Restraint of Trade Agreements: Law and Exceptions

The General Rule: Section 27 of the Indian Contract Act, 1872

Section 27 of the Indian Contract Act, 1872, is a cornerstone of Indian contract law, specifically dealing with agreements in restraint of trade. Its wording clearly states that any agreement that restricts a person from engaging in a lawful profession, trade, or business is void to that extent. This rule is designed to:

• Promote Free Trade and Competition: It prevents the creation of monopolies and ensures a competitive market environment.
• Protect Individual Liberty: It safeguards an individual's fundamental right to earn a livelihood, enshrined partly under Article 19(1)(g) of the Indian Constitution (Freedom to practice any profession, or to carry on any occupation, trade or business).
• Prevent Undue Hardship: It protects individuals from being bound by agreements that severely limit their ability to secure employment or engage in business.

A key distinction between Indian and English law on this matter is the "test of reasonableness." English law, as established in cases like Nordenfelt v. Maxim Nordenfelt Guns & Ammunition Co. [1894], permits restraints that are reasonable in scope, geography, and time, and are not contrary to public policy. However, Indian law, as interpreted by courts since early cases like Madhub Chunder v. Raj Coomar (1874), does not explicitly recognize this doctrine of reasonableness for agreements in restraint of trade, making even partial or limited restraints void unless they fit into recognized exceptions.

Circumstances Where Agreements in Restraint of Trade are Considered Valid (Exceptions)

Despite the general prohibitory nature of Section 27, certain agreements are considered valid either by statutory provision or judicial interpretation. These exceptions balance the public policy against restraint of trade with legitimate business interests.

1. Statutory Exceptions

The Indian Contract Act, 1872 itself provides one direct exception, and the Indian Partnership Act, 1932, adds several others.

• Exception to Section 27: Sale of Goodwill
  • When a person sells the goodwill of a business, they may agree with the buyer to refrain from carrying on a similar business within specified local limits. This restraint is valid, provided such limits appear to the court to be reasonable, having regard to the nature of the business.
  • This exception protects the buyer who has paid for the reputation and customer base of a business, ensuring they can reap the benefits of their purchase without immediate competition from the seller.
• Indian Partnership Act, 1932
  • Section 11(2): Restriction on an Existing Partner: Partners may agree that none of them will carry on any business other than that of the firm during the continuance of the partnership.
  • Section 36(2): Restriction on an Outgoing Partner: A partner may, upon ceasing to be a partner, agree with the other partners that they will not carry on any business similar to that of the firm within a specified period or within specified local limits, provided the agreement is reasonable.
  • Section 54: Restriction on Partners upon Dissolution of Firm: Partners may, in anticipation of the dissolution of the firm or upon dissolution, agree that some or all of them will not carry on a business similar to that of the firm within a specified period or within specified local limits, provided the agreement is reasonable.
  • Section 55(3): Restriction on Sale of Goodwill of a Firm: On the sale of the goodwill of a firm, a partner may make an agreement with the buyer that such partner will not carry on any business similar to that of the firm within a specified period or within specified local limits, provided the agreement is reasonable.

2. Judicial Exceptions/Interpretations

Courts in India have, through various pronouncements, carved out certain situations where negative covenants, particularly in employment contracts, are deemed valid. It is crucial to distinguish between restraints during employment and post-employment restraints.

• Restraints During the Period of Employment (Service Contracts)
  • Courts have consistently held that negative covenants operating during the period of employment are generally not considered to be in restraint of trade under Section 27, provided they are reasonable and not excessively harsh or unconscionable.
  • The rationale is that an employee is expected to serve their employer exclusively during the term of the contract and not compete with the employer while still employed. This protects the employer's legitimate business interests, trade secrets, and confidential information.
  • Case Law: In Niranjan Shankar Golikari v. The Century Spinning and Manufacturing Company Ltd. (1967), the Supreme Court upheld a negative covenant preventing an employee from serving elsewhere or divulging trade secrets during the term of employment. The Court differentiated between restrictions operating during and after the contract's termination.
• Protection of Trade Secrets and Confidential Information (Post-Employment, with caveats)
  • While post-employment non-compete clauses are generally void, courts have recognized a limited exception for covenants specifically designed to protect genuine trade secrets, proprietary information, or confidential data.
  • Such restrictions must be reasonable in scope and duration and directly related to protecting specific confidential information, not merely to prevent competition. The burden is on the employer to prove the existence and use of such secrets.
  • Case Law: In cases like Wipro Ltd. v. Beckman Coulter International S.A. (2006), courts have indicated that while direct non-compete after employment is difficult to enforce, protection of confidential information through other means (e.g., injunctions against using such information) is possible.
• Exclusive Dealing Agreements
  • Agreements where a manufacturer agrees to supply goods to only one distributor, or a distributor agrees to deal only with one manufacturer, can be valid if they are reasonable and do not lead to a monopoly or significant restriction of competition. The focus is on regulating trade, not restraining it absolutely.
  • For example, an agreement between a publisher and an author for exclusive publishing rights for a specific period is generally valid.
• Trade Combinations
  • Associations of traders formed to regulate business or fix prices are generally valid if they are not aimed at creating a monopoly or acting against public interest. For instance, an agreement among cinema owners in a locality to regulate timings or prices may be valid if it aims at promoting their common interest without causing public detriment.

Comparative Analysis: Indian vs. English Law

Feature	Indian Law (Section 27, ICA)	English Law (Common Law)
General Rule	All agreements in restraint of trade are void, even partial restraints.	Agreements in restraint of trade are prima facie void, but can be valid if reasonable.
Test of Reasonableness	Generally not applicable, except in the specific statutory exceptions (like sale of goodwill) where limits must be reasonable.	Central to determining validity; restraint must be reasonable in the interests of both parties and the public.
Statutory Exceptions	Explicitly provided for sale of goodwill (Section 27 Exception) and under the Indian Partnership Act, 1932.	No direct statutory provision, relies on common law principles and case precedents.
Judicial Interpretations	Strict interpretation; generally upholds restraints during employment but invalidates most post-employment restraints, with narrow exceptions for trade secrets.	More flexible; allows for reasonable post-employment restraints if necessary to protect legitimate business interests (e.g., trade connection, trade secrets).