M J Antony: Restrictive clauses in contracts

OUT OF COURT

A quarter-century-old suggestion of the Law Commission on freedom of trade is still ignored.

The growing competition in trade and commerce now compels parties to closely watch the terms of contracts they sign. There might be "negative covenants" that restrict the freedom of the parties to deal with rivals in the field. For instance, a franchise agreement might restrict a franchisee's right to do business in competing goods and services. A professional might be restrained from leaving his job and joining a rival company. A celebrity might have signed an agreement limiting his right to endorse another product.

Though Section 27 of the Indian Contract Act deals with such agreements, cases do arise often these days raising the issue of freedom of profession, trade and business. One recent instance was the Supreme Court decision in Percept D'Mark Pvt Ltd vs Zaheer Khan. The renowned fast bowler of the Indian cricket team entered into a promotion agreement with the company, which carries on business in event management and celebrity endorsement. According to the contract, the company was to act as the exclusive agent to market and manage media affairs for the cricketer for three years. After the stipulated period, he dropped this company and chose another, leading to arbitration proceedings in the Bombay High Court. Dissatisfied with the high court order, it moved the Supreme Court, which dismissed its appeal.

According to Section 27, every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void. The crucial clause in the agreement in this case was the one containing the right of first refusal. Under this term, the company was to be given an opportunity to match any third party offer made to Khan before he could be permitted to enter into the third party agreement. If the company failed to match the third party offer, Khan could go to the third party. Otherwise, he had to stay with the original company. Khan's argument was that this clause amounted to restraint of trade referred to Section 27 of the Contract Act.

The Supreme Court crystallised the rule in Section 27 thus: A restrictive covenant extending beyond the term of the contract is void and not enforceable. The doctrine of restraint of trade does not apply during the continuance of the contract of employment and it applies only when the contract comes to an end. This doctrine is not confined only to contracts of employment, but is also applicable to all other contracts.

Applying these rules, the court found that the first refusal clause in this case amounted to restraint of trade as it curtailed the cricketer's future liberty to deal with companies of his choice for endorsements, promotions, advertising or other affiliations. Moreover, the contract had already expired.

The court, however, did not go into certain serious problems with the provision in the contract law, pointed out in certain earlier judgements, like Gujarat Bottling Co vs Coca Cola. In that decision of 1995, the contract between the two companies contained a negative covenant. It barred GBC from manufacturing, bottling, selling or dealing in products of any other brands. GBC argued that the term amounted to restraint of trade. This was rejected by the Supreme Court.

The Coca Cola judgement, nevertheless, pointed out that Section 27 required amendment. The thirteenth Law Commission report also had recommended an amendment to the Contract Act. It suggested a change in the law to allow such restrictions, general or partial, as were reasonable in the interest of the parties. This was in tune with the law in England and several other countries. Though a quarter of a century has passed since the report was submitted, the law-makers have not taken up the issue so far. This indeed is a serious lapse.

The provision was reportedly lifted from David Field's draft code for New York that was based on the old English doctrine of restraint on trade prevailing in ancient times. The provision was never applied in New York. The adoption of the rule has been severely criticised by jurists. Sir Frederick Pollock has observed that "the law in India is tied down by the language of the section to the principle, now exploded in England, of a hard and fast rule qualified by strictly limited exceptions." The high courts in the country have held that neither the test of reasonableness nor the principle that the restraint being partial or reasonable are applicable to a case governed by Section 27 of the Contract Act.

Modification of the law is necessary as situations are bound to arise in this liberalised era where restraint on trade could prevent advancement of commerce. On the other hand, some restrictive covenants might be good if they are reasonable and necessary for freedom of trade. In the absence of a clear provision, the courts now use their discretion to interpret the agreements as they deem proper.