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Cutting the Gordian Knot - Restrictive Covenants in Employment Contracts

Feb 27, 2019 | Mumbai (India) |International In-house Counsel Journal

In India, in order to protect trade secrets, confidential information and human resources, it is common for companies and organizations to include ‘restrictive covenants’ in employment contracts. As a general counsel, I always kept a keen eye on these restrictive covenants, their applicability and how it impacts the employer-employee relationship in various geographies specially in India, the United Kingdom and the United States. While on one hand, it is wise to say that any such restraint on the freedom of an individual is against public policy and constitutional rights, on the other hand it is equally unreasonable for employers to suffer the misuse of these liberties by the employees. The departing employees often take the help of advance technology tools, delete the vital information from the machines after copying them and then blatantly misuse the copied information which may be in the form of trade secrets, list of customers, pricing and similar such information. These ex-employees then approach the same customer, give them much discounted price and thus play an important role in taking away the customers of the former employer. They also persuade directly or indirectly, other team members to join the competitor company.

Hence, it is common for the employers to essentially place restrictions and limitations on an employee to deal, solicit or engage with employees and customers as well as on the usage of information that they become privy to during the course of their employment. These are primarily to protect the interest of the employer from competition. In this attempt by the employers to protect themselves from competition, there is a clash with the right of the employees to freely seek employment wherever they choose. The courts have traditionally been hostile to restrictive covenants because they regard them as (i) deprivations of employees’ ability to earn a living, (ii) anti-competitive, (iii) the result of unequal bargaining power between employers and employees, and (iv) contrary to general principle of promoting free labor.

Let us first understand in brief the legal position in India. The Indian Contract Act, 1872 (“Contract Act”), which provides framework of rules and regulations, governing the formation and performance of a contract and deals with the legality of such restrictive covenants. It stipulates that an agreement, which restrains anyone from carrying on a lawful profession, trade or business, is void to that extent. Under section 27 of the Contract Act, agreements in restraint of trade are void. Further, Article 19(1) (g) of the constitution of India, grants every citizen the right to practice any profession, carry on any trade, occupation or business. However, the right to carry on a profession, trade or business is not unrestricted and it can be restricted and regulated by the authority of law and such restrictions have to be reasonable and in public interest.

The restrictive covenants in the employment agreements primarily include non-compete, non-solicitation, confidentiality of information and trade secrets. Till now, the conservative view of Indian courts of holding these restrictive covenants as void, has created a complete ‘Gordian Knot’ in my mind as a general counsel and I started resisting the request coming from business heads to initiate actions against the defaulting ex-employees’ for breach of non-compete and non-solicit covenants as agreed by them in the Non-Disclosure Agreement. I would quote the landmark case laws to them and diffuse their intent to bring the defaulters to task.

Let us take a look at few of the landmark cases on these matters to understand the position in India.

  1.  Allahabad High Court in Bholanath Shankar Dar v. Lachmi Narain1, has observed that “it is unfortunate that Section 27 seriously trenches upon the liberty of the individual in contractual matters affecting trade. Section 27 was enacted at a time when trade was yet undeveloped and the object underlying the section was to protect the trade from restraints. When trade in India was developed to a larger extent, there was no reason why a more liberal attitude would not be adopted by acknowledging such restraint as reasonable”.
     
  2. The Indian courts have drawn a clear distinction between a restriction in a contract of employment which is operative during the period of employment and one which is operative after the termination of employment. The former restrictive covenants which restrict an employee from engaging himself or herself in a trade or business or provide services of similar nature to another master, which are operative during the term of the contract when an employee is bound to serve an employer exclusively are not regarded as a restraint of trade and therefore do not fall under Section 27 of the Indian Contract Act, 1872. In Niranjan Shankar Golikari v. Century Spinning and Mfg. Co. Ltd3. The apex court observed that "A similar distinction has also been drawn by courts in India and a restraint by which a person binds himself during the term of his agreement directly or indirectly not to take service with any other employer or be engaged by a third party has been held not to be void and not against Section 27 of the Contract Act, 1872".
     
  3. In India, an employment contract containing restrictive covenants which will be operative post termination of the contract are unenforceable, void and against public policy and since it is prohibited by law it cannot be allowed by the Indian courts. In Pepsi Foods Ltd. and Ors. v. Bharat Coca-Cola Holdings Pvt. Ltd. and Ors.4, it has been held that "post termination restraint on an employee is in violation of Section 27 of the Indian Contract Act, 1872. A contract containing such a clause is unenforceable, void and against public policy and since it is prohibited by law it cannot be allowed by the Courts injunction. If such injunction was to be granted, it would directly curtail the freedom of employees for improving their future prospects by changing their employment and such a right cannot be restricted by an injunction. It would almost be a situation of "economic terrorism creating a situation alike to that of bonded labour".
     
  4. In Percept D'Mark (India) Pvt. Ltd. Vs. Zaheer Khan and Anr5, the aggrieved respondent had agreed to a right of first refusal in favour of the appellant which extended beyond the term of the agreement. The apex court considered such a contract for personal services to be void and concluded that any restriction extending beyond the term of a contract is clearly hit by section 27 of the Contract Act, and is void. Accordingly the Supreme Court held that "Clause 31(b) contains a restrictive covenant in restraint of trade as it clearly restricts respondent No. 1 from his future liberty to deal with the persons he chooses for his endorsements, promotions, advertising or other affiliation and such a type of restriction extending beyond the tenure of the contract is clearly hit by Section 27 of the Contract Act and is void."
     
  5. In Jet Airways ltd. V. R. Jan Peter Ravi Karnik6, the defendant was employed by the Plaintiff aircraft company as a pilot. The Plaintiff had organised necessary training for the defendant and other pilots. In consideration, the defendant agreed and undertook that during a period of 7 years from the date of completion of training in India and abroad and on resuming actual service with the Plaintiff as First Officer, he would not accept employment, similar in nature, either in full time or part time with any other employer. The defendant resigned from the services for which the plaintiff had invoked the negative covenant clause in the agreement. The Bombay High Court accepted the contention of the defendant that it would be unfair and unreasonable to enforce such a vague and blanket restraint after the period of employment as he has a right to explore new business opportunities and it goes to the fundamental right to earn a livelihood. The court emphasised the requirement on behalf of the employer to substantially prove that the employee intends to misuse or disclose confidential information, trade secrets and IPR of the employer. Unless the employer convinces the court, the freedom of trade, occupation, and business under Article 19 of the constitution shall overrule the implication of such negative stipulations.
     
  6. Another interesting case law is Sandhya Organic Chemicals V. United Phosphorus Ltd., Gujarat High Court held that the onus of proof shall lie on the party who claims the violation of an agreement. Sandhya Chemicals invented a new process of manufacturing aluminium and zinc phosphides and claimed that one of its employee who had known the trade secrets leaked information to United Phosphorus. The employee joined United Phosphorus. After more than two years of leaving Sandhya Chemicals, the employee was alleged to have leaked trade secrets in helping United Phosphorus start selling a similar product using the same process. Sandhya Chemicals brought a suit of injunction against United Phosphorus from making use of the trade secrets by a former employee of Sandhya Chemicals. The court held that unless Sandhya can prove patentability of its product, United Phosphorus can bring out similar products and would have no liability whatsoever towards Sandhya Chemicals. Neither is it liable for making use of trade secrets from an ex-employee of Sandhya Chemicals. This case shows how difficult it would be for any company to actually prove the violation of NDA post employment.
     
  7. The courts in India are flexible in granting an injunction and other reliefs, preventing an employee from breach of confidential information and trade secrets, if proved by the employer with sufficient evidence that information which is categorized as "confidential information" and/or "trade secrets" that has been shared with an employee during the course of their employment has been misused. In order for the information to be classified as "confidential" or "trade secret" it should not usually be within the public domain. Information which can be known to anyone in an employment for a considerable period of time without any special efforts cannot be categorized as "trade secret" or "confidential information". The human skills which are acquired and developed by an employee during the course of an employment cannot be termed as trade secret and an employer cannot be said to have any proprietary rights over such human skills. The Bombay High court in Star India Private Limited v Laxmiraj Seetharam Nayak and Anr.7 held that "Acquisition of excellence is a very long process in the career of every one. No one else can have proprietary rights or interest in such acquisition of excellence. Such excellence cannot be acquired merely by possessing a trade secret of any one".
     
  8. In Wipro Limited v. Beckman Coulter International S.A. the Delhi High Court has laid down the four basic commandments of restrictive covenants. These commandments are based on various judgments of the High Courts and the Supreme Court: (1) restrictive covenants during the subsistence of a contract would not normally be regarded as being in restraint of trade, business or profession unless the same are unconscionable or wholly one-sided (2) post-termination restrictive covenants between employer and employee contracts restricting an employee's right to seek employment and/or to do business in the same field as the employer would be in restraint of trade and therefore void (3) courts take a stricter view in employer-employee contracts than in other contracts, the reason being that in employer-employee contracts, the norm is that the employer has an advantage over the employee and (4) the question of reasonableness as also the question of whether the restraint is partial or complete is not required to be considered at all whenever an issue arises as to whether a particular term of a contract is or is not in restraint of trade, business or profession.
     

The legal position with regard to post-contractual covenants or restrictions has been consistent, unchanging and completely settled in India. In India, while construing the provisions of Section 27 of the Contract Act, neither the test of reasonableness nor the principle of restraint being partial is applicable, unless it falls within express exception contained in Section 27. The exception relates to sale of goodwill of a business under an agreement, whereby the Seller agrees to refrain from carrying on similar business within specified local limits as long as the Buyer or any person deriving title to the goodwill from him carries on a like business, provided that the Court considers such restrictions to be reasonable, regard being given to the nature of business. From a practical aspect Promoters of Indian companies agree to non-compete restrictions for a term of 3 (three) to 5 (five) years post-closing of the transaction within specified territorial limits, in the course of an asset sale and acquisition transaction whereby the business of a company is sold along with the goodwill associated with the business. These restrictions are held to be reasonable and comes well within the exception of Section 27 of the Contract Act.

However, with the changing time, even the long held conservative view on the restraint of trade is changing. The judicial decisions are pointing towards the shift in the mind set. In England, restrains whether general or partial are subjected to the test of reasonableness. In United States of America, the enforceability of restrictive covenants is a matter of state law and not federal law. Most American jurisdictions subject the restrictive covenants to the test of reasonableness which is similar to the law of England, focusing primarily on three aspects (a) the duration of the restriction, (b) the geographic scope of the restriction and (c) the substantive nature of the activity being restricted. Similar reasonability tests are applied to non-solicitation. In the state of California, there is a general prohibition on restrictive covenants which restrict an individual's ability to carry on a business or trade, so restrictive covenants are largely unenforceable in the State of California. The limited exceptions are similar to those under the Indian laws when an individual sells all of his or her business interest in a company or partnership, including the goodwill. He or she can enter into a non-compete covenant. However in those limited situations, California courts will enforce a restrictive covenant, only if it is reasonable in terms of duration, geographic scope and substantive scope as set out above. In United States of America, an employer is permitted to protect its confidential information and trade secrets however the information which the employer seeks to protect as confidential information and trade secrets is put to the rigorous test of whether the information which the employer wants to protect is in fact a trade secret or confidential information. Interestingly, some federal courts in the USA, have adopted a theory commonly referred to as the “inevitable disclosure” doctrine. Under this doctrine, the former employer need not show that trade secret information has actually been disclosed, but rather, that the new position would necessarily require the former employee to rely on trade secret information8.

My experience shows that departing employees have a sense of ownership over the data that they copy. Intellectual property commonly stolen includes customer lists, secret formulas, source code, strategy documents and other trade secrets. The information is then used against the organization when the departing employee goes to work for a competitor or decides to start a new company. Right evidence at the right time plays a significant role in determining the breach of confidential information, while seeking injunction against the ex-employee.

When suspicions of employee data theft arise, it is important to promptly engage a computer forensics expert to perform a theft-of-IP analysis in order to preserve electronic data and uncover important evidence. Using specialized software, the expert can reveal digital footprints such as: (i) USB activity; (ii) Files recently opened; (iii) Cloud storage usage; (iii) Files sent to personal email accounts; (iv) Log of files deleted; and (v) Recently printed documents. The results of the analysis can provide the foundation for legal action such as a temporary restraining order, permanent injunction, subpoena of personal devices, or other litigation to prevent the misappropriation of company data.

It has come through hard learning that, if there are concerns that a departing employee has stolen proprietary data, then it is important to take steps not to delete important electronic evidence located on his or her computer. If the computer is powered on, then leave it on, because important evidence may be stored on the computer’s random access memory and could be deleted if the computer is powered off. Also, ensure that the computer cannot be accessed remotely by disconnecting it from the network. If the computer is already turned off, then place it in secure storage. Furthermore, confirm that the employee’s login credentials are disabled or have been changed, but do not let the IT staff reinstall the operating system or reassign the computer to another employee. Such actions could destroy or overwrite any evidence of wrongdoing. Finally, resist the temptation to “take a peek” at what is stored on the computer by turning it on and accessing files because this could alter the data, thereby making the investigation more complex. If the suspected employee had a company-issued cell phone, place it in secure storage as well. Smartphones hold an abundance of useful information, such as text messages, emails, call logs, Internet activity and more. The simple act of resetting the phone, however, can permanently destroy this data. All these are very critical points, while dealing with preserving the right evidence against the departed employee for seeking the injunction and other judicial remedies.

Finally, I would like to say that though it was not so easy to cut this Gordian Knot, we succeeded in cutting it in a recent case, when we successfully sought the injunction against the defaulting ex-employes restraining them not to approach the clients with whom they have done business with during the course of employment with our company and also not to solicit the services of our employees during the restricted period. Times are changing and the mind-set of judges are shifting. It required wrestling with two competing interests in employment cases where disputes arise after the termination of employment. From the employee’s perspective, the question is, “What can I do when I go to work for a new employer?” From the employer’s view point, the question is, “Can I prevent my former employee from using my trade secrets or confidential information?” Underlying the answers to these basic questions are two competing policy considerations which the courts must attempt to balance. On one hand, employees should be free to use their general skills and knowledge for themselves or for employers of their choice and inthe absence of the misuse of confidential information or breach of a fiduciary duty, employees should be able to compete with their former employers. On the other hand, employers should be able to protect their business assets, tangible or intangible, from being used without authorization and/or to their disadvantage. Employers should not be made to suffer from unfair competition from former employees who may either be in business for themselves or employed by a competitor9.

Divya Kumat has over 22 years of professional experience and has progressively held senior positions in legal and secretarial functions of leading companies in the country. As an Executive Vice President, Chief Legal Officer & Company Secretary of Datamatics Global Services Limited, Divya manages the secretarial and legal compliance functions for more than 30 group companies in India and overseas. She has been actively involved in various in-organic initiatives like joint venture collaborations, mergers, acquisitions, and amalgamation in India and overseas. At Datamatics group companies, she successfully implemented the Contract Management Policy globally, Insider Trading Policy, Whistle Blower Policy, Investor Grievance Policy and enhanced the IPR wealth of the Group by seeking various copyrights, trade mark, service mark registrations in India, the UK, the US, European Union countries, China, Norway, Austria and Switzerland.

Divya is a proud recipient of several awards from the Company as well as the Industry, viz. Outstanding Achievement Award; General Counsel of the Year 2014 – Female; Leading Woman Owned Innovative Project Award; Best Use of Technology & Innovation in Legal; Leading Woman Company Secretary; Excellence Award; Leadership in Execution Award; Merger Execution Award; Leadership in Business Excellence; Quality Award etc. She was also recently listed as top 100 General Counsels of India in 2017 by Legal500. In 2017, she was also awarded as Best IT Legal Business Leader 2017 - India & Global IT & BPO Service Provider of the Year 2017 by AI 2017 and Star Echelon – In-house Category during The Leadership Summit & Excellence Awards, 2017.

Recently Divya was listed as one of the top 125 India’s Finest In-house legal counsels in the 2017 edition of the book released by Indian Corporate Counsel Association in collaboration with Government of India, In-house counsel Worldwide and Asia Pacific Corporate Counsel Alliance.

Divya is commerce and law graduate and is also a qualified company secretary from India and UK securing merit position. She completed her Masters in Law by securing 1st position in the Merit List and was awarded two gold medals.

Prior to working with Datamatics, Divya worked as Legal Head of Computer Sciences Corporation, a U.S. Multinational in India.

 

Datamatics Global Services Limited is a global provider of Information Technology, Data Management, Business Process Management and Consulting services to several Fortune 500 companies.

Datamatics’ core operation focuses on “Data to Intelligence”; i.e. leveraging data to extract intelligence and patterns thereby facilitating smarter and quicker decision making. The company has a four -pronged agenda of providing fully integrated offerings through Smart Processes, Smart Systems, Smart Devices and Smart Data. These offerings are powered by Robotics, Analytics, Artificial Intelligence, and Machine Learning algorithms which offer improved business efficiency in the interconnected world.

 

1) AIR [193] All.83

2) Pollock and Mulla, Indian Contract and Specific Relief Acts, Vol. 1, Lexis Nexis, Butterworths, 2006, New Delhi) 813.

3) (1967) ILLJ740SC

4) 81 (1991) DLT 122

5) AIR [2004] BOM.362  

6) Manu/MH/0434/2000

7) 2003(3) Bom CR563

8) PepsiCo, Inc. V. Redmond, 54 F. 3d 1262 (7th Cir.1995)  

9) Michael G. Horan and Ian D. Werker, “Trade Secrets, Confidential Information and the Employment Relationship”.