If you are an employer/ co-founder, you must be aware of the non-compete clauses in the employment or co-founder’s agreements which are inserted to limit the competition to safeguard your interest in case the other party decides to leave. But are these non-compete clauses enforceable? And can you sue the other party in case of breach?
Surprisingly, Indian courts have constantly taken a liberal view to allow competition and declared the non-compete clauses void. However, just because majorly courts have allowed competition by non-validating the non-compete clauses, it doesn’t mean that these should not be drafted in the agreements.
The main concern is the enforceability of non-competition clauses. Let’s dive deeper and understand what exactly are non-compete clauses and how to enforce them.
What are non-compete clauses?
In today’s extremely competitive era, clauses like ‘non-competition’ are found in almost every commercial contract. Their purpose is quite clear from the name itself i.e., to stop the other party from competing with you. It means either or both the parties of the contract are bound by restrictions such as starting a similar business or joining a competitor for a limited time period after exit from the contract. The competition may be limited on geographical basis also.
For example, in a co-founder’s agreement, all the co-founders are restricted from starting a competing business or engaging with any competing entity within an identified geography after resignation for a period of 1 year.
Purpose of non-compete clauses
The rationale behind drafting a non-compete clause is summarized in below points:
- Restrict competition
- Non-disclosure of trade secrets
- Unauthorized usage of confidential or proprietary information
- Preventing compromise with brand value due to founders’ resignation
- Limiting competition geographically
Are Non-compete clauses enforceable?
Enforceability of non-compete clauses has always been a grey area and there’s no definitive answer to this. It will always be subject to the evidences, applicable provisions, and their interpretation taken by the courts. For more clarity, the applicable provisions and case laws have been given below:
1. Article 19(1)(g) of Constitution of India –
It says that all citizens of India have the right to practise any profession, or to carry on any occupation, trade or business. Article 19(6) further allows reasonable restrictions imposed by any law. Here the applicable law is Indian Contract Act, 1972 discussed below.
2. Section 27 of the Indian Contract Act, 1872 –
Section 27 declares every agreement void to the extent it restricts anyone from exercising a lawful profession, trade or business of any kind. However, it carves out an exception and allows restriction for anyone who sells goodwill of a business from carrying a similar business.
On a bare perusal of Section 27 and literal interpretation, all the non-compete clauses may be declared void. Therefore, understanding the dire need to amend Section 27 of the Contract Act, 13th Report of the Law Commission of India also commented that “The present section does not reproduce English Common Law and invalidates many agreements which are not allowed by that law.” It further stated that “The section was enacted at a time when trade was yet undeveloped and the object underlying the section was to protect the trade from restraints …. But today, trade in India does not lag far behind that in England or the United States and there is no reason why a more liberal attitude should not be adopted.” It recommended that Section 27 be suitably amended to permit reasonable restrictions”.
3. Decided Case laws
| S. No. | Case | Judgement/ Courts’ view | Non- compete clause Void or Valid? |
| 1. | Niranjan Shankar Golikari v. The Century Spinning and Mfg. Co. Ltd | “..A negative covenant that the employee would not engage himself in trade or business or would not get himself employed by any other master for whom he would perform similar or substantially similar duties is not a restraint of trade unless the contract as aforesaid is unconscionable or excessively harsh or unreasonable or one-sided”
| Valid |
| 2. | Ozone Spa Pvt Ltd v Pure Fitness & Ors | “..restriction to operate the said services upon the defendants in the competing business during the term of the agreement has also to be within the designated territory or within the range of 4 kms thereafter which should be fair, just and reasonable as the absolute restriction on the basis of negative covenant without any affirmative covenant corresponding to the same would be too harsh upon the defendants and would be even greater than the licensed area.” | Valid |
| 3. | Superintendence Company of India (P) Ltd. v. Sh. Krishan Murgai | “The Courts, therefore, view with disfavour a restrictive covenant by an employee not to engage in a business similar to or competitive with that of the employer after the termination of his contract of employment. The true rule of construction is that when a covenant or agreement is impeached on the ground that it is in restraint of trade, the duty of the Court is, first to interpret the covenant or agreement itself, and to ascertain according to the ordinary rules of construction what is the fair meaning of the parties. If there is an ambiguity it must receive a narrower construction than the wider.” | Void |
| 4. | Percept D’Mark (India) Pvt. Ltd. v. Zaheer Khan and Anr. | “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 choses 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.” | Void |
| 5. | Pepsi Foods Ltd. and Others v. Bharat Coca-cola Holdings Pvt. Ltd. & others | “Admittedly in the service and employment contracts of the plaintiffs, there is a negative covenant clause, restraining an employee from engaging or undertaking employment for 12 months after he has left the plaintiffs’ service. It is well settled that such post termination restraint, under Indian Law, is in violation of Section 27 of the Contract Act. Such contracts are unenforceable, void and against the public policy. What is prohibited by law cannot be permitted by Court’s injunction.” | Void |
| 6. | Affle holdings Pte Limited v Saurabh Sing | “the petitioner, had bought the entire controlling interest of ATPL, with a view to acquire its business along with its goodwill. 10.6 The fact that a substantial consideration stands paid to respondent no.1 for acquisition of those rights, is not disputed… The prohibition, on respondent no.1, in indulging in competitive business or commercial activity, in my view, is reasonable both in time and space and, therefore, cannot be held to be in restraint of trade, and thus, void” | Valid |
How to enforce non-compete clauses
On a detailed analysis of the above-mentioned case laws, it can be inferred that non-compete clauses can be enforced post-termination of employment also. Following are ways to prove that the non-compete clause is not unconscionable or excessively harsh or unreasonable or one-sided:
- Test of reasonableness: Reasonability is a subjective matter. It cannot be defined, because which non-compete provisions are reasonable and which ones are unreasonable is not apparently identifiable like black and white. It’s a grey area which needs analysis on a case-to-case basis. Nevertheless, imposing only practical restrictions related to time limits, geographical area, exclusive services/ products or limits on the competing activities of the employees post service, which appears reasonable to the courts, is the first step towards enforceability.
- Unauthorized use of trade secrets: Employer can demonstrate to the court that the employee’s professional/ business activities are an outcome of unsanctioned usage of trade secrets of the employer.
- Diversion of customers/ clients: If the employer can provide sufficient evidences that the employee has utilized confidential information of the employer to divert customers or clients then non-compete clause can be enforced.
- Competition in nearby location (intentionally): There may be situations where location plays a massive role in brand value of the company and ultimately in its business. This is the reason many a times employers restrict employees from competing in nearby area. Therefore, employer can establish that a competing business of an ex-employee can be detriment to the brand value of the company.
- Substantial loss due to breach: Employer can show evidences of substantial financial loss due to the breach of non-compete clause.
Key points to draft an enforceable non-compete clause
On a bare perusal of the decided case laws, it can be concluded that if the non-compete clause is ambiguous, courts will use the rule of narrow construction to protect the interest of the leaving employee. Therefore, it should not lack clarity because otherwise it would be extremely difficult to enforce the non-compete clause. A few check points to draft an enforceable non-compete clause are given below:
- No standard template: non-compete clauses can never be “one-size-fits-all” clauses because every business is different in terms of its reach, industry, competition, employees, services/products and scope of confidential information.
- Impose reasonable restrictions only: If the restrictions are too harsh on the employee, it may render the non-compete clause void. For example, life time restriction on engaging with a competing business
- Define confidential information: What will fall under the ambit of confidential information must be drafted carefully to include the trade secrets, proprietary, technical and/or business information, trading methods, algorithms, intellectual property rights, and all the relevant information depending on the industry. The employee shall be restricted from divulging or utilizing any confidential information.
- Include time period: A reasonable time period depending on the industry, seniority level of employee and competition in the market shall be included. Reasonable time will vary from business to business.
- No unreasonable geographical restrictions: No unreasonable geographical restriction shall be included in the non-compete clause because it may prima facie be declared void. It is a best practice to mention the extent of area to which competition shall be restriction.
Conclusion
Above discussed case laws are a proof of strict interpretation of Section 27 of the Contract Act by the courts due to which all the non-compete clauses becomes prima-facie void. No clear provision/ exception for valid non-competition clause in agreements adds on to the ambiguity of its enforceability.
However, test of Reasonableness and a well drafted non-compete clause can definitely aid in enforcement of non-compete clause. At the end, its validity depends on the discretion of the courts who have, so far now, closely interpreted the “restraint of trade” provisions.
References:
https://www.macelree.com/the-top-10-mistakes-with-non-competition-agreements/
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