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Post-Employment Restrictive Covenants and the Unsettled ‘Reasonableness’ Test

Rakshith Bhallamudi is an Associate at TS Suresh and Associates, an all-service law firm based in Bangalore.

The Infosys Clause and the Place of Reasonableness in Section 27 of the Indian Contract Act, 1872

The Indian tech giant Infosys in its offer letter to employees provides for a clause that stipulates that an employee shall not, for a period of six months, accept an offer of employment from a customer with whom the employee has directly worked with during their time at Infosys in the preceding 12 months. It also says that they shall not accept offers from ‘named competitors’ if such employment involves working with a customer with whom the employee has worked with during their time at Infosys in the preceding 12 months. Use of such non-compete clauses is a widespread practice as companies hope to minimise or even avoid the potential threat(s) of compromised confidentiality and trade secrets that come with (key) employees leaving and working for their rivals. This is most likely done despite the knowledge of these companies that such covenants are rendered void by Section 27 of the Indian Contract Act, 1872.

A literal reading of Section 27 provides for only the test of restraint and excludes the test of reasonableness within its first part. Courts in India generally share this view and are more or less hostile to agreements restraining trade- more so towards post-employment restrictive clauses citing ‘unequal bargaining power’. However, the perceived absence of reasonableness is not so straightforward. Section 27 has been interpreted beyond the ordinary meaning of the word ‘trade’, to also include restraints on the right of being employed, restraints that exclude competition, and even restraints against public policy and the general principles of promoting free labour. The position of reasonableness seems to be taken as settled- it is not a consideration in evaluating the validity of a restraint at all. However, the presumption of exclusion of the test of reasonableness is rebuttable. In the case of Niranjan Shankar v. The Century Spinning And Mfg. Co. Ltd., a distinction was made between application of restrictive covenants in the course of employment and restrictions imposed post-employment. While it was clearly held that the former does not fall under the ambit Section 27, on the latter question, the court dodged a formal look into the issue of circumstances rendering post-employment covenants valid but expressed by obiter that even post-employment restraints are reasonable in protection of trade if the ‘area-nature’ rule is adhered to.

In the subsequent case of Superintendence company of India v. Murgai, the question of validity of a post-service restraint in a contract was not decided against, but actually left undecided. However, the obiter in this judgment was that virtually all post-contractual restraints were barred by Section 27, and there is no scope for reading reasonableness into the section whatsoever. As Shantanu Naravane observes, Justice Sen’s reasoning is far from persuasive in as much it says that India deliberately took a narrower approach in only adopting the restraint test, citing Madhub Chunder v. Rajcoomar Doss and Shaikh Kalu v. Ram Saran Bhagat ("Kalu") cases, as an accurate representation of the context in which the drafting of Section 27 took place. The intended departure of Indian law from common law may be correct, but such a departure was not from the reasonableness test, rather it was from the then existing position that made a restraint valid because it was confined to a particular place - it was to avoid the problems brought by partial/general restraint distinction. The fact that the reasonableness inquiry only originated in the mainstream in 1913- which was after the Indian Contract Act came into force, further reinforces this position. Finally, the judgment in Kalu referred to in the obiter, ultimately decided the case using common law principles. The New York Draft Code that Section 27 follows, only restricted the common law because back then, contracts in restraint of trade were being allowed to a dangerous extent. In India on the other hand, trade was in its infancy. Though it could be argued that, as noted in Oakes & Co. vs Jackson, the legislature may have wished to offer the least number of exceptions to develop trade, some scholars are sceptical of this and deem it more likely that the provision was merely lifted without much reflection. Even if it were true, the question still warrants reflection given the change in nature of trade in recent times.

Next, in the Gujarat Bottling v. The Coca Cola ("Gujarat Bottling") case, the court only recognized the distinction made in Murgai, and akin to that case, it chose to not decide on the aspect of reasonableness in post-contractual restraints and went on to decide the case on its facts and on supposition that an enquiry into reasonableness of the restraint is not envisaged by Section 27. It can be inferred, as also noted by Naravane, that this avoidance of the court stems from the court’s opinion that other conditions render moot the issue of reasonableness. Such avoidance marches into the case of Percept D’Markr v. Zaheer Khan ("Zaheer Khan"), where the court decided the case not by dismissing the force of the reasonableness approach, but on the ground that an interlocutory proceeding was not an appropriate place to entertain such a task- a position later validated by a division bench on appeal.

The reluctance of the Courts in the above cases to conclusively decide on the place of reasonableness within Section 27 is not cloudy. However, despite this, the many judgments delivered post-Zaheer Khan on the issues pertaining to post-employment contracts, proceeded to decide cases on the assumption that the position of law is/was settled, by taking recourse to the abovementioned judgments. The decisions in Affle Holdings v. Sourabh Singh, Le Passage to India Tours v. Deepak Bhatnagar, and Wipro Ltd v. Beckman Coulter held that post-employment restrictive covenants are void without inferring the reluctance of the previous cases and in so far as they rely on the obiter of Justice Sen and other non-binding opinions to justify (and apparently prove) the exclusion of the test of reasonableness. The cases seem to apply a literal interpretation to Section 27 without acknowledging the clear expansion the provision is undergoing by way of judicial interpretation.

Settling the position of Reasonableness?

Even if the intent of the drafters was to exclude reasonableness as a test in the first part of Section 27, there are compelling reasons for adopting it now, because firstly, Section 27 is inherent in the test of restraint and second, in the absence of other standard(s) of evaluation, reasonableness offers the best chance of ensuring a fairer balance of interests between the parties, especially in the current socio-economic landscape. Coming to the first element, as Professor Smith notes, putting reasonableness and restraint, concepts that are so intricately connected to each other, in water-tight compartments fails in practice. This is because, to determine whether or not a provision is a restraint, one has to necessarily consider reasonableness. The nature of trade is such that in order to consider a ‘restraint’ on it, the action of restraint must be continuous and not a one-off situation. If this is true, then even restrictions in the course of employment ought to be considered restraints, even though in India they are not- the position in India currently is that we are moving forward with a broad and unclear definition of restraint and narrowing it down on a case-by-case basis without explicitly recognizing a standard of evaluation of such restraint. Moreover, the language used in the cases of Gujarat Bottling and Zaheer Khan reflect the use of reasonableness without actually calling it that. Professor Smith highlights how, in order to even decide which contracts are to be considered for determining whether or not they count as restraint, Judges take recourse to and assess the ‘potential reasonableness’ of the said action in question at the first instance. It is the possibility and potential of the provision in dispute in a particular case to be considered as being reasonable in the concluding analysis that prompt judges to consider the many generalizations pertaining to numerous contracts of similar type and the persisting commercial practices that matter in arriving at a decision as to which agreements require detailed inspection. Even common law countries like the UK were historically hostile to restrictions on trade whether general or partial, and the response was strict. However, as noted in Thorsten Nordenfelt v. The Maxim Nordenfelt, the strict position which existed during the times of Queen Elizabeth- of all trade restraints being void on account of public policy- gradually changed, and now their invalidity is only presumed and evaluated against a test of reasonableness.

Coming to the second element, one should consider the case on non-traditional clauses. Infosys could make draft provisions that create fiduciary duties, or even put monetary penalties by way of their automatic triggering post-employment. If Infosys required its employees to ‘share profits’ from any new trade acquired following their resignation, the effective function of such a provision by Infosys would be to cause the employees to decline such a trade or business that they would otherwise take up. Economic disincentives like these will operate as a restraint not in their form but in function. The problem here is that such clauses cannot merely be subjected to the test of restraint as there is no guarantee that such clauses would even fall under the ambit of Section 27, given that the question is “whether restraint” and not “whether likelihood” of restraint, as there is no express bar against the employee to seek work. Without reasonableness, test of restraint may not even consider the ability of the employee to compete when clauses do not expressly bar them.

Rasonableness gives the opportunity to ask whether there is a likelihood of restraint at the initial stage and at the second stage, it gives the opportunity to ask whether or not there is restraint in fact.e The mere possibility of existence of such covenants operating, whose function is to restrain trade and those that may possess only little deterrent effect hence falling outside the purview of ‘restraint of trade’ due to judges’ inability to take recourse to a particular standard of evaluation, will only produce vastly counterproductive results going forward. Restraint test may work well in purely formalist cases but may not adequately justify functionalist cases and unfortunately for us, the problem of economic disincentives warrants the adoption of a functionalist approach which, thereby, necessitates the adoption of the test of reasonableness.

Finally, disincentives like those noted above could also pose difficulties in using the concept of unequal bargaining power to justify the non-enforceability of such agreements. Unequal bargaining power is seen as justifying the protection of the employee by the judiciary by stressing on the significance of personal freedom and employee mobility. Now, ordinary contracts are not subject to judicial scrutiny on the basis of unequal bargaining power. There has to be something special about this protection being extended to post-employment restrictive covenants. There can be two routes of justification in this regard- one, that the imbalance of power in such cases is so great that inequities sufficient to make contracts unenforceable exist in many cases to justify the costs of a reasonableness enquiry. Then the second, a route also taken by the Indian Judiciary, is that the value of freedom to trade triumphs all else because, among other things, the livelihood of a person depends on it. In the case of traditional restrictive clauses, the first and second routes may be easy to establish but this is not the case when it comes to non-traditional clauses. Both these considerations are tough to satisfy when economic disincentives are used as not enough cases exist (yet), there is no direct restriction on an employee’s freedom, and given that the test of restraint may not consider the ‘likelihood’ of restraint to come within the ambit of Section 27.

As observed in Chicago Board of Trade v. United States, reasonableness is adhered to because knowledge of intent may aid the judiciary in interpreting facts and judging and predicting consequences, and not to save an otherwise obnoxious regulation as such. It is possibly only a matter of time in this rapid age of change, before employers will find new, creative ways of retaining employees and ensuring that their interests are adequately protected. If the intricacies of the facts and circumstances of a case are not even considered in favour of adopting a black and white approach, we risk being counterproductive.

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