doctrine is not confined to contracts of employment but to but to other contracts as well.

In the above terms, the Supreme Court dismissed the Appeal.

Conclusion

From a conspectus of the aforementioned case laws, the position of law that emerges is that, doctrine of restraint of trade embodied in Section 27 of the Contract Act is not applicable to cases, the negative covenants whereof, binds the employee to the company for a particular period of years.¹² In simple terms, if a contractual clause stipulates that the employee is obligated to serve the company for a period of two years during which the employee is not allowed to seek employment elsewhere, such clauses do not run afoul of Section 27 of the Act and thus, legal. However, if the same clause stipulates that after termination of the agreement, the employee is not allowed to join a particular firm of his choice for a particular period after termination of his Agreement, the said clause squarely falls within the edifice of Section 27 of the Act and thus void.

By Daksh Pandit