Niggling non compete clauses

Newspapers have widely reported that the very public Ambani feud is ending with, among others, a ten-year non compete clause whereby, neither of the Ambani brothers will promote companies or enter into joint ventures that compete with the existing companies headed by the other. Are such clauses legal?

At the outset, let it be understood that there is no single non-compete clause in law and no single answer to the question unless one is prepared to contextualise the question. The classic non-compete prohibits one party from competing in the same type of business as the other party for a specified period within a specified geographical area: distribution and dealer contracts across India are littered with such restrictions. These days, many key employee contracts carry a modified version of this basic theme especially in technology- intense industries. Again, joint venture agreements commonly feature non-competes that prevents partners from competing with their own joint venture entity or investment in a competitor. Whatever be the form of the restriction, at the end of the day, it is basically a contract and the law would honour it if it were a legal and enforceable contract.

Section 27 of the Indian Contract states that “every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind is to that extent void.” This stringent rule is subject to a single exception: “One who sells the good-will 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 good-will from him, carries on a like business therein; provided that such limits appear to the court reasonable…” The Indian Partnership Act permits further exceptions to the rigours of Section 27. Between Section 11, 36, 54 and 55, partners cannot compete with their partnership firm while they are partners and can’t compete after they exit if that is written into the dissolution deed. Indian law is replete with cases where non compete clauses between partners have been upheld and the Hukmi Chand case [AIR 1980 Raj 155] is one such instance.

One can of course legitimately argue that the law on partnership non-competes is legislated and cannot inspire a general belief in the enforceability of non-compete clauses in India. Since specific laws do not cover joint venture agreement type of non-compete clauses or the Ambani family split, there is some room for skepticism, but let us look at the direction the Indian law is taking.

Well into the 1980’s, the Indian courts were very “constructionist” in the way they viewed non-compete clauses and the Bakelite Hylam Ltd. v S.J. Hasan , [(1985) 1 Lab.LJ 438] is typical of the genre. An analysis of the judgment brings out the following legal principles:

  1. when a non-compete contract is challenged, the court must determine if it constitutes a restraint on trade;
  2. A contract which restrains trade is prima facie void;
  3. Restrictions operating during the period of contract of employment are valid unless unconscionable or excessively harsh or unreasonable;
  4. Restrictions operating beyond the termination of service are void;
  5. The test of reasonableness does not apply to post service restrictions.

Short of the legalese, what this means is that a restrain while we have a relationship is fine but a continuing restrain after the business relationship ends is not. As I see it, this distinction is completely arbitrary because many business relationships exist only because restraints exist after the relationship ends! Illustratively, franchises, distributorships, dealerships and similar unincorporated business partnerships are growing exponentially in India as our economy accelerates. The business community is constantly experimenting with alternative alliances and groupings and many involve informal partnering and project specific consortium action to which there is no legislative sanction. If you think about it, these non-compete clauses facilitate trade, rather than impede it: Who in his right mind will informally partner to achieve a larger purpose or share business information but for non-compete clauses? We could well ask the question: does Section 27 restrain trade or facilitate it?

In 1995, the Supreme Court, in the case of Gujarat Bottling Co. Ltd. v Coca Cola Co . [AIR 1995 SC 2372], had to deal with facts to which the obvious and legislated exceptions to Section 27 did not apply. Here, Coca Cola had licensed Gujarat Bottling Co. to bottle and sell the beverage subject that Gujarat Bottling could not manufacture, sell, deal or otherwise associate with competing products. When Gujarat Bottling breached the covenant, the matter went up to the Supreme Court, which held that “a negative covenant that the employee would not engage himself in a trade or business or would not get himself employed by any other master for whom he would perform similar or substantially similar duties, is not therefore a restraint of trade unless the contract as aforesaid is unconscionable or excessively harsh or unreasonable or one sided….”

This decision represented a substantial departure from previous case law and probably points to the future. Naturally, reasonableness must be judged from case to case but guidance comes from a succession of decisions on what constitutes reasonableness. Illustratively, in the case of Niranjan Shanker Golikari v Century Spinning and Manufacturing Co. (AIR 1967 SC 1098) . A shift supervisor was held bound to his non-compete obligations because his employer acquired German technology for its tire cord yarn plant subject to stringent confidentiality restrictions. Similar restraints were upheld by the Delhi High Court in Modern Food Industries India Pvt. Ltd. v Shri Krishna Bottlers Pvt. Ltd., [AIR 1984 Del 119], which has held that the validity of a restraint will generally depend on (a) the proprietary interest sought to be protected; (b) the reasonableness of the restriction; and (c) the larger public interest.

In conclusion then, it is clear that in the years to come, non-compete clauses are likely to be upheld even if they kick in after contractual relation ends. Concern, if any, flows from the Delhi High Court’s ‘larger public interest’ observation in the Modern Food Industries case because what you think is in the public interest, is often, a matter of whose horn you blow. Given the vast quantities of taxpayer’s money that has disappeared into the black hole of the milling industry, was nationalisation of the jute and cotton mills in the public interest? Was the nationalisation of banks in the public interest? Given the inflated property prices and the vast slums we have to deal with today, was rent control in the public interest? Over the years, courts have held that these, and many other similar laws, have been both for and against public interest!

I would think that sooner or later, a non-compete clause will be challenged not on the ground that it is unreasonable, but because it is against the public interest. Section 3 of the Competition Act 2002 prescribes that: “No enterprises or persons shall enter into any agreement in respect of production, supply, distribution, storage, acquisition or control of goods or provision of services, which causes or is likely to cause an appreciable adverse effect on competition within India.” Further sub-section (2) provides that “any agreement entered into in contravention of the provisions contained in sub-section (1) will be void.” I am afraid, the courts are yet to address this question and given the market dominance of the Ambani Empire, it is a very good question.

Indeed, an even bigger question arises. Listed Reliance entities are arguably binding themselves to non-compete clauses to meet the personal agendas of individual shareholders with no visible benefit to the company. Given the dilemma, would Indian courts hold that these agreements are void and without consideration or will they hold that acquiring a single controlling owner — as opposed to feuding multiple owners — is itself a value driver so huge that it is both reasonable and in the public interest?

Originally Published on July 11, 2005 in Businessworld


Add Your Comments

Your email address will not be published. Required fields are marked *