Non-compete and Non-solicitation Agreements

This article discussing checklist – Addressing Suspected Violations of Non-compete and Non-solicitation Agreements is written by Balaji, pursuing Diploma in Entrepreneurship Administrative and Business Law from NUJS, Kolkata.

Modern day business requires 5 factors of production i.e Land, Labour, Capital, Entrepreneurship and Knowledge. Labour is more used in the context of traditional manufacturing sector. In current day labour has given way to employees with the boom in the service sector.  

In manufacturing sector, the significance of employee’s role is relatively less compared to the service sector. In Service sector the employees’ role in the final revenue generated is significant. This is linked to the quantum of time spent and use of Knowledge (5th factor of production). Knowledge as a factor of production is present even in manufacturing sector.

Knowledge can be in the form of Intellectual property, trade secrets, customer data etc. In organisation, it becomes part of documents/repositories, organisational processes, practices, routines and norms. Knowledge is normally created over a period of time with the help of tireless efforts and costs. Many cases it gives substantial competitive advantage and creates barriers to entry for other players. Thus, employees create significant value with the help of Knowledge which is made available or created by themselves. On the flip side, employees can affect the revenues significantly if they do not perform their role properly or use the Knowledge to which they had access to one employer for the benefit of another employer. This is true even of promoters and directors of new age enterprises.  

Enterprises are required to protect the Knowledge which is created by itself or by its employees from being used by key personnel (which includes key employees, promoters, directors) post their separation from the organisation. To the extent possible, the enterprise should seek protection under Intellectual property laws. This protection is for a long period as determined under the laws. However, certain aspects cannot be protected under the Intellectual property laws. Accordingly, enterprises do not want the key personnel to commence business in similar products/services or join the competition as it would affect their revenues. This is sought to be secured by a non-compete clause in the employment contract. Further, the enterprises seek prohibition of the se of its suppliers/service providers, employees, agents, consultants, clients to ensure that the new enterprise do not get benefit of the industry experience and knowledge. This is sought to be secured by non-solicit clause in employment contract.

With the advent of Globalisation and increased competition in India, non-compete, non-solicit and confidentiality agreements are the latest trends especially in IT and Technology sectors. First step in this process is to ensure that the employment contract is properly drafted. Company secures important rights through the employment contract. Rights includes rights over intellectual property created by the employee during employment, confidentiality of key information, non-compete and non-solicitation etc.,

 

Non-Compete

Non-Compete clause prevents key personnel from competing with the business of the employer during their employment.  It also prevents them from competing with employer post their separation.  Whilst non-compete during employment is legally valid, post contractual restriction is not legally valid.  It is considered as restraint of trade unless it specific and reasonable in terms of time, geography and nature of product / services.  Absolute prohibition from taking up employment with competitor is also not valid.  However, non-compete agreement with key employees, directors and promoters, meeting above restrictions is normally valid.  In certain cases, where the promoter’s shares are acquired by an entity, they also pay non-compete fee to the promoters to ensure that they do not compete with acquirer for a certain period of time.  Objective of a non-compete clause is to ensure that key personnel who have had access to the Knowledge of the enterprise should not utilise it for the benefit of themselves or another employer which affects the revenues of the enterprise.  Further, the key personnel should also not utilise their professional relationship developed during their employment with the enterprise for securing business for new employer or for themselves which would cut into the revenues of the enterprise as it is in the same product/service category.

 

Non-Solicit

Non-Solicitation clause prohibits the key personnel from encouraging the employer’s clients, employees, agents, consultants, suppliers, service providers etc from terminating their relationship with the employer.  They not only terminate their relationship with employer but also join hands with the key personnel in his new enterprise which would facilitate provision of similar services / products.  Non Solicitation clause again would be valid only if it is reasonable in terms of time, geography and product / services.

 

Indian Law

Non-compete and Non-solicit clauses are governed by Section 27 of Indian Contract Act, 1872.  According to Section 27 ‘Every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void’.  Literal interpretation of the section means restraint, whatsoever partial or total, in trade is void to that extent.  It implies that only the concerned clauses in the agreement will be rendered void not the whole agreement. Exception to this provision mentioned in the statute is in respect to the sale and purchase of the goodwill of the business.

The rigid provision of Indian contract Act, 1872 have found exception in specific circumstances as in the case of Nilanjan Golokari v The Century Spinning and Mfg wherein these types of negative covenants have been affirmed.  Thus as stated earlier, reasonable clauses in respect of non-compete, non-solicit are likely to be accepted by the courts.

 

Violation of Non-compete and Non-solicit clauses – Checklist

An enterprise must act quickly when it suspects that some key personnel or former key personnel is violating the above clauses.  Unless the action is taken immediately the enterprise may not be in a position to avoid the impact of the same on itself.

 

Cease and Desist Communication to Key Personnel

As a preliminary step the enterprise might send a cease and desist letter to the concerned key personnel/former key personnel.  Objectives of this communication is as follows

  • It can be used to remind the contractual obligations of the key personnel/former key personnel
  • Communicate that legal action would be initiated if the concerned person does not stop violating

Benefits of this communication is as follows:

  • Some persons respond positively to such communications by stopping the violation.  This would enable avoidance of litigation time and costs.
  • Enterprise can get valuable information of suspected violation.  The key personnel or his counsel would respond to this communication by detailing their perspective and circumstances.  This may give information which was not earlier available to the enterprise
  • It can demonstrate enterprise’s reasonableness in trying to resolve the dispute without court intervention

 

Cease and Desist Communication to new employer

Enterprise might send the copy of the communication or similar communication to the new employer.  This would bring to the notice of the new employer the existence of contractual obligations of his new employee.  New employer might decide not to continue the relationship as he may not want to abet the violation of the new employee.  There is a risk that enterprise might precipitate the situation without complete information on violation or without confirmation of its accuracy.

 

Initiate Legal Action

Enterprise considering legal action to enforce a non-compete or non-solicit obligations should evaluate the following aspects before initiating legal action

  1. Is the impact of the violation likely to be significant enough?  If it is not, there would be considerable wastage of management time and cost.  Potential benefit should justify the pursuance of legal action
  2. Employer has adequate evidence to demonstrate the violation – example any documented evidence or witness who can testify
  3. Would there be negative publicity to the enterprise on account of the legal action which would impact its image
  4. Would the legal action impact the motivation levels of existing employees and have negative impact on performance?
  5. Confidence level of success of litigation based on various factors like evidence available, legal precedents etc.  If the confidence level is low, it may not be worth pursuing for the sake of demonstration of intention.  On the contrary, in case the enterprise is not successful, it may encourage other employees to ignore their obligations under their contracts

If it decides to initiate legal action, it should seek interim relief in the form of injunction against continuation of violation. This would restrict the damage on the enterprise. This in itself would be a effective remedy if the legal action has been taken on time.

 

Summary

The current law in India dealing with non-compete and non-solicit clauses is very rigid.  Various judicial pronouncements have upheld that these clauses beyond the period of service of employee is not legally valid as they are considered as restraint of trade.  Section 27 of Indian Contract Act, 1872 provisions are unambiguous which makes those clauses void.  However, if these clauses are worded reasonably and if it promotes trade and commerce it can be valid.  It must be limited by time and geographical jurisdiction.  Even in that situation, the enterprises would be advised to first seek the path of cease and desist letter and thereafter validate its position in a legal action before pursuing with the same

References:

  1. Indian Contract Act, 1872
  2. NUJS Study Material
  3. Blog in Ipleaders website – Tanay Khanna
  4. Article by Peter A Steinmeyer and Zachary C Jackson

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