A non-compete clause or covenant not to compete (CNC), is a term used in contract/agreements under which one party agrees to not pursue a similar business/profession/trade in competition against another party.
As far back as 1415, English common law had already been "old and settled" that restraint on trade was unenforceable. The same remained unchanged until 1621, when a restriction that was limited to a specific geographic location was found to be an enforceable exception to the previously-absolute rule. Almost a hundred years later, the exception became the rule with the 1711 watershed case of Mitchell v/s Reynolds which established the modern framework for the analysis of the enforceability of non-compete agreements.
In Mitchell v. Reynolds (1711) Lord Smith L.C. said:
"it is the privilege of a trader in a free country, in all matters not contrary to law, to regulate his own mode of carrying it on according to his own discretion and choice. If the law has regulated or restrained his mode of doing this, the law must be obeyed. But no power short of the general law ought to restrain his free discretion."
Restraint of trade is a common law doctrine relating to the enforceability of contractual restrictions on freedom to conduct business. The common law has evolved to reflect changing business conditions. The restraint of trade doctrine's current use is small, given modern and economically oriented statutes of competition law in most countries. Its approach was based on the two concepts of prohibiting agreements that ran counter to public policy, unless the reasonableness of an agreement could be shown. A restraint of trade is simply some kind of agreed provision that is designed to restrain another's trade.
In Nordenfelt v. Maxim, Nordenfelt Gun Co., a Swedish arm inventor promised on sale of his business to an American gun maker that he "would not make guns or ammunition anywhere in the world, and would not compete with Maxim in any way.
Lord Macnaghten ruled that while one could validly promise to "not make guns or ammunition anywhere in the world" it was an unreasonable restraint to "not compete with Maxim in any way.“This approach in England was confirmed by the House of Lords in Mason v. The Provident Supply and Clothing Co, wherein Mason was a salesman for a clothing company which had branches all over England. He agreed not to assist in a similar company for 3 years within a 25 mile radius from London. It was decided the area was to much. The court noted Mason had only a minor role in a small part of London and he had been working with a two week notice period. This was void. i.e. restrictions in area and time that must not be wider than is reasonably necessary for protection of the business.
A business might abuse a non-compete covenant to prevent an employee from working elsewhere at all. Most jurisdictions in which such contracts have been examined by the courts have deemed CNCs to be legally binding so long as the clause contains reasonable limitations as to the geographical area and time period in which an employee of a company may not compete. Courts have held that, as a matter of public policy, an individual cannot be barred from carrying out a trade in which (s)he has been trained except to the extent that is necessary to protect the employer.
Press Note 18 : Introduced in 1998 which banned all foreigners with existing joint ventures (technology transfer/trade mark agreement) in India from establishing new ones under the 'automatic route' without a No Objection from their partner and in its absence, a specific FIPB approval.
Press Note 1 : Introduced in 2005 which replaced Press Note 18, wherein a foreign entity has an existing joint venture or technology agreement, any further investment in the same field in India by such foreign entity cannot be made under the automatic route, and that the foreign partner would have to obtain approval of the Foreign Investment Promotion Board (FIPB). The Parties may contractually safeguard their interests in JVs through provisions in JV/collaboration agreements which tackle 'conflict of interest' situations.
Section 27 of the Indian Contract Act, 1872 (“IC Act”) stipulates that an agreement, which restrains anyone from carrying on a lawful profession, trade or business, is void to that extent. The reasoning behind this section is that agreements of restraint are unfair, as they impose an undue restriction on the personal freedom of a contracting party.
However, as an exception, if a party sells his goodwill to another he can agree with the buyer that he will not carry on a similar business within the specified local limits.
Indian law is rigid and invalidates all restraints, whether general or partial. Neither the test of reasonableness, nor that of partial restraints applies to a case governed by Section 27 of the IC Act, unless the restraint falls within the exception of that section. Upon a literal construction, Section 27 of the IC Act invalidates all agreements that impose a total bar on the exercise of a lawful business.
The question whether an agreement is void under Section 27 of the IC Act shall be decided upon the wording of that Section alone.
In Gujarat Bottling Company Ltd. v. Coca Cola Company, AIR 1995 SC 2372, the Court ruled that a negative stipulation contained in a franchise agreement restraining the franchisee from dealing with competing goods was to facilitate the distribution of the goods of the franchiser and could not be regarded as a restraint of a right to trade.
However, in Parasulla Mallick v. Chandra Kanta Dass, AIR 1918 Cal 546, where the defendant and the plaintiff used to carry on the business of ferrying boats and arrived at a business settlement whereby the defendant promised to pay a certain amount to the plaintiff in order that the plaintiff abstain from carrying on his boat business for a period of three (3) years, the court ruled that the agreement was void as the restraining covenant was a vital part of the agreement and did not fall under the “goodwill exception” to section 27 of the IC Act.
The law has, as a matter of public policy, always opposed any interference with the freedom to contract and restraints on the liberty of an individual, unless injurious to the interests of the state. This principle is not confined to restraints of trade in the ordinary sense of the word “trade,” but includes restraints on the right of being employed.
The Supreme Court in the case of Niranjan Shankar Golikari v. Century Spg. & Mfg. Co. Ltd. reported in AIR 1967 SC 1098 held that when an employee for a term binds himself not to take employment during that term it will not be hit by section 27 and restrained the employee from serving anywhere else for the duration of the agreement.
In Superintendence Co. of India Pvt. Ltd. v. Krishan Murgai, AIR 1980 SC 1717, the contract of employment placed the employee under a post-service restraint preventing him from serving in any other competing firm for two years within the local limits of his last posting. As such, the restraint was operative for a period of two years after he left the company. The two substantial questions involved were:
Whether a post-service covenant in restraint of trade between the parties was void under section 27 of the IC Act; and
Whether the said restrictive covenant, assuming it to be valid, was on its terms enforceable at the instance of the employer against the employee?
The court concluded that the negative covenant during the term of the contract was not in restraint of trade, and that the doctrine of restraint of trade could never apply during the continuance of the contract. However, a restrictive covenant extending beyond the term of service was void.
The court further observed that employee covenants in agreements should be carefully scrutinized, because there was an inequality of bargaining power between the parties; and, more often than not, no bargaining power, especially in cases where the employee was presented with a standard form of contract that he had to accept or reject.
M/s. Sociedade de Fomento Indl. Ltd. v. Ravindranath Subraya Kamath, AIR 1995 Bom 158, the employer filed a case against the employee, seeking to enforce an agreement to restrain the employee from adopting and using any of the processes invented by the former employer in a subsequent employment, the court held that the agreement was void, because an employee could not be restrained from using knowledge which he gained during the course of his previous employment, forever.
The Indian courts have in cases of “non-compete clause” in employment agreement differentiated them as in during the term and after the term of employment.
Terms which restrict employment after the expiry of the agreement the courts have applied the ‘reasonableness’ test and the view has been that the livelihood cannot be taken away and therefore would be hit by section 27.
Further covenants that prohibit employees from engaging in a business similar to or competitive with that of the employer beyond the term of employment are invalid. The same applies to non-compete agreements between companies, except franchise agreements, notwithstanding that, the popular view is that non-compete arrangements between companies are valid.
In Taprogge Gesellschaft MBH v. IAEC India Ltd., AIR 1988 Bom 157, the Bombay High Court held that a restraint operating after termination of the contract to secure freedom from competition from a person who no longer worked within the contract, was void. The court refused to enforce the negative covenant and held that, even if such a covenant was valid under German law, it could not be enforced in India.
With the change and development in trade and economic thought, the general principle applicable to agreements in restraint of trade needs to be suitably modified. In this regard, the Law Commission of India has recommended in its 13th report that Section 27 of the IC Act should be amended so as to allow restrictions and contracts in restraint of trade, if they are in the interest of the parties as well as of the public. However, no action has been taken so far.
Under recent amendments to the Income-Tax Act, 1961, any sum received or receivable in cash or kind under an agreement for not carrying out any activity in relation to any business or for not sharing any know how, patent, copyright, trademark, license, franchise or any other business or commercial right of similar nature or information or technique likely to assist in the manufacture or processing of goods of provision for services, will now be chargeable to tax as profits or gains from business or profession. Therefore, the revenue authorities seek to tax payments received by companies for entering into non-compete covenants as business profits.