In this blog post, Seuj Bikash, an Advocate, presently practising in the Gauhati High Court who is also currently pursuing a Diploma in Entrepreneurship Administration and Business Laws from NUJS, Kolkata, details Lock-in and Penalty Clauses. 

Introduction

The employer-employee relation in a business establishment is generally regulated by an Employment Agreement or contract between the employer or business organisation and the employee since such relation involves serious issues of diverging interests related to employment. It is very normal that the employer and the employee both are motivated and guided by their own interest. It is advantageous for an employer to retain a well-experienced, trained and skilled employee in service of the organisation for a long period. Often the employer has to incur heavy expenses for training of the employee and therefore the employer must have to ensure the interest of his business that such an employee serves his/her organisation at least for a certain period of time. On the other hand, the employee always gets attracted towards better opportunities for advancement of his/her career. In the competitive corporate world, if more lucrative offers come from other employers or business organisations, the employee will not like to miss such opportunities to shine his career. Therefore, the employer often incorporates the “lock in” and “penalty clauses” in the employment agreement/contract so that such an employee can be retained for a definite period of time.

The lock-in and penalty clauses

The lock-in clause is that specific clause in the employment agreement which sets a particular time-frame within which the employment agreement cannot be terminated by either any one or both parties to the employment Agreement. If any party to the agreement violates the said clause, then such violation is regarded as a breach of the agreement/contract and in accordance with the law of contract breaching party have pay to pay a sum, which is generally a heavy one, stipulated in the agreement to the aggrieved party. The employer also incorporates penalty clause in the employment agreement to recover the expenses incurred by him on the training or skill development of the employee. Though incorporation of such clauses helps in controlling the attrition rates of employees in the business organisation, often such clauses are being regarded as objectionable by the Indian Judiciary. Usually, the damage amount fixed in the employment agreement is inconsistent with the income of the employee for which the employee is compelled to serve the employer for a long duration. In such condition, a specific provision of the Indian Contract Act,1872 is invoked to protect the interest of the employee, i.e., the section 27 of the said Act which provides 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. However, a remedy is also available to the employer under the same Act who has incurred expenses on training and skill development, etc. of the employee so that such expenses may be recovered by the employer, that is, section 73 of the Act. The section-73 of the India Contract Act states that when a contract has been broken, the party who suffers from such breach of contract is entitled to receive, from the party who has broken the contract, compensation for any loss or damage caused to him thereby, which naturally arose in usual course of things from such breach, or which the parties knew when they made the contract, to be likely to result from the breach of it. From this provision in the law of contract it appears that only in respect of those losses or damages which occurred naturally in usual course of things can be received by the aggrieved party to the contract and the aggrieved party is entitled only to such damages as will compensate him for loss suffered to the extent that such loss or damages are reasonably foreseeable as resultant of such breach. This principle of the law of contract is directly applicable with regard to the lock-in clause in the employment agreement. Therefore, in determining the amount to be paid as compensation for breach of the lock-in clause, the courts in India use to rely on the actual expenses incurred by the employer which is a reasonable amount incurred by the employer on the employee’s training, skill development, etc. To determine what will be the exact amount to be paid by the employee to the employer for such breach, the court has to look in to the fact and circumstances of each case and the proof of damages produced by the employer.

The section 74 of the Indian Contract Act, 1872 is worth mentioning in relation to the penalty clause in an employment agreement/contract. The section 74 of the Indian Contract Act,1872 states that when a contract has been broken, if a sum is named in the contract as the amount to be paid in case of such breach, or if the contract contains any other stipulation by way of penalty, the party complaining of the breach is entitled, whether or not actual damage or loss is proved to have been caused thereby, to receive from the party who has broken the contract reasonable compensation not exceeding the amount so named or, as the case may be, the penalty stipulated for. Often the employer includes a specific penalty clause in the employment agreement/contract/bond which requires an employee to agree beforehand to pay a fixed sum to the employer by way of penalty in the event of a breach of the agreement by the employee, irrespective of any actual damages or loss. Therefore, in many occasions, the courts in India had to face with the question whether the said section 74 of the Indian Contract Act, 1872 could be strictly applied to compel the employee to pay the sum which the employee earlier agreed to pay to the employer in case of breach of the employment agreement by him. The courts in a number of cases have taken the stand that even if the employment-agreement/contract/bond may stipulate payment of any penalty amount in the event of breach, it does not mean that the employer shall be entitled to receive the stipulated amount in full as compensation on the occurrence of such default; rather the employer shall be entitled only to reasonable compensation as determined by the court.

In Chand Thapar and Bros.(P) Ltd. Vs. H.H. Jethanandi, 76 CWN 338,a matter before the Calcutta High Court, it was held (in paragraph no.10 of the Judgement) that the parties to a contract may at the time of entering into it provide that in case of any breach, the party in default shall pay the other a certain specified sum. That sum may be liquidated damages. In such cases, it is not to be interfered by the Court. It is well settled that the essence of the liquidated damages is a genuine covenanted pre-estimate of damage. U/s 74 of the Indian Contract Act, when liquidated damages are entered into a contract itself as payable in the event of a breach, then the damages payable when a breach occurs, are to be assessed in the ordinary way subject to that fixed amount as maximum; and it is for the employer to prove the exact amount of damages which he suffered and that amount only could be awarded. The sum named in the contract itself, is not the conclusive evidence. The employer shall have to prove his damages irrespective of the specified amount in the contract. Therefore, the employer cannot get a decree for damages unless he proves that he has suffered loss or damages.

Validity of Negative covenant and injunction against the employee

The agreement/contract which prevents a party to the agreement/contract from doing specific things is called a negative covenant. Some negative covenant restrains the employee from serving other company or organisation involved in similar types of businesses during the course of employment, and some negative covenants do the same even after the course of employment, i.e., even after the end of the terms of employment stipulated in the employment agreement. The objective of the negative covenant is to protect the trade secrets of the employer and to restrict the employee from using the confidential information, skills, knowledge acquired from training provided by the employer and activities of the employer acquired by the employee during the service period for personal benefit of the employee himself or that of similar other business organization. In a number of cases decided by the Honourable Supreme Court, the Apex Court has observed that negative covenants during the course of employment are valid in the eye of the law, but the same operating after the termination of employment are void. The findings of the Apex Court, in Niranjan Shankar Golikari Vs The Century Spinning and MFG. Co. Ltd. reported in AIR 1967 SC 1098 may be referred in connection with this particular point of law. In that case, the Apex Court observed that- the considerations against covenants are different in cases where the restriction is to apply after the termination of the contract than those cases in where it is to operate during the period of the contract. Negative covenants operative during the period of the contract of employment when the employee is bound to serve the employer exclusively are generally not regarded as restraint of trade and therefore do not fall u/s 27 of the Indian Contract Act. A negative Covenant that the employee will not engage himself in trade or business and will not get himself employed by any other master for performing 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. An important question decided in the same case was whether the injunction to enforce a negative covenant can be granted by the court. It was held that there is nothing to prevent the court from granting a limited injunction to the extent it is necessary to protect the employer’s interests where the negative stipulation is not void.

Thus, from the above discussions it can be asserted that though the court may grant injunction to enforce negative covenants, such power should be utilised carefully considering the different facts and paradigms that may vary from case to case, such as excessive harshness of the contract, its opposition to the public policy and good conscience, etc. The court has to see while enforcing the negative covenant that the employee should not be unnecessarily and unjustly driven to idleness or sent back to the respondent organisation to serve in lieu of an inappropriately lesser remuneration. Above all, the yardstick of reasonability must always be observed.

Conclusion

Trained, skilled and experienced employees are inexorably important resource of a company or business organisation for its continuous growth in the competitive corporate world. But, such an employee looking for better opportunities cannot be compelled to serve a particular employer for a long period by mere incorporation of lock-in and penal clauses in the employment agreement or by negative covenants since protections are available to the employee in the law of contract and precedents. Therefore, the employer organisations often take some indirect methods to achieve the same end. The employers often introduce a system of granting a discretionary bonus to the employee. The discretionary bonus or performance related reward, if the employee has left the organisation before the period stipulated in the employment agreement, are withheld by the employers. Sometimes there is a provision for withholding the same if the employee fails to reach a target fixed in the contract. Some employers also adopt a system of granting a bonus or cash-based incentive to the employees who serve the company for a minimum threshold period. Policies to encourage career growth or advancement, promotion to higher ranks within the same organisation, etc. are also undertaken by various business organisations. Such policies which provide mutual benefits to both employer and employees are certainly more efficacious to prevent attrition of employees within the Organization than the compulsive provisions incorporated in the employment agreements/contracts/bonds.