Agreements in Restraint of Trade under Indian Contract Act, 1872

By Disha Bhardwaj 11 Minutes Read

Introduction

According to Indian Contract Act, one of the essential requirements to form a contract is that it should not be void as provided in Section 10, which says, “All agreements are contracts…that are not hereby expressly declared to be void”. Chapter II of the Act titled voidable contracts and void agreements provides a range of agreements that are expressly declared void, agreements in restraint of trade is one such provision prescribed under Section 27.

Agreements in restraint of trade are defined as those agreements by which one is restrained from exercising lawful trade, profession or business of any kind in return for some consideration.

Therefore, in simple terms, the agreements that prevent an individual from pursuing an act termed as trade or business in the way they like are termed as agreements in restraint of trade and are declared void or invalid.

This provision also backs the fundamental right mentioned under Article 19 (1) (f) of the Indian Constitution, which states that all citizens shall have the right to practice, propagate and profess any occupation, trade, business.

Foundation in common law

The basis of delegitimizing agreements in restraint of trade is to realize two purpose, first to establish free markets and secondly to induce and inculcate the competitive spirit in the market as if these agreements were to gain force the competition structure of the markets would collapse as the  bigger firms would simply eliminate competition and establish monopolies .  

The current stand is derived from the case of Nordenfelt v Maxim Nordenfelt Guns and Ammunition Co Ltd. [1]  in which Thorsten sold his business to a company, which then transferred the business to Maxim Nordenfelt. At this time, Thorsten entered into an agreement with Maxim that he would not engage in the manufacture of guns for 25 years, other than what he manufactures on behalf of the company. Later, Thorsten broke his vow claiming that the agreement was not enforceable as it was in restraint of trade. The decision of the court was in Thorsten’s favor.

In common law the test of reasonability is imposed to determine the validity of the restraint which basically validated the restriction if it

o   The party imposing has a valid interest to protect

o   The restraint is no more than necessary

o   The restraint is not contrary to public interest

Nature of validity of the agreements

● The nature of these agreements is void, that is invalid but they are not illegal, which essentially means that one can enter into such agreements but they are not enforceable and hence, if one of the parties to such agreement fails to comply by the terms the other cannot take up any action against such failure of compliance.

The aggrieved party cannot take the matter to a relevant court or tribunal to have his rights enforced as the agreement was void in the first place thereby implying absence of any obligations to have been imposed.

● The Madhub Chunder v. Rajcoomar Dass [2] case is a landmark judgment that elucidates the Indian judiciary’s strict stance on agreements that restrain trade, reinforcing the legal principle that such agreements are void, barring very limited and specific exceptions.

In this case according to the agreement, the plaintiff promised not to carry on a particular business within certain geographical limits in exchange for money from the defendant. Specifically, the plaintiff was restrained from conducting the business of manufacturing and selling ice within the city of Calcutta; the Calcutta High Court later held that the agreement was void under Section 27.

Exceptions to the provision

There are certain conditions that are excused from the application of the general rule of the provision under which the agreements are considered as void such as:

1. Sale of goodwill

● Goodwill is not a physical attribute of a firm but rather an intangible asset that holds value in terms of brand value and reputation which further inculcate loyalty and certain behavior within the customers.

● When the sale of goodwill is made there are certain restrictions that are permitted in favor of the buyer but these restrictions ought to be within certain bounds such as :The seller can be restrained only from carrying out a similar business.

a. The restraint can be applied only to certain local limits.

b. The limits/restraint should appear to be reasonable.

● In order to establish goodwill, it is necessary to carry out the business; a mere license permitting a certain business would not imply that there is a goodwill of that business if no manufacturing is carried out.

For instance: If A obtains a business to produce liquor and he does not produce the liquor he cannot claim a goodwill out of such business.

● In the case of Chandra v. Parshulla [3] the plaintiff was the owner of a fleet of buses that used to ply between Pune and Mahabaleshwar. The defendant also had a similar business in the same area. To avoid competition, the plaintiff bought the defendant’s business along with the goodwill, and by contract made him agree not to open a similar business in the area for 3 years. The defendant did not comply and started his business. It was held by the court that the agreement was valid, as it fell within the exception to S.27.

2. Provisions of partnership act

● There are certain provisions in the partnership act 1932 according to which due to the ties between those who enter and carry out joint business also known as partners can regulate the act of each other due to the bounds of the partnership relationship.

These provisions are :

a. Section 11(2) – an individual who is a partner of the firm must not carry business of their own while being in the partnership.

b. Section 36 (2) – between partners to not engage in a similar business as that of the said firm within specified territorial and time limits.

c. Section 54 – Under the anticipation of dissolution of the firm the partners will not carry on a business similar to that of the firm.

d. Section 55 (3)-  Any partner may, upon the sale of the goodwill of a firm, make an agreement with the buyer that such partner will not carry on any business similar to that of the firm.

● All of the restrictions laid down above are however subject to bounds of specific time period and local territorial boundaries to be reasonable.

● In the case of Firm Daulat Ram v. Firm Dharm Chand [4] the two parties had entered into an agreement that included a restrictive covenant. According to this agreement, the plaintiff was restrained from carrying on a particular trade within a certain geographical area. The agreement aimed to prevent competition between the firms in a specific market. The Lahore High Court held that the restrictive covenant was void and unenforceable

Conclusion

The provision of agreements in restraint of trade under the Indian Contract Act enables the individuals to carry out the business they prefer on their own terms and thereby declares all the hindrances with this respect to be void.  The basis of this provision is to establish an open sphere of interaction and competition within various components in the market. However there are certain exceptions which permit certain reasonable restrictions to be imposed, sales of goodwill allows the buyer to be able to avail certain restrictions against the seller in order to ensure the former avoids losses. Similarly the partnership act also imposes certain bounds to enclose the individuals having partnership ties, their loyalty towards the firm they are all associated to must be kept intact and hence there are certain regulations that govern their conduct.

[1] [1894] AC 535 

[2] (1874) 14 Beng LR 76

[3] 28 Indian Appeals 190

[4] AIR 1942 Lah 13

Disha Bhardwaj