Agreements in Restraint of Trade

Broken down

The rule

Four elements.

1. An agreement, in any form.
2. By which any one is restrained. It need not be a party who is restrained.
3. From exercising a lawful profession, trade or business of any kind. The words are as wide as they could be made. An unlawful trade is outside the section, because there is no protected freedom to carry it on.
4. The agreement is void to that extent. Note the severance language: only the offending restraint falls, and the rest of the contract may survive.

"To that extent", and what it does

Section 27 does not void the whole agreement. It voids it to the extent of the restraint. So an employment contract containing a bad post employment covenant remains a good employment contract; only the covenant is unenforceable. Contrast section 26, which voids the agreement outright.

Exception 1: sale of goodwill

Goodwill is the value attaching to a business's reputation and connection, the likelihood that customers will keep coming. A person who sells it and then reopens next door has sold nothing, so the law permits a covenant to protect the buyer, on four conditions.

1. The seller must actually have sold the goodwill of a business.
2. The covenant must be not to carry on a similar business.
3. It must be within specified local limits.
4. It lasts only so long as the buyer, or a person deriving title from him, carries on a like business there, and the limits must appear to the Court reasonable, regard being had to the nature of the business.

Note what is absent: any limit on duration. The exception controls the restraint by area, not by time, and the time limit is supplied indirectly by the requirement that the buyer be carrying on a like business.

Employment covenants: during and after

This is the division MU examines, and the two leading cases sit on either side of it.

During employment: outside section 27

Niranjan Shankar Golikari v. The Century Spinning and Manufacturing Co. Ltd., AIR 1967 SC 1098.

Facts. The appellant joined the respondent company as a shift supervisor and was trained in the manufacture of tyre cord yarn under a collaboration with a foreign firm. His contract ran for five years and provided that during that period he would not work in a similar capacity for any other concern, and would keep the technical aspects of his work secret. Shortly after his training he left and joined a rival concern at higher pay. The company sued for an injunction. It was granted, and his appeal to the High Court failed.

Held. The appeal failed. Negative covenants operative during the period of employment, when the employee is bound to serve his employer exclusively, are not to be regarded as being in restraint of trade and do not fall under section 27. Such a covenant is not a restraint unless the contract is unconscionable, excessively harsh, unreasonable or one sided.

Why it matters here. It draws the line. A covenant that bites while the employment subsists is enforceable, because it is an incident of the duty of exclusive service the employee has already undertaken, not a restriction on his freedom to earn a living.

After employment: inside section 27, and void

The corollary is that a covenant restraining an employee after the employment ends is a restraint on his exercise of his trade, and section 27 makes it void, however modest and however reasonable. This is where Indian law parts company sharply with English law, which would test such a covenant for reasonableness and often uphold it.

Superintendence Company of India (P) Ltd. v. Krishan Murgai, AIR 1980 SC 1717.

Facts. A service agreement contained a negative covenant in clause (10) restricting the employee after he should "leave" the company. His services came to an end and the company sought to enforce the covenant.

Held. Per Tulzapurkar J. for himself and Untwalia J., even assuming the covenant was valid and not hit by section 27, it was not enforceable against the respondent. The company should have used language covering every case of cessation of employment for any reason whatever, instead of the word "leave", which in relation to an employee ordinarily means a voluntary leaving of the service and does not include a case where he is discharged or dismissed or his services are terminated by the employer.

Why it matters here. Two things. It is the post employment half of the topic. And it is a drafting lesson worth stating in an answer: the covenant failed on the meaning of a single word. Note also that the report's own catchwords cite "section 57 of the Specific Relief Act, 1963", which is the pre-2018 numbering of what is now section 42 of that Act, dealt with in [Injunction to Perform a Negative Agreement].

What survives after employment

Section 27 strikes at restraints on trade. It does not protect an ex employee who takes what is not his. So the following remain enforceable after the employment ends:

• an obligation not to disclose or use the employer's trade secrets and confidential information;
• an obligation not to take away the employer's records, lists and documents;
• rights under the law of confidence, and under statute in respect of intellectual property.

What is not a restraint of trade

• A sole selling or exclusive dealing agreement, where a trader agrees to deal only in one manufacturer's goods, is ordinarily a business arrangement that regulates trade rather than restrains it, and it is not void merely because it limits choice.
• A restraint on an unlawful trade, because the section protects only a lawful profession, trade or business.
• A covenant during employment, on Golikari.
• Restrictions under a statute or imposed by a licence.

Partnership: where the repealed exceptions went

The Partnership Act 1932 now supplies the rules that Exceptions 2 and 3 to section 27 used to contain, and it is worth naming them because they are the standing statutory exceptions to section 27 outside the Contract Act.

• Section 11(2): partners may agree that a partner shall not carry on any business other than that of the firm while he is a partner.
• Section 36(2): an outgoing partner may agree with his partners not to carry on a similar business within a specified period or specified local limits, and such an agreement is valid if the restrictions are reasonable.
• Section 54: partners may, upon or in anticipation of dissolution, agree that some or all of them will not carry on a similar business within a specified period or specified local limits, and such an agreement is valid if the restrictions are reasonable.

Note that a reasonableness test does appear in these provisions, which is why partnership restraints behave differently from employment restraints.

A worked example

Deepa runs a bakery in Bandra. Consider four covenants.

• She sells the bakery and its goodwill to Emil, agreeing not to run a bakery anywhere in Maharashtra for as long as he runs one in Bandra. Exception 1 is engaged, but the limits must appear to the Court reasonable, regard being had to the nature of the business. A neighbourhood bakery draws its custom locally, so a restraint across the whole State is likely to be held unreasonable, and the covenant fails. Confined to Bandra and its immediate surroundings, it would stand.
• Her employee Faisal agrees that while employed he will not bake for any other business. A covenant during employment. On Golikari it is outside section 27 and enforceable, unless it is unconscionable or one sided.
• Faisal agrees that for two years after leaving he will not work in any bakery within five kilometres. A post employment restraint. Section 27 makes it void, and its modest area and duration do not save it, because there is no general reasonableness test outside Exception 1.
• Faisal agrees never to disclose Deepa's recipes or to take her customer list. Not a restraint on his trade but a protection of confidential information and property. Enforceable after the employment ends.

Now add a drafting point. Deepa's covenant with Faisal says it applies "if he leaves the company". On Krishan Murgai the word "leave" ordinarily means a voluntary departure, so if Deepa dismisses him the covenant would not apply by its own terms, quite apart from section 27.

What it does NOT mean

"A reasonable restraint of trade is valid in India." It is not, except within Exception 1, where reasonableness is applied to the local limits of a goodwill covenant. This is the difference from English law and it is examined directly.

"Section 27 makes the whole contract void." It voids the agreement to that extent only, so the rest of the contract survives.

"An employer can never restrain an employee." During the employment he can, on Golikari, and he may always protect trade secrets and confidential information, before and after.

"Section 27 still has three exceptions." Exceptions 2 and 3 were repealed by the Indian Partnership Act 1932. One remains in the section; the partnership rules are now in sections 11, 36 and 54 of that Act.

"Exception 1 requires the restraint to be limited in time." It does not. It requires specified local limits that appear reasonable, and it lasts only while the buyer carries on a like business there.

Quick revision

• s.27: every agreement restraining anyone from exercising a lawful profession, trade or business of any kind is void to that extent.
• No general reasonableness test. England has one; India does not. Reasonableness appears only inside Exception 1, applied to local limits.
• Exception 1, sale of goodwill: seller may covenant not to carry on a similar business within specified local limits, so long as the buyer or his successor carries on a like business there, the limits being reasonable regard being had to the nature of the business. No time limit in the section.
• Exceptions 2 and 3 repealed by the Partnership Act 1932. See its ss.11(2), 36(2) and 54, which do apply a reasonableness test.
• Golikari, AIR 1967 SC 1098: a negative covenant during employment is not a restraint of trade and is enforceable unless unconscionable or one sided.
• Krishan Murgai, AIR 1980 SC 1717: post employment covenant unenforceable; "leave" means a voluntary leaving and does not cover dismissal or termination by the employer.
• Always enforceable after employment: trade secrets, confidential information, and the employer's records.

Test yourself

1. State section 27 and its exception. 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 saves an agreement by one who sells the goodwill of a business to refrain from carrying on a similar business within specified local limits, so long as the buyer or a person deriving title from him carries on a like business there, provided the limits appear to the court reasonable having regard to the nature of the business.

2. How does Indian law differ from English law on restraint of trade? English law tests such a restraint for reasonableness between the parties and in the public interest and enforces it if it passes. Indian law has no general reasonableness test: section 27 voids every agreement in restraint of a lawful trade to that extent, and reasonableness enters only within Exception 1, where it is applied to the local limits of a goodwill covenant.

3. Is a negative covenant during employment void? No. In Niranjan Shankar Golikari v. The Century Spinning and Manufacturing Co. Ltd., AIR 1967 SC 1098, the Supreme Court held that negative covenants operative during the period of employment, when the employee is bound to serve exclusively, are not in restraint of trade and do not fall under section 27, unless the contract is unconscionable, excessively harsh, unreasonable or one sided.

4. Why did the covenant fail in Krishan Murgai? Because of the word used. The clause restricted the employee after he should "leave" the company, and the Court held that in relation to an employee "leave" ordinarily means a voluntary leaving of the service and does not cover a case where he is discharged, dismissed, or his services are terminated by the employer. So even assuming the covenant was otherwise valid, it did not apply on the facts.

5. What happened to Exceptions 2 and 3 to section 27? They were repealed by the Indian Partnership Act 1932, section 73 and the Second Schedule. Restraints between partners are now dealt with by that Act: section 11(2) for a partner during the partnership, section 36(2) for an outgoing partner, and section 54 on or in anticipation of dissolution, each valid if the restrictions imposed are reasonable.