Source: Supreme Court 

Why in News? 

Recently Justices PS Narasimha and Joymalya Bagchi resolved the contentious issue of whether employment bonds are valid and legally enforceable in India while upholding the validity of employment bond agreements that mandate minimum service periods or impose financial penalties for early resignation. The Court ruled that such clauses do not violate Section 27 of the Indian Contract Act, 1872, which prohibits restraints on trade, provided the restrictions operate only during the period of employment. 

• The Supreme Court held this in the matter of Vijaya Bank & Anr. v. Prashant B Narnaware (2025). 

What was the Background of Vijaya Bank & Anr. v. Prashant B Narnaware (2025) Case? 

• The case centered around a contentious clause in Vijaya Bank's employment contract with a respondent-employee, which required him to serve a minimum of three years or pay a penalty of ₹2 lakh for premature resignation. 
• The respondent, a Senior Manager-Cost Accountant, had resigned before completing his tenure to join IDBI Bank, triggering the penalty clause. 
• Challenging the bond's validity, the employee argued that it violated Section 27 of the Indian Contract Act, 1872, as the imposition of Rs. 2 lakh penalty for early exit prohibited him from joining new employment. 
• The respondent further argued that the penalty clause was opposed to public policy as he was compelled to comply with the illegal condition of depositing Rs. 2 lakh, which he had done under protest. 
• The state opposed the validity of employment bonds, contending that such restrictive covenants amount to restraint of trade and are against public policy. 
• The case involved interpretation of Section 27 of the Indian Contract Act, 1872 (ICA) and the balance between employer's legitimate interests and employee's freedom of trade. 

What were the Court's Observations? 

• A bench of Justices PS Narasimha and Joymalya Bagchi held that employment bonds are legally valid and enforceable when imposing reasonable conditions. 
• The Court emphasized that public sector undertakings have legitimate interest in retaining skilled employees and avoiding expensive recruitment processes. 
• The Court justified the ₹2 lakh penalty as proportionate for a Senior Manager (MMG-III) drawing lucrative salary, stating it was "not so high as to render resignation illusory." 
• The judgment clarified that restrictive covenants operating during employment subsistence do not violate freedom of trade or employment under Section 27.

Legal Principles Established

Restrictive Covenants During Employment: 

• The Court held that restrictive covenants operating during the subsistence of an employment contract do not put a clog on the freedom of a contracting party to trade or employment. 
• Section 27 does not apply to restrictions that operate only during the period of employment and do not prevent the employee's right to seek other job opportunities post-resignation. 
• The Court referenced Niranjan Shankar Golikari v. Century Spinning Co. (1967) which upheld reasonable restrictions during employment but struck down post-termination bans. 
• In Superintendence Company (P) Ltd. v. Krishan Murgai (1981), the Court upheld the validity of restrictive covenants during the subsistence of a contract. 

Public Policy Considerations:

• The Court stated that "re-skilling and preservation of scarce specialized workforce in a free market are emerging heads in the public policy domain" which need to be factored when testing employment contract terms. 
  • "To survive in an atmosphere of deregulated free-market, public sector undertakings were required to review and reset policies which increased efficiency and rationalized administrative overheads." 
• The Court held that "ensuring retention of an efficient and experienced staff contributing to managerial skills was one of the tools inalienable to the interest of such undertakings." 
  • "Incorporating a minimum service tenure for employees, to reduce attrition and improve efficiency" cannot be said to be unconscionable, unfair or unreasonable and thereby in contravention of public policy. 

Reasonableness Test:

• The Court cautioned against oppressive or unconscionable clauses, particularly in standard-form contracts where employees may have little bargaining power. 
• The penalty amount must be proportionate to the employee's salary and position and should not make resignation practically impossible. 
• The terms must be transparent and the employee should have reasonable notice of the restrictive covenant.

What is Section 27 of the Indian Contract Act, 1872? 

About: 

Section 27: Agreement in Restraint of Trade  

• "Every agreement by which anyone is restrained from exercising a lawful profession, trade, or business of any kind, is to that extent void." 
• This provision categorically invalidates any agreement that restricts an individual's ability to engage in lawful profession, trade, or business activities. 

Key Principles and Scope: 

• Absolute Prohibition: Section 27of ICA does not make distinction between reasonable and unreasonable restraints and invalidates any agreement restraining trade outright. Unlike English common law, which distinguishes between total and partial restraints, Section 27 makes all agreements imposing any form of restraint void, whether total or partial. 
• No Consideration of Reasonableness: The general rule established by Section 27 is that any agreement that restrains a person from carrying out a lawful profession, trade, or business is void to the extent of such restraint. This rule is absolute and does not consider whether the restraint is reasonable or not. 

Statutory Exceptions: 

• Sale of Goodwill: 
  • The exception provided in the proviso to Section 27 allows for restraints in agreements for the sale of goodwill. It permits the seller of a business's goodwill to agree with the buyer not to carry on a similar business within specified local limits, provided these limits are reasonable and necessary for protecting the buyer's interests.
• Partnership Act Provisions 
  • The Indian Partnership Act, 1932 provides specific instances where restraints may be enforceable: 
    • Section 11: Permits partners to agree on non-compete clauses during the partnership. 
    • Section 36: Allows reasonable restraints on a partner after leaving the firm, provided they are reasonable in duration and geographical scope. 
    • Section 54: Endorses agreements that restrict partners upon dissolution or retirement within reasonable limits.
• Service Contracts During Employment: 
  • Reasonable restraints placed on employees during their employment period for the company's benefit are valid, but these expire when employment ceases. 

Landmark Case Laws: 

• Madhub Chander v. Rajcoomar Doss (1874): 
  • In this case, the Division Bench drew a distinction between the English law and Indian law and opined that any kind of restraint by which a person was prevented from exercising a lawful profession, trade was void.  
  • The Privy Council, through Sir Richard Couch, held that Section 27 makes no distinction between reasonable and unreasonable restraints and invalidates any agreement restraining trade outright.
• Niranjan Shankar Golikari v. Century Spinning & Manufacturing Co. Ltd. (1967): 
  • The Supreme Court of India recognised the enforceability of negative covenants in employment contracts, provided they are operative during the period of employment.  
  • The Apex Court held that a clause preventing an employee from joining a competitor during the term of employment does not amount to a restraint of trade under Section 27. 
• Superintendence Company of India (P) Ltd. v. Krishan Murgai (1980): 
  • The Supreme Court reaffirmed the principle that post-employment restraints are void.  
  • The Apex Court struck down a clause that restricted an employee from engaging in a similar business for a certain period after leaving employment, emphasizing the absolute nature of Section 27. 
• Gujarat Bottling Co. Ltd. v. Coca-Cola Co. (1995): 
• The Supreme Court ruled that non-compete clauses preventing the franchisee from engaging in similar business during the term of the agreement do not violate Section 27.  
• However, any post-termination restraints were held void.