The American FTC intends to prohibit non-compete clauses in employment contracts. How will this impact Indian companies and what is a better alternative?
Index
Introduction
Can an employer control what job his former employee takes up after their employer-employee relationship has ended? Non-compete (“NC”) clauses in employment contracts suggest that the answer is ‘yes.’
In India, which is an avowed socialist country, non-compete clauses are almost always void with a single statutory exception. However, in the US, which has a more laissez-faire approach to employer-employee relations, the answer is more complicated.
The US is a true federal nation unlike India which is only quasi-federal. Historically in the US, states have introduced and enforced their own regulations around NC clauses in employment contracts. Therefore, there is a patchwork of regulations in the US. In some states NC clauses are void, in others they are unenforceable; in some states NC clauses only apply to certain categories of workers while in others NC clauses are perfectly valid.
Recently, the Federal Trade Commission (“FTC”) which is the consumer protection and antitrust body at the Federal level of the US (like the CCI in India), issued a notice [1] that it intends to introduce a new rule that would render all NC clauses in employment contracts void.
This is big news for two reasons: (1) if the US, which is seen as the bastion of capitalism, comes down heavily on NC clauses the world will soon follow and (2) for the first time NC clauses have moved from the domain of contract law to competition law.
It might seem strange that historically competition law, not contract law, has largely dealt with non-compete clauses. It stems from the fact that NC clauses in contracts predate modern competition law. Disputes over NC clauses in contracts started appearing in courts as far back as 1711 [2] whereas modern competition law really took shape in the early 20th century especially after the Standard Oil case [3].
Having said all that, why should Indians care? The FTC rule itself may not have any impact in India. However, it is in the FTC’s analysis and reasoning that we find observations that can impact Corporate India.
The FTC Rule
In January 2023, the FTC, issued a notice [1] seeking comments for rule it proposes to introduce. This rule, if issued as-is, would:
- Completely prohibit employers from including any NC clauses in employment contracts.
- Require employers to rescind or amend existing employment contracts and delete NC clauses.
- Require employers to notify existing employees about the FTC rule and that they are not bound by NC clauses.
- Encompass not just full-time employees but independent contractors and gig workers as well.
The FTC estimates that this rule would result in an increase in worker wages of about USD 250 – 296 billion per year across the board. It also expects that the knock-on effects would translate to massive consumer savings for example up to USD 148 billion per year in healthcare costs.
An Interesting Analysis
The most valuable part of the FTC Notice is in its several hundred pages of analysis. This is where the potential impact on India shines through. The most interesting observations from the Notice are:
- The FTC states that employment contracts usually reflect an unequal bargaining power between employer and employee. The FTC also gives startling examples. It refers to the case of a security guard employed by a company that provides security services. The security guard’s employment contract had a NC clause that prohibited him for working for a competing employer within a 100 miles radius for 2 years after termination of the contract! We have noted this unequal bargaining power in a previous article as well.
- The FTC cites research that shows that NC clauses:
- Reduce competition in labour markets.
- Reduce worker wages not just for those workers under NC clauses but also for those workers not directly under NC clauses.
- Negatively impact competition in goods and services by reducing labour mobility.
- The analysis covers both sides of the argument:
- It shows that there is some evidence that NC clauses increase worker earnings within companies. However, this probably comes at the cost of overall reduction in wages across industry.
- In states where NC clauses are void or unenforceable, companies may spend less on training their employees.
- There is some research that suggests that in states where NC clauses are valid, companies spend more on innovation. However, this seems to be money spent on exploitative research i.e., discovering ways to expand profit rather than exploratory research in discovering new products.
- NC clauses impact different classes of workers differently. In the case of senior executives, who are more likely to branch out and set up businesses of their own, NC clauses restrict new business formation and exploratory innovation. This feeds into higher goods and services prices for consumers.
- The rule covers the vanilla form of the NC clause. However, the FTC notes that there are other clauses and provisions not expressly called non-compete which nonetheless operate in the same way if their scope is broad enough:
- Non-disclosure agreements (“NDAs”)/confidentiality clauses.
- No-business agreements.
- Liquidated damages provisions – the worker needs to pay specified damages to the employer if he engages in certain conduct.
- Training Repayment Agreements (“TRAs”) – very similar to employment bonds in India, a departing worker must repay the employer for the money that the employer has spent on his training should he leave before a certain period has elapsed.
- The FTC proposes that its rule will carve out an exception for cases where a person is selling his business or stake in a business to a competitor. There is a very similar exception to the prohibition against restraint of trade under the Contract Act in India.
- Interestingly, the FTC notes that even in states where NC clauses are void or unenforceable, companies continue to include them in employment contracts. This is primarily to scare the employees into toeing the line. In many cases, employees are unaware of the prevailing law regarding NC clauses and therefore do not argue against it.
Situation in India
As we discussed earlier, the law in India is clear – anything in restraint of trade is unlawful. This stems firstly from Article 19(1)(g) of the Constitution which guarantees citizens the freedom to practice and profession or carry on any trade.
Secondly, Section 27 of the Indian Contract Act reiterates the same point. Section 27 does carve out a very restricted exception for those who are purchasing the goodwill of another person’s business. In such cases non-compete can be imposed only for a restricted duration and within a restricted geography.
Many judgements in India on NC clauses have also focused on the provisions of the Specific Relief Act as they pertain to enforcement of such clauses. However, for the sake of this discussion, that Act is a non-starter as the Constitution and s. 27 of the Contract Act make most NC clauses in employment contracts void from the outset.
The most pertinent judgement in India on NC clauses in employment contracts was Niranjan Golikari v. Century Spinning [4]. This judgement on the one hand laid out very clearly the viability of NC clauses in employment contracts only in certain situations while on the other it spawned countless litigations in which employers have relied on the judgement to support their case for the validity of NC clauses.
Facts
The respondent hired the appellant on a fixed contract as part of a specialty textile division. This division used highly sensitive technology that German partners had shared with the respondent, and which was not known to the rest of the industry in India. The appellant left the respondent company prior to his contract’s expiry and took up a position at a close competitor of the respondent. The respondent’s case was that the appellant was contractually prohibited from joining a competitor engaged in the same specialty textile business. It also argued that the appellant had breached a non-disclosure clause and shared the sensitive German technology with his new employer. The appellant argued that the NC clause in his employment contract with the respondent was in restraint of trade and therefore unlawful.
In this case, the Court conclusively ruled that:
- During ongoing employment, a NC clause in the employment contract would be valid and binding on the employee.
- However, NC clauses cannot survive a contract. Therefore, after termination of employment a NC clause is no longer binding on the employee.
- The non-disclosure clauses in the contract were tailored towards the specific sensitive German technology and were reasonably restrictive.
The first point means that ‘moonlighting’ is a breach of contract. However, the second point is more apt in the modern day. No clause in restraint of trade can survive a contract. An employment contract ends once the employer-employee relationship is terminated and therefore this clause ceases to operate. However, there are other clauses that do survive contracts such as confidentiality clauses which courts have reiterated in other decisions [5][6][7].
The issue with the Niranjan Golikari case was that in examining whether the NC clause during an employee’s employment was valid or not, the Court referred to a reasonableness test i.e. whether the restriction imposed by the employer was reasonable or not. The Court used this test specifically within the boundaries of an ongoing employer-employee relationship. However, advocates in later cases have tried to inspire courts to apply this test even to NC clauses post-termination of the employment contract. These efforts have unanimously been fruitless as in India the statute is clear on the point.
We come again to that earlier question – why does the FTC’s proposed rule matter to Indians? As any lawyer reading this and who has drafted employment contracts would know, in India just as in the US, employers routinely include NC clauses in employment contracts to scare employees into toeing the line. The handy ‘severability’ clause allows them to include a void NC clause while sparing the rest of the contract the same fate.
The FTC action is important because it shows the competition authority taking charge of the issue. From the observations earlier in the article, the new FTC rule will require companies to notify their employees about the rule and that NC clauses in their employment contracts are not valid. If the Competition Commission of India (“CCI”) or the Ministry of Corporate Affairs issues a similar rule, the impact would be twofold: (1) there could be some reputational backlash as employees (and social media commentators) become aware en masse that the fearsome NC clauses in their contracts were never valid to begin with and that their employer was always aware of the fact (2) companies who were solely relying on NC clauses would be left high-and-dry without a contingency plan.
Alternatives
Companies mainly impose NC clauses in employment contracts for 2 reasons:
- To prevent competitors from poaching their best employees.
- To prevent departing employees from revealing trade secrets to competitors.
In its note, the FTC has suggested alternatives to NC clauses that companies can employ to achieve the 2 goals stated above:
- Better incentives – this is a no-brainer. If you have a valued employee and you want to retain her, give her a good reason to stay with you.
- Trade secrets – the US has the Uniform Trade Secrets Act within its bundle of intellectual property laws. Companies can use this law to protect their trade secrets which are not patents, copyrights, or trademarks. Unlike the US, India does not have a similar law and in any case enforcement of intellectual property rights remains lax in India.
- NDAs/confidentiality clauses – tailored NDAs can often protect employers from departing employees relaying sensitive information to competitors much better than NC clauses can. More on this in the next section.
Best Practice
In India, confidentiality clauses in contracts tend to be as broad in scope as possible due to any one of the following reasons:
- Lack of effort or disclosure by the client
- Lawyers’ lack of business understanding
- Desire to cover every eventuality
A typical confidentiality clause might look like this:
Confidential Information refers to any data or information relating to the Company and the Client, whether business or personal, which would reasonably be considered to be private or proprietary to the Client and that is not generally known and where the release of the Confidential Information could reasonably be expected to cause harm and/or loss to the Company and/or the client. It is including but not limited to (i) any marketing strategies, plans, financial information, projections, operations, sales estimates, business plans and performance results relating to the past, present or future business activities of the Company or its clients, its affiliates, subsidiaries and affiliated companies; (ii) plans for products or services, and customer or supplier lists; (iii) any scientific or technical information, invention, design, process, procedure, formula, improvement, technology or method; (iv) any concepts, reports, data, know-how, works-in-progress, designs, development tools, specifications, computer software, source code, object code, flow charts, databases, inventions, information and trade secrets; (v) any other information that should reasonably be recognized as confidential information of the Company or its clients; and (vi) any information generated by the receiving party or its representatives that contains, reflects, or is derived from any of the foregoing.
Evidently, the drafting party has attempted to cover all eventualities.
The broader the provisions the falser the sense of safety. The mark of a well-constructed contract is how well it holds up in court.
We submit that the lawyers who have gone through the Niranjan Golikari judgement and have interpreted the ‘reasonableness test’ as a question of ‘what an employer can get away with’ are mistaken. In fact, the reasonableness test should be seen as a guideline on how the contract should be constructed in the first place i.e., anticipatory rather than reactionary.
Here are some guidelines for best practices as regards sensitive information:
- All employees regardless of classification should be subject to the same general confidentiality restrictions such as on physical materials, computer files, customer data. However, instead of relying on the phrase ‘including but not limited to’ the HR and Legal departments should work with other teams to create a definite blacklist of covered items. The inclusive phrase is a crutch to avoid thinking deeply about potential issues.
- Certain categories of workers such as developers, senior executives, HR, Legal etc. will also have access to trade secrets. Each vertical or function head should be responsible for submitting a list of special and specific sensitive information that her vertical/function is privy to and the list of team-members who have access to the information or who will likely gain access to it in the future.
- Team-members in point no.2 should sign further confidentiality agreements containing references to the information in point no. 2 as a mandatory requirement before any such information is shared with them.
- HR and/or Legal departments should have conversations with team members mentioned in point no. 2 to explain the importance of maintaining confidentiality and the legal impact of any breach of it. HR/Legal departments should avoid tick-box emails in lieu of these conversations. Anecdotal evidence, especially from SEBI action against company employees for insider trading, suggests that employees often overlook ‘system-wide emails.’
Different circumstances require different legal approaches when it comes to breaches of employment contracts. However, one example of how the suggested action could work is as follows.
Situation
Company “Innovator” creates a new division to work on a new service. It hires 5 senior executives to helm different parts of the division. The new service is a roaring success. Company “Rival” competes with Innovator. It looks on enviously at Innovator’s new successful service. Rival’s leadership decides to copy the successful new service. Rival understands what makes the new service so great but not exactly how it is put together. Rival creates its own new division and poaches Innovator’s 5 senior executives on handsome pay rises.
Traditional Outcome
Innovator’s attempts to prevent Rival from hiring its 5 senior executives by enforcing NC clauses in their employment contracts would fail as discussed earlier. If in addition to these clauses, Innovator had also included broad confidentiality clauses and raised the issue in court, the senior executives would likely argue that the broad-based confidentiality clauses serve as de-facto NC clauses.
Suggested Action
If Innovator had avoided NC clauses completely, it would not have been in any worse position. By using our suggested best practices, each of the senior executives would be restricted from sharing information about a very specific part of the new service. Moreover, Innovator should have also included a clause requiring the employee to alert management at his subsequent employer if it came to his attention that Rival was impinging on any of Innovator’s trade secrets. Courts would see this additional clause as reasonable and would allow it to survive the employment contract with Innovator.
For example, Innovator could bar the marketing executive from sharing details about the market research the company conducted prior to launching the new service and which determined the service’s positioning and placement. In Court, Innovator would implead all 5 of the senior executives. The argument would be that as all 5 executives contributed to different parts of the project, Rival could not have successfully launched a copycat service unless all the 5 executives had shared confidential information about their own domains. Further, Innovator could also point to the clause requiring the executives to alert Rival about any infringement of Innovator’s trade secrets. This clause would either further incriminate the executive in question or shift the blame onto Rival’s shoulders. In such a case, based on preponderance of probabilities, the Court would likely favour Innovator’s argument (as in the Niranjan Golikari case) and shift the onus on the 5 executives to prove that they did not in fact breach their confidentiality clauses.
References
- “Non-Compete Clause Rulemaking.” Federal Trade Commission, Federal Trade Commission, 5 Jan. 2022, www.ftc.gov/legal-library/browse/federal-register-notices/non-compete-clause-rulemaking.
- (1711) 1 PWms 181 [Mitchell v. Reynolds]
- 221 U.S. 1 [Standard Oil Co. of New Jersey v. United States]
- 1967 SCR (2) 378 [Niranjan Shankar Golikari vs The Century Spinning And Mfg. Co.]
- (1981) 2 SCC 246 [Superintendence Company of India v. Krishan Murgai]
- (2006) 4 SCC 227 [Percept D’Mark (India) (P) Ltd. v. Zaheer Khan And Anr.]
- 2008(3) Mh.L.J. [VFS Global Services v. Suprit Roy]
2 Responses
This is an extremely comprehensive, global, and practical analysis of the non-compete clauses in the contract. The conclusion in the article is apt i.e. clear and reasonable confidentiality clause is a better approach to tackle the threat of sensitive information shared by ex-employees to competitive firms.