The non-compete clause: Need for a relook

It is time to take a studied view and amend Section 27 of the Indian Contract Act, written for the 19th century, in the India of today

The non-compete clause
The non-compete clause

While the think tanks were anticipating a global economic downturn on account of various factors across the globe, the Covid-19 pandemic struck unannounced and brought the world economy to a grinding halt. Reports suggest that there are hardly any businesses that have been spared, big or small. Now, projections by experts regarding losses to businesses, closures and unemployment are alarming, surpassing impact by any previous global crisis and perhaps, still not quantified.

In India, a recent snap poll of CEOs indicates significant loss of profit to businesses and estimates job losses in the range of 15-30% due to the ensuing lockdown. An economic downturn, generally, leads to rise in disputes, prominently in the sphere of labour/employment and contractual arrangements. Reduction of exposure to expense by companies and cutting fixed costs, like salaries and benefits, may be attributed for such disputes.

A spike in litigations is seen in such times as, inevitably, pay cuts, job losses and movement of talents in respective sectors rise. Whether pay cuts by enterprises, because of the current lockdown, can be a valid and legitimate act or not, is an issue pending before, the Supreme Court of India. However, this piece seeks to bring forth another contentious issue that permeates an employer and employee relationship–the enforcement of non-compete, non-solicitation and confidentiality–the boilerplate clauses of an employment contract.

Such clauses are put to protect the employer’s know-how, trade secrets and confidential information during employment and beyond. India has a long chain of judicial decisions dealing with enforcement of such “negative covenants” and at the heart of all of them is Section 27 of the Indian Contract Act, 1872. This provision states that every agreement that restrains a person from exercising a lawful profession, trade or business is neither valid nor binding. The only exceptions being–cases of partnership and where goodwill of a business is sold to the person seeking reasonable enforcement of the negative covenant. The broad contours of the provision provide it with inflexibility to encompass any reasonable exception–something the courts in India have found difficult to unshackle.

While, the Supreme Court in the case of Niranjan Shankar Golikari (1967) settled that such clauses can be enforced during the course of employment or during subsistence of a contract, the rigid and overarching impact of Section 27 is felt when enforcement of such clauses are sought beyond the period of employment or contract. Rendering postemployment enforcement of such clauses invalid, courts in India have taken the view that restraining an employee from pursuing his employment is not only a restraint of trade and free will, but is also an embargo on the employee’s ability to earn a living.

Though, the ways and means of recruitment and training of human resource by companies have undergone a paradigm shift over the years, the courts in India continue to be bound by the Section as it stands, making enforcement of such clauses difficult. However, over a period of time and to a limited extent, the courts have started enforcing nonsolicitation and confidentiality clauses post cessation of employment. It’s not that arguments have not been advanced to import the concept of reasonable restrictions or partial restraints in Section 27 in aid of enforcement of the negative covenants.

This concept is borrowed from the views taken by courts in England, who, while testing the negative covenants, have followed a flexible approach to permit reasonable restrictions to trade, in sync with evolution of trade and commerce. In contrast, courts in India have refrained from invoking the doctrine of reasonableness while judging the validity of negative covenants and have declared such covenants to be invalid keeping in view of the statute. There is no escape from the prohibition imposed by Section 27 unless the contract falls within the statutory exception.

It has been the view of the courts that it is the domain of the Legislature to consider the inclusion of the concept of reasonable restrictions in Section 27. This interpretation of Section 27 has consistently been followed by courts in India since its inception. Other than the sphere of employer-employee relationship, the principle of invalidity of any contract that restrains trade also pervades into contractual arrangements between business partners, vendors, franchises and agents. But the principle and scope of Section 27 has remained unchanged.

Like, a right of first refusal under a contract for promotion of services of a famous cricketer that operated beyond the term of the contract was held to be in restraint of trade by the Supreme Court [Percept D’Mark v Zaheer Khan (2005)]. The doctrine of restraint in England is flexible: that if reasonable, post-employment negative covenants are enforceable. Further, the concept of reasonableness there has expanded so as to allow severance of any unreasonableness from a clause and to enforce the remaining portion of the clause, if possible.

In India, Section 27 leaves no room for such severance. Recently, the UK Supreme Court, while adjudicating the case of a global head of financial services division of a UK company, severed a part of the non-compete clause to enforce it. While doing so, the court invoked the ‘blue pencil test’ whereby unreasonable parts of a clause, found to be in restraint of trade, can be severed (akin to marking with a blue pencil) to leave the remainder of the clause enforceable.

The decision appears to be in sync with the evolution of trade as it observes, “High-ranking employees can do particular damage to the legitimate interests of their employers following termination of their employment; and it may be that, when they enter into their post-employment covenants, they are able to negotiate with their employers on nearly an equal footing.” [Tillman v Egon Zehnder Ltd. (2019)] There have been calls in the past for amending Section 27 of the Indian Contract Act (which was promulgated in 1872) and probably bringing the same in line with the relevant developments in the English Common Law.

In 1876, Kindersley, J., while deciding whether the law of contract of India (Section 27) or England would be applicable to the particular case, observed the difference in both the laws [Oakes v Jackson (1876)]. He attributed the rigidity of Section 27, as compared to English law, to the infancy of trade in India at that time.

According to him, the Legislature must have decided not to provide many exceptions to Section 27 in order to prevent any hinderance to trade and its expansion. This exposition was noted by the Law Commission of India in 1958 in its Thirteenth Report. Besides this, the Commission observed that Section 27 invalidates many agreements which the English Common Law otherwise permits.

Owing to subsequent advancement of trade and commerce in India, since the nineteenth century, the Commission recommended amendment to Section 27 to permit reasonable restraints, in line with the English Commons Law. Unfortunately, the said amendment never took place.

In 2019, India surpassed the United Kingdom to become the fifth largest economy in the world. For the past 25 years, Indian economy has grown exponentially, with large multinational corporations setting shops here. Consequently, the employer-employee paradigm has also undergone a change. Today, a company invests heavily to search, skill and retain its top talents.

Joining bonus is not unknown to the corporate world and sponsored international assignments and trainings are a norm. If any, a senior-level executive is privy to expensive, novel and sophisticated models and know-how, which are critical for a business. It may be something that helps a company to remain competitive. Therefore, in some cases, a cooling-off period (non-compete clause), before an employee joins a rival company, may be critical for the ex-employer and it may be reasonable for the employer to ask the employee to wait before knocking the doors of the competitors.

To an extent, India has realised that changes in legal regime is imperative and it has tried to catch up with changing economic landscape with the introduction of a new insolvency resolution regime, establishment of commercial courts, etc. However, the retention of Section 27 of the Contract Act in the statute book, as it stood in the nineteenth century, is an example of the law being static when the world has moved on. If Section 27 ever had to be amended, it is now.