Agreement in restraint of trade

Background

Section 27 of the Contract Act, 18721 (ICA) dealing with agreement in restraint of trade states as under:

(1) 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.

It thus provides that an agreement restraining a person from carrying on a lawful profession, trade or business is void to that extent. However, an agreement not to carry on within specified local limits, a business similar to the business of which goodwill is sold, can be enforced, provided the limits of restraint are reasonable.

The provision regarding restraint of trade has been lifted from David D. Field’s Draft Code for New York which was based upon the old English doctrine of restraint of trade, as prevailing in ancient times. While construing the provisions of Section 27, the High Courts in India have 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, unless it falls within the exception.

The original draft of the Law Commission did not contain any provision regarding restraint of trade. But the provision of Section 27 was introduced afterwards at the time of enactment, the main object being to protect trade in India. The Law Commission in its Thirteenth Report2 had recommended that the provision should be suitably amended to allow such restrictions and all contracts in restraint of trade, general or partial, as were reasonable, in the interest of the parties as well as of the public. However, no action had been taken on the said recommendation.

Scope

The section is general in nature, and declares all agreements in restraint of trade void, pro tanto, except in the case specified in the exception. The section lays down a very rigid rule invalidating restraints, not only general restraints but also partial ones, and also restricts the exception of narrow local limits.

Broadly, agreements in restraint of trade are those in which one or both parties limit their freedom to work or carry on their profession or business in some way. Such agreements are often criticised because they conflict with public interest, and because they are unfair in unduly restricting personal freedom.

In a sense, every promise relating to business dealings operates as a restraint of trade, because it restricts the promisor’s future liability. It is the restraint which is “unreasonably detrimental to a freely competitive private economy”. (Farnsworth, Contracts, 3rd edn., p. 331). Further Lord Birkenhead laid down two tests to decide whether an agreement is in restraint of trade. They are:

(a) Whether it is reasonable as between parties.

(b) Whether it is consistent with the intent of public.

The Delhi High Court in Modicare Ltd. v. Gautam Bali2, has explained the validity of Section 27 of ICA as:

Section 27 of the Contract Act makes void i.e. unenforceable, every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind. Thus, even if the defendants or any of them, under their agreement with the plaintiff, had undertaken not to carry on or be involved in any capacity in any business competing with the business of the plaintiff, even after leaving employment with/association of the plaintiff, the said agreement, owing to Section 27 supra, would be void and unenforceable and the plaintiff on the basis thereof could not have restrained any of the defendants from carrying on any business or vocation, even if the one which the defendant had agreed not to carry on. I find it incongruous that the law, on the one hand would disable a plaintiff from enforcing a contract where the defendant had voluntarily agreed not to do something, by going to the extent of declaring such contract void, but on the other hand, enable the same plaintiff to the same relief under the law of tort. To hold so, would make the law look like an ass.
Section 27, contained in a legislation of the year 1872, on promulgation of the Constitution of India in the year 1950, conferring the right to practice any profession or to carry on any occupation, trade or business, the status of a fundamental right, under Article 19(1)(g) thereof, today has a different connotation. Article 19(6) only clarifies that nothing contained in clause (g) shall affect the operation of any existing law or prevent the State from making any law, imposing in the interest of general public, reasonable restrictions on the exercise of right conferred by the said clause. Thus, restrictions, in the interest of general public and if reasonable, to the fundamental right to practice any profession or to carry on any occupation, trade or business, can be imposed only by law. The law of tort of unreasonable interference in carrying on business, in view of Section 27 of the Contract Act in force since 1872, was not the existing law within the meaning of Article 19(6) of the Constitution.

Restrictive nature of covenants in the agreement

A contract may have several covenants, which may be positive, negative, general or partial. In contacts containing negative obligations, the restraint is direct. When a positive obligation limits freedom, it imposes an indirect restraint and can be equally restrictive or unreasonable as a negative obligation.

The principle of restraint of trade and restrictive nature of covenants in agreements have been elucidated by several courts in a plethora of judgments. In Navigators Logistics Ltd. v. Kashif Qureshi3, the Delhi High Court has explained the validity of Section 27, ICA as:

Section 27 of the Contract Act is as under:

* * *

The interpretation of Section 27 of the Contract Act is not res integra.

56. Applying the aforesaid law to the facts of the present case, it is found that as per the plaintiff also, there was no fixed term for which either of Defendants 1 to 8 had agreed to serve the plaintiff. The clause in the employment contract claimed by the plaintiff also is to the effect that Defendants 1 to 8, for a period of one year after ceasing to be the employee of the plaintiff, to not compete with the plaintiff. Such a clause in the employment contract, as per the judgments aforesaid of the Supreme Court, is void under Section 27 of the Contract Act. Once the clause is void, there can be no injunction or damages in lieu of injunction on the basis thereof.

The High Court of Delhi in Arvinder Singh v. Lal Pathlabs (P) Ltd.4, has explained the principle of Section 27, ICA as under:

As per Section 27 of the Contract Act every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind is to that extend void. It is the exception which protects from being void such an agreement provided the conditions envisaged by the exceptions are satisfied. The condition for the exception is that if the goodwill of a business has been sold, an agreement to refrain from carrying on similar business, if it appears to the Court to be reasonable, would be protected and would be enforced.

The words “profession” “trade” and “business” used in Section 27 are specific words and we see no scope to give meaning to the word profession applying the rule of noscitur a sociis.

The reasoning of the learned Single Judge is obviously on the basis that the activity of a profession is akin to that of a business, for if this was not the reasoning, the exception to Section 27 of the Contract Act would not even apply. Such agreements not to carry on business if goodwill of a business is sold, subject to the restriction being reasonable, are alone carved out from the general embargo embossed by Section 27 of the Contract Act.

The sweep of the span of the injunction to prohibit the appellants to carry on their profession as pathologist or radiologist in any manner whatsoever would render the appellants incapable of working as a pathologist or radiologist in any capacity whatsoever, and this would be contrary to Section 27 of the Contract Act.

In Percept D’Mark (India) (P) Ltd. v. Zaheer Khan5, the Supreme Court explained the provisions of Section 27, ICA as under:

If the negative covenant or obligation under Clause 31(b) is sought to be enforced beyond the term i.e. if it is enforced as against a contract entered into on 20-11-2003 which came into effect on 1-12-2003, then it constitutes an unlawful restriction on Respondent 1’s freedom to enter into fiduciary relationships with persons of his choice, 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) a restrictive covenant extending beyond the term of the contract is void and not enforceable; (b) the doctrine of restraint of trade does not apply during the continuance of the contract for employment and it applies only when the contract comes to an end; and (c) As held by this Court in Gujarat Bottling Co. Ltd. v. Coca Cola Co.6, this doctrine is not confined only to contracts of employment, but is also applicable to all other contracts.

Construing the section in its literal terms, the section only deals with agreements which operate as a total bar to the exercise of a lawful business, and does not cover agreements which merely restrain freedom of action in actual exercise of a lawful business. The above principle was emphasised by the Supreme Court in Gujarat Bottling Co. Ltd. v. Coca Cola Co.7, as:

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.

If the negative stipulation contained in paragraph 14 of the 1993 Agreement is considered in the light of the observations in Esso Petroleum Co. Ltd. v. Harper’s Garage (Stourport) Ltd.8, it will be found that the 1993 Agreement is an agreement for grant of franchise by Coca Cola to GBC to manufacture, bottle, sell and distribute the various beverages for which the trade marks were acquired by Coca Cola. The 1993 Agreement is thus a commercial agreement whereunder both the parties have undertaken obligations for promoting the trade in beverages for their mutual benefit. The purpose underlying paragraph 14 of the said agreement is to promote the trade and the negative stipulation under challenge seeks to achieve the said purpose by requiring GBC to wholeheartedly apply to promoting the sale of the products of Coca Cola. In that context, it is also relevant to mention that the said negative stipulation operates only during the period the agreement is in operation because of the express use of the words “during the subsistence of this agreement including the period of one year as contemplated in paragraph 21” in paragraph 14. Except in cases where the contract is wholly one sided, normally the doctrine of restraint of trade is not attracted in cases where the restriction is to operate during the period the contract is subsisting and it applies in respect of a restriction which operates after the termination of the contract.

Shri Shanti Bhushan has submitted that these observations must be confined only to contracts of employment and that this principle does not apply to other contracts. We are unable to agree. We find no rational basis for confining this principle to a contract for employment and excluding its application to other contracts. The underlying principle governing contracts in restraint of trade is the same and as a matter of fact that courts take a more restricted and less favourable view in respect of a covenant entered into between an employer and an employee as compared to a covenant between a vendor and a purchaser or partnership agreements.

Since the negative stipulation in paragraph 14 of the 1993 Agreement is confined in its application to the period of subsistence of the agreement and the restriction imposed therein is operative only during the period the 1993 Agreement is subsisting, the said stipulation cannot be held to be in restraint of trade so as to attract the bar of Section 27 of the Contract Act. We are, therefore, unable to uphold the contention of Shri Shanti Bhushan that the negative stipulation contained in paragraph 14 of the 1993 Agreement, being in restraint of trade, is void under Section 27 of the Contract Act.

In Niranjan Shankar Golikari v. Century Spg. and Mfg. Co. Ltd.9, the Supreme Court held that restraint of trade may be good if shown to be reasonably necessary for freedom of trade. The Court has held thus:

As to what constitutes restraint of trade is summarised in Halsbury’s Laws of England (3rd edn.), Vol. 38, at p. 15 and onwards. It is a general principle of the common law that a person is entitled to exercise his lawful trade or calling as and when he wills and the law has always regarded jealously any interference with trade, even at the risk of interference with freedom of contract as it is public policy to oppose all restraints upon liberty of individual action which are injurious to the interests of the State. This principle is not confined to restraint of trade in the ordinary meaning of the word “trade” and includes restraints on the right of being employed …The rule now is that restraints whether general or partial may be good if they are reasonable. A restraint upon freedom of contract must be shown to be reasonably necessary for the purpose of freedom of trade. A restraint reasonably necessary for the protection of the covenantee must prevail unless some specific ground of public policy can be clearly established against it … A person may be restrained from carrying on his trade by reason of an agreement voluntarily entered into by him with that object. In such a case the general principle of freedom of trade must be applied with due regard to the principle that public policy requires for men of full age and understanding the utmost freedom of contract and that it is public policy to allow a trader to dispose of his business to successor by whom it may be efficiently carried on and to afford to an employer an unrestricted choice of able assistants and the opportunity to instruct them in his trade and its secrets without fear of their becoming his competitors (Fitch Dewes10). Where an agreement is challenged on the ground of its being a restraint of trade the onus is upon the party supporting the contract to show that the restraint is reasonably necessary to protect his 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.

Recently, the Delhi High Court in Aakash Educational Services Ltd. v. Sahib Sital Singh Bajwa11, reiterated the position of law on the scope of enforceability of negative covenants in a commercial contract, holding that once a contract is terminated, a negative covenant thereunder to restrict the trade, business or profession of any party is hit by Section 27 of ICA. The court also held that while such negative covenants may be legal during the subsistence or currency of the contract, however, post termination of the contract, barring exceptional cases, they will be unenforceable.

Partnership contracts

A number of exceptions to Section 27, ICA have been incorporated in the Partnership Act 1932 (IPA), keeping in view the overall importance of the common partnership business. Such exceptions pertain to agreements between partners in four situations:

(a) during continuance of business;

(b) at the time of any partner ceasing to be a partner;

(d) on sale of goodwill of the firm.

Section 11 of IPA authorises the partners to determine their mutual rights and duties themselves trough a mutual agreement, which may be express or implied. The section further explains that an agreement, whereby it is agreed that a partner shall not carry-on business other than that of the firm while he is a partner, is valid.

As per Section 36, IPA, when a partner ceases to be a partner in the firm and his accounts are settled, he may be required to make an agreement that after he ceases to be a partner, he shall not carry on any business similar to that of the firm within a specified period or within specified local limits. Such an agreement tends to protect the interest of partners still continuing the business, and therefore held to be valid.

Section 54 of IPA states that on dissolution of the firm, some of the partners may procure an agreement from other partner(s), the latter agreeing not to carry on business similar to that of a firm. Such an agreement shall also be valid provided the local limits or the limit of time in respect of which the restrictions are imposed, are reasonable.

As per Section 55, on the sale of goodwill there may be an agreement between the partners and the buyer of goodwill, that the partners shall not carry on any business similar to that of the firm within a specified period or within specified local limits. Such an agreement has been held to be valid.

In Hukmi Chand v. Jaipur Ice & Oil Mills Co.12, the Jaipur Bench of Rajasthan High Court has upheld the validity of the agreement entered into between a retiring partner and the other partners, wherein the former sold his share of goodwill and agreed not to carry on similar business on the adjoining plot of land, which came to his share. The Court further held that the burden of proof that the restrictions imposed in any agreement of restraint of trade are reasonable, is on the party which pleads them as reasonable.

Contracts of service

There are also several cases where restraints are placed on personal service during the subsistence of personal service contract, and it has held that such restraint would be reasonable only during the period of such contacts and not beyond that.

The Delhi High Court in K.D. Campus (P) Ltd. v. Metis Eduventures (P) Ltd. India13, has held that once the employer has treated the employment contract of the employee as terminated, then he cannot proceed to enforce any negative covenant as against the employee. The Court held as under:

In the present case the contract of employment has admittedly been prematurely terminated. According to the plaintiff, unilaterally and illegally by the defendants No. 2 to 8. It is not the case of the plaintiff that the plaintiff, notwithstanding such unilateral and illegal termination of the contract of employment by the defendants No. 2 to 8, is continuing to treat the defendants No. 2 to 8 as in the employment of the plaintiff or is continuing to pay the emoluments which the plaintiff under the contract had agreed to pay to the defendants No. 2 to 8. Rather, it is the plea of the defendants No. 2 to 8 that their past emoluments, for the period for which they served the plaintiff, were also not paid and which compelled them to look for employment elsewhere. Once the plaintiff itself is treating the contract of employment with each of the defendants No. 2 to 8 as terminated and has stopped performing his obligations under the said contract to the defendants No 2 to 8, in my view the present case would fall in the genre of employer seeking to enforce the negative covenant after the termination of service and which is not permissible in law.

In my opinion, it is only during the period for which the employee continues to serve the employer and receives emoluments from the employer can the employer enforce the negative covenant unless it is shown that the enforcement of negative covenant beyond the period of wrongful repudiation of the contract is necessary to protect the interest of the employer. However, such restraint can be to protect any proprietary right of the employer and not to prevent competition.

The plaintiff in the present case has indeed not shown any proprietary right which may be infringed by Defendants 2 to 8 joining employment elsewhere or by indulging in the activity of teaching. Moreover, Defendants 2 to 6 who are teachers cannot be expected to teach any subject other than that in which they are qualified to teach and it is also not the plea that they are capable of getting employment elsewhere in any other capacity. We are today living in an age where employment avenues are scarce and if Defendants 2 to 8 are restrained as sought, they would necessarily be driven to idleness and a state of penury.

In Superintendence Co. of India (P) Ltd. v. Krishan Murgai14, the Supreme Court has also affirmed that any negative covenant beyond the termination of the service is void. The Court has held as under:

Under Section 27 of the Contract Act, a service covenant extended beyond the termination of the service is void. Not a single Indian decision has been brought to our notice where an injunction has been granted against an employee after the termination of his employment.
On a true construction of Clause 10 of the agreement, the negative covenant not to serve elsewhere or enter into a competitive business does not, in my view, arise when the employee does not leave the services but is dismissed from service. Wrongful dismissal is a repudiation of contract of service which relieves the employee of the restrictive covenant.

Protection of trade secrets and confidential information

In an employment contract, the employer has trade secrets and business connections, worthy of protection. In case of restraints in contracts of employment, it is necessary to show that employee has entered into a contract with a customer, or has trade secrets of the employer. An employer can lawfully prohibit his employee from accepting any position, after determination of his employment, where the employee is likely to utilise the information of trade secrets acquired by him.

Trade combinations

Agreements between traders to combine and regulate their business for the purpose of promoting their common interest are not considered to be against public policy and consequently not in restraint of trade. The main objective of making such agreement is to avoid competition between themselves by mechanism such as fixing minimum process, pooling their resources, regulating supply of goods and services, pooling profits and distributing the same as per some agreed formula. Similarly, if two or more persons agree to jointly carry on their business and avoid competition among themselves or even to monopolise the trade, is nothing but doing lawful act of promoting their commercial interest, and the same is valid.

Though an agreement between persons to regulate their own trade is valid, a bare agreement in restraint of competition is void. Such an agreement would be valid if it is ancillary to their commercial interest and is also consistent to public interest.

Solus agreements

There may be agreements where one party is to deal exclusively with the product of a particular producer or manufacturer and not to deal with any other person. Such agreements are called solus or exclusive dealing agreements. For example, a buyer of a certain commodity may agree that he will purchase all his requirements from a particular manufacturer only, or vice-versa. The validity of such agreements depends on the object of the parties. Such a type of agreement would be valid if it is reasonable for benefiting the parties to the agreement, and if such agreement aims at putting undue restrictions by one party on the other with an objective to monopolise trade, then such an agreement is void.

Exception – Sale of goodwill

Regarding the exception to the section relating to sale of goodwill, when a person sells the goodwill of his business, he may give an undertaking to the buyer of the goodwill that he will not carry on that kind of business of which the goodwill is being sold. Such an agreement puts a restraint on the seller of the goodwill, but the same is valid for the purpose of protection of interest of the buyer of goodwill, for which he has paid the consideration. When there is no sale of goodwill of a business, an agreement not to carry on such business would be against public policy and therefore void. Therefore, the scope of exception to Section 27 is limited. Further it would operate only so long as the buyer or a person deriving title from him carries on a business for lifetime. Further, the restrictive covenant would strand extinguished when the goodwill comes to an end.