Authored By: Nidhi Yadav
ILS Law College, Pune.
Abstract
In countries like India, where unemployment and market volatility grip individuals with a persistent fear of losing jobs or facing the daunting risks of entrepreneurial ventures, restrictive covenants in employment contracts add a layer of uncertainty. These covenants, which include non-compete obligations, non-solicitation clauses, confidentiality agreements, and numerous others, have become subjects of contention in the evolving employment landscape. These thrusts invented by the commercial industries not only govern various contractual powers but depict the reality of the interplay between an employer’s rights and an employee’s rights, which have a profoundly negative impact on professional and self-moving forces.
In this article, we turn our attention into the rather controversial and sensitive terrain of restrictive covenants in employment contracts, exploring the tensions they create between business imperatives and individual liberties. Through a critical lens, we shall examine the evolving jurisprudence, the judicial balancing act between protection and restraint, and the ramifications of landmark precedents that have shaped this high-stakes arena of employment law.
The idea behind Restrictive Covenants
In the complex web of employment relationships, restrictive covenants serve as both shield and sword—they are crafted to safeguard an employer’s commercial sanctum while frequently casting a shadow over an employee’s freedom to pursue their profession. These contractual clauses, which include non-compete agreements, lock-in periods, non-solicitation obligations, and confidentiality provisions, are born of a fundamental conflict between the employer’s right to protect its trade secrets and market position versus the employee’s constitutional and legal right to earn a livelihood and exercise autonomy.
The Indian labour market, characterized by job scarcity and economic instability, poses unique challenges for professionals. Employees often find themselves ensnared not by a lack of skill or opportunity but by the spectre of legal action initiated by former employers seeking to enforce restrictive covenants that formed a part of their employment contracts. In high-stakes situations like mergers and acquisitions (M&A), when the protection of proprietary information, trade secrets, and intellectual property is crucial, such provisions are especially common among senior executives. Typically confined by temporal and geographical boundaries, these restrictions aim to prevent unfair competitive advantages but simultaneously raise concerns about their fairness and legality in the field of employment and contract law.
At the core of this legal conundrum lies a stark dichotomy. Are restrictive covenants valid instruments of business protection, or do they operate as unreasonable restraints of trade and an affront to the doctrine of public policy? The enforceability of restrictive covenants is a common issue for Indian courts, especially in light of constitutional protections guaranteeing the right to livelihood and freedom of occupation, which has created a labyrinth of competing interests, where a single clause can determine the trajectory of careers and the fortunes of enterprises. While employers argue that these provisions are necessary to shield legitimate business interests, critics contend that they often serve as a corporate façade, curtailing employees’ fundamental rights under the guise of safeguarding intellectual capital.
Restrictive Covenants and its kinds
Before we delve into the legal analysis of restrictive covenants, we first look at the meaning of restrictive covenants and its kinds. Restrictive covenants refer to contractual clauses that impose certain limitations or obligations on one party, typically employees, to protect the legitimate interests of the other party, usually employers. These covenants are designed to safeguard critical business assets such as trade secrets, proprietary information, intellectual property, and client relationships. By imposing conditions on the conduct of employees during and after their tenure, restrictive covenants seek to prevent unfair competitive practices, ensure loyalty, and maintain the integrity of an organization’s operations.
In employment contracts, restrictive covenants manifest in various forms, each designed to address specific business concerns which impose distinct limitations on employees. Noncompete agreements, for instance, restrict employees from joining competing businesses or starting their own ventures in the same industry for a defined period and within a specified geographical area after leaving an employer. These clauses are typically justified as protecting trade secrets, client relationships, and market position, though their enforceability in India remain a contentious issue.
Lock-in periods, another form of restrictive covenant, require employees to remain with an organization for a predetermined duration, often tied to the repayment of training costs or other investments made by the employer. While these provisions aim to safeguard organizational resources, they raise concerns of coercion and restraint on free employment.
Non-solicitation obligations primarily focus on preventing employees from poaching clients, customers, or colleagues from their former employer after parting ways. These clauses are frequently used in industries where client relationships are critical and highly competitive.
Lastly, confidentiality provisions bind employees to maintain the secrecy of sensitive information, such as trade secrets, proprietary technologies, or strategic plans, both during and after employment. Unlike other restrictive covenants, confidentiality agreements are more readily enforceable, as they align with the principle of protecting legitimate business interests without unduly restraining professional mobility of employees.
Collectively, these restrictive covenants operate at the intersection of employer prerogatives and employee freedoms, focussing on careful judicial scrutiny to ensure that they do not tip the scales unfairly in favour of one party.
Legal Framework behind restrictive covenants in India
The legal enforceability of restrictive covenants in India primarily depends on two foundational statutes: the Indian Contract Act, 1872, and the Constitution of India. Together, these laws establish the guiding principles for determining the validity of agreements that seek to impose employment restrictions on individuals.
Section 27 of the Indian Contract Act, 1872, unequivocally declares that “Every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void.”[1] This provision enshrines the principle that agreements restricting an individual’s right to engage in lawful economic activities contravene public policy. The rationale behind this restriction lies in promoting free trade and safeguarding individuals’ professional autonomy.
The sole statutory exception to this prohibition is in the cases which involve the sale of goodwill. Under Section 27 of the Act, a seller of goodwill may enter into an agreement with the buyer to refrain from carrying on a similar business within specified local limits, provided that the restriction is reasonable in scope and duration, and the buyer continues to conduct a similar business. This exception highlights the need to balance the interests of the buyer and seller in commercial transactions while maintaining adherence to public policy considerations.
The genesis of Section 27 of the said Act stems from the virtuous Article 19(1)(g) of the Constitution of India, which guarantees all citizens the right to practice any profession, or to carry on any occupation, business or trade.[2] This fundamental right embodies the democratic ethos of individual liberty and freedom of choice in professional pursuits. Courts of India have examined restrictive covenants in employment contracts in light of these fundamental principles of freedom and everlasting precedential justice and have generally ruled in favour of employees’ rights over restrictive covenants.
Legal Scenario in India
Restrictions during the employment period
In cases such as Niranjan Shankar Golikari v Century Spinning & Mfg Co.[3], the approach adopted by Courts in India with respect to employees is that restrictions placed by restrictive covenants, such as non-compete clauses, during the period of employment are considered legally valid for the protection of the business interests of the company and hence, do not violate Section 27 of the Indian Contract Act, 1872. It functions merely as a tool towards the fulfilment of the employment contract and not a restraint of trade because it only requires the employee to exclusively serve the employer during the period of employment.
Recently, in the controversial case of Lily Packers Private Limited vs. Vaishnavi Vijay Umak and Ors[4] (“Lily Packers Case”), wherein the validity of lock-in periods in employment contracts was in question, the Delhi High Court in its judgement validated the enforceability of lock-in periods and gave a green signal to employers to incorporate such negative covenants in their employment agreements provided that these covenants operate during the period of employment. In this case, the Delhi High Court while relying on the well-settled principle laid down in Niranjan Shankar Golikari vs. The Century Spinning and Mfg. Co. Ltd[5], clarified that “Any reasonable covenant operating during the term of the employment agreement would be valid and lawful. It cannot, therefore, be argued that in the present cases there is a violation of any fundamental right as enshrined in the Constitution of India. It was further observed that employment contracts in general are contractual disputes and not disputes which raise issues of violation of fundamental rights, in such fact situations. There may be certain employment conditions which could be considered unreasonable curtailment of the employee’s right to employment but a 3-year period of lock-in cannot be held to be such a condition”.
Therefore, the controversial Lily Packers Case6 lays down two important precedents which shed light on the grey area of validity and enforceability of restrictive covenants in employment contracts. The Delhi High Court had arrived to the conclusion that firstly, lock-in clauses must be agreed upon by the concerned parties out of their own freewill and volition during employment negotiations. Secondly, such lock-in period included in employment contracts should typically kick in post completion of probation period.
While the ruling in the Lily Packers case serves as a significant precedent for future disputes regarding the validity of restrictive covenants in employment contracts, careful attention must be paid to balancing employees’ right to livelihood against employers’ legitimate interests.
Post-employment Restrictions
The controversy regarding the existence of such restrictions beyond the period of employment remains in a grey area due to the plethora of legal complexities involved. Judicial precedents suggest that the right of livelihood of an employee should always be upheld over the commercial interests of the employer, despite any existing agreements between the two parties. The Apex Court in Percept D’Markr (India) Pvt. Ltd vs Zaheer Khan & Anr[6] held that a negative covenant in the contract between the media entertainment company and the cricket player, Zaheer Khan, which prevented him from joining a rival entity of the media entertainment company after the termination of the agreement between the parties was held to be void and unenforceable.
The uncertainty surrounding the enforceability of restrictive covenants such as non-compete clauses has led to the inclusion of ‘garden leave’ clauses in employment agreements. These clauses ensure that employees receive their full salary during the period they are restricted from engaging in competitive activities. The Bombay High Court, in VFS Global Services Private Limited v. Mr. Suprit Roy[7], held that paying compensation during garden leave does not extend the employment contract. Consequently, the garden leave clause is considered a restraint of trade and is subject to section 27 of the Indian Contract Act, 1872. Despite this, the concept of ‘garden leave’ remains popular and widely implemented in India and across the globe. Moreover, Indian courts are much inclined to enforce such garden leave clauses which are aimed at preventing the disclosure of confidential information and the solicitation of customers and employees.
In recent years, Indian courts have continued to emphasize the invalidity of post-employment restrictive covenants while also recognizing the need to protect an employer’s legitimate business interests. Courts have generally held that protecting trade secrets and confidential information is valid; however, they have stipulated that restrictive covenants, especially noncompete clauses, must be specific and reasonable in scope, duration, and geographical limitations. For instance, the Delhi High Court in Ozone Spa Pvt Ltd v Pure Fitness & Ors9 had restricted the defendants from establishing, running or setting up any competing business in the local area where the premises of the plaintiff was situated in accordance with the exception to Section 27 of the Indian Contract Act, 1872.
Doctrine of Blue Pencil and its applicability across various jurisdictions
When a restrictive covenant is deemed overly broad in terms of duration or scope, many legal systems allow courts to “blue pencil” the offending provisions. “Blue penciling” refers to a judicial process in which a court modifies an overbroad covenant to make it reasonable and enforceable. However, the application of blue penciling varies across jurisdictions. However, states vary in how they address overbroad covenants and the availability of blue penciling.
The term “blue pencil doctrine” was first introduced in India during the colonial-era cases and has continued to be used by courts to enforce contracts by removing irrelevant or illegal sections, thereby protecting the interests of the parties involved. Initially, this doctrine was applied in the context of non-compete clauses and trade restrictions, and this doctrine has since been extended to a wide array of areas such as arbitration, memoranda of understanding, real estate transactions, and contracts against public policy.
A landmark case in the application of the blue pencil doctrine is the case of Shin Satellite Public Co. Ltd. v. Jain Studios Limited[8], where the court had emphasized on “substantial severability” over “textual divisibility.” This means that the court seeks to preserve the main, substantial part of the contract by removing only trivial or unnecessary sections. For the doctrine to be applied, substantial severability is required, and it is the court’s responsibility to evaluate the contract accordingly for ensuring such applicability.
In the United States, particularly in jurisdictions such as New York, courts will only permit blue penciling if the covenant was not originally overly broad or if the employer, in good faith, sought to protect a legitimate business interest. This means employers cannot draft restrictive covenants that are knowingly excessive and expect courts to reduce them to an acceptable level[9].
In the United Kingdom, a court will not amend or alter a covenant. It will only apply the “blue pencil test” where the unenforceable provision can be severed without modifying or adding to the remaining terms, and where such severance does not substantially alter the original intent or effect of the restrictive covenants[10].
A Legal Crossroads- Future of Restrictive Covenants in India
Restrictive covenants stand at a confluence of law, liberty, and commerce, embodying a perpetual clash between the cold imperatives of business and the indomitable spirit of individual freedom. They are not mere clauses etched into employment contracts but battlegrounds where livelihoods and legacies are forged or shattered. Restrictive covenants in employment contracts represent the act of a delicate balance between protecting business interests and safeguarding employee freedoms. Indian jurisprudence, anchored in Section 27 of the Indian Contract Act, 1872, and constitutional principles, in its quest for balance, walks a tightrope, guided by the luminous principles of constitutional freedom and public policy, yet tethered by the pragmatic demands of commerce.
As a result, the courtroom of judges becomes an arena of profound consequence. Every ruling, whether it validates a non-compete agreement or denounces a post-employment restraint as void, shapes the delicate contours of employment law for generations to come. The recent judgments, such as the Lily Packers Case[11] and Percept D’Markr[12], characterizes the judiciary as cautious and bold: cautious in upholding legitimate business interests during employment and bold in striking down overreach when livelihoods are at stake. The evolving employment landscape necessitates continuous scrutiny to ensure equitable outcomes. Employers must exercise caution in drafting restrictive covenants, ensuring they are reasonable, specific, and compliant with legal standards to avoid potential invalidation.
As India marches forward in its economic aspirations, the debate over restrictive covenants grows ever more critical. Will the law continue to champion the constitutional promise of professional freedom, or will it bend under the weight of globalized business imperatives? The answer lies not in the rigid doctrines but in the judiciary’s ability to interpret the law as a living force that evolves to meet the complexities of a changing world while never losing sight of its foundational ethos.
In the crucible of this legal conflict, one thing remains certain: the scales of justice must remain steady, lest they tip towards a world where liberty is sacrificed at the altar of commerce, or business becomes a hostage to unbridled individualism. The challenge is not merely to resolve disputes but to craft a legal order where both ambition and autonomy can coexist—where contracts bind, but not at the cost of the human spirit that seeks to thrive beyond them.
Reference(s):
[1] The Indian Contract Act, No.9 of 1872, §27.
[2] India Const. art. 19, cl.1(g).
[3] Niranjan Shankar Golikari v Century Spinning & Mfg Co (1967) 2 SCR 378 (India).
[4] Lily Packers Private Limited vs. Vaishnavi Vijay Umak and Ors, ARB.P. 1210, 1212 and 1213/2023 (India).
[5] Id. 6 Id.
[6] Percept D’Markr (India) Pvt. Ltd vs Zaheer Khan & Anr, AIR 2006 Supreme Court 3426 (India).
[7] VFS Global Services Private Limited v. Mr. Suprit Roy, 2008 (3) MhLj 266 (India). 9 Ozone Spa Pvt Ltd v Pure Fitness & Ors, 2015 222 DLT 372 (India).
[8] Shin Satellite Public Co. Ltd. v. Jain Studios Limited, AIR 2006 SC 963 (India).
[9] Kim A. Leffert, Andrew S. Rosenman, Ruth Zadikany, United States: Restrictive Covenants, Mayer|Brown (Jul. 25, 2024), https://www.mayerbrown.com/en/people/z/zadikany-ruth.
[10] Miriam Bruce, Christopher Fisher, United Kingdom: Restrictive Covenants, Mayer|Brown (Jul.25, 2024), https://www.mayerbrown.com/en/insights/publications/2024/07/restrictive-covenants-uk.
[11] Id.
[12] Id.
