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Business and Goodwill

Section 27 of the Indian Contract Act, 1872 specially provides that every agreement by which anyone is restrained from exercising a lawful profession[1], trade or business of any kind, is to the extent void. Section 27, does not draw any distinction between partial (reasonable) and complete restraint. Thus whether the agreement imposes a total restraint, e.g., it says that A shall not carry on a trade anywhere in the country during his lifetime, or it imposes a partial restraint requiring A not to trade with a certain area or for a certain duration, the contract is void. Point to be noted in this regard is that in India even reasonable restraint are void unless they fall under two kinds of exceptions that are upheld, first category is of this which are specifically mentioned in the statues and the second is of those which are created by the judiciary by its judgements. It is quite pertinent to note at this juncture that the Indian Contract Act owes its origin to the English Contract Act where contracts in restraint of trade are upheld if the degree of restraint is reasonable.

RESTRAINT OF TRADE:

In India Agreements in Restraint of Trade are governed by Sec. 27 of the Indian Contract Act, 1872, which is enunciated as follows:

“Every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void.”

The assessment of these two tests of reasonableness is made against the facts and circumstances at the time the agreement was made not at the time the agreement is sought to be enforced or damages claimed for breach.

The onus of establishing that as between the parties, the restraint is reasonable, having regard to their respective interests, lies on the person seeking to rely on the restraint, and the onus of establishing that it is nevertheless contrary to public interest lies on the person who asserts it.

The starting point is that restraints are contrary to public policy and, therefore, void unless in the special circumstances of the particular case:

   1. The restraint is reasonable as between the parties.

   2. The restraint is reasonable having regard to the public interest in competition.

RESTRICTIVE COVENANTS

The basic premise of this article revolves around service contracts, which are signed, between employers and employees and are generally termed as restrictive covenants. With regard to restrictive service covenants the position in India is that a restrictive covenant between master and servant operative during the period of employment is valid and enforceable.

 The reason given by the Apex court while upholding such a covenants is that it is reasonable and necessary to protect the employer’s interest. In the Indian law, a service covenants extending beyond the term of service is void[2], where in similar cases; the English law would allow a restraint, which would be reasonable. Negative covenants operative during the period of employment when the employee is bound to serve the employer exclusively, are generally not regarded as restraint of trade and do not fall under Section 27 of the Indian Contract Act. The negative covenant is a contract of employment placing a restraint on the employee that he shall not serve in any competitor’s firm for two years at the place of his last posting after the employee left his first company. But a term restricting an employee from trade secrets and confidential information[3] after ceasing employment can be enforced. The principle contention raised in this article is that even a post service restrictive convent, if reasonable, qualified and limited in operation both temporally and spatially should be taken as valid and enforceable alike any other covenant which is operative during the course of employment as it is necessary for the employer’s trade interest[4].

EXCEPTIONS TO AN AGREEMENT IN RESTRAINT OF TRADE:

There are many exceptions to the rule, some of them are created by statutes and some are arising from judicial interpretation of section 27. The exceptions are as follows:

a)      Sale of goodwill: One who sells the goodwill of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits, so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business therein: Provided that such limits appear to the Court reasonable, regard being had to the nature of the business.

b)      Partnership: Under Partnership Act, partners of a firm may restrict their mutual liberty to do any trade other than within their firm. An outgoing partner may also be restricted from carrying on similar trade for a period of time.

c)      Trade Combinations: Companies doing business in the same field may regulate their trade practices for example opening and closing time of business even if they marginally put restraint. However, restrain on employment are not allowed in disguise of regulation. This was seen in the case of Kores Mfg Co Ltd v. Kolok Mfg Co Ltd[5] where the Companies made an agreement that they would not hire anybody who has worked in the other company in past 5 yrs. The agreement was held void.

d)     Restraint upon employees: The restraint upon employees can be seen in the case of Niranjan Shanker Golkari v. Century Spinning and Manufacturing Co Ltd[6]– A company were offered collaboration by a foreign company on the condition that they will maintain complete secrecy. A person was employed in the company on the condition that he will not work for any other company in the same business for 5 years. SC held the agreement valid.

            But as my topic of research is sale of goodwill I will be dealing with it only. Sale of goodwill which is a statutory exception.

What is Goodwill[7]?

The first issue towards approaching this section is the definition of goodwill. ‘The goodwill which has been the subject of sale is nothing more than the probability that the old customer will resort to the old place.’  The definition cited above is of course the very simplistic and rather lay men meaning of what goodwill results in. It has been more elaborately defined in Trego v. Hunt by Lord Macnaughten as:

‘Often it happens that goodwill is the very sap and life of the business, without which the business would yield little or no profits. It is the whole advantage whatever it may be , of the reputation and connection of the firm , which may have been built up by years of honest work or gained by lavish expenditure of money.’

Goodwill is essentially an intangible asset of a firm accruing to it by the good conduct and business performance. Therefore it can effectively be defined as the benefits arising from connection and reputation of the business and is primarily an asset. It is intangible and rather difficult to identify per se. It is also difficult to specify when the goodwill takes existence and no business which commences possesses goodwill from the start. It is generated as the business is carried on and may be augmented with the passage of time.

It has been held in the case of CIT v. B.C. Srinivasa Setty[8] that the goodwill is affected by everything relating to the business , the personality of the owners, the nature and character of the business , its name and reputation , its location , its impact on the contemporary market and on the prevailing socio-economic ecology.

Lord Eldon’s observation in the case of Churton v. Douglas John.[9] is a very important aspect of the meaning of goodwill, ‘goodwill must mean every advantage -every positive advantage , If I may so express it as contrasted with negative advantage of the later partner not carrying on the business himself – that has been acquired by the old firm in carrying on its business , whether connected with the premises in which the business was previously carried on, or with the late firm , or with any other matter carrying with it the benefit of business.’

It is the public approbation[10] which has been won by the business, and that is considered as a marketable thing it is the probability of the customers or clientele of the firm resorting to the person or persons who succeed to the business as a going concern.

In Laxmidas v. Nanabhai[11] , the question was regarding maintainability of a suit and counter claims. The essential reading regarding Section 55 was laid down as ‘ Goodwill is a part of the assets of a firm. The prima facie[12] rule is that the goodwill of the firm being a part of that assets has to be sold just like other assets before the account between the partners can be settled and partnership wound up.’ But no particular reference to goodwill which is only one of the several assets of a firm in a plaint for taking accounts of a dissolved partnership is required. Similarly the existence of goodwill is an asset of the firm , which has to be sold and the proceeds divided between the partners in the account taking is no bar to the conversion of a counter claim into a plaint in a cross suit is not easy to comprehend.

What is therefore seen is that goodwill like any other asset can be sold at the time of dissolution. The most relevant judgement on this section has been the case of Khushal Khemgar Shah & others v. m/s Khorshed Banu Dadibar[13]. The facts of the case read as follows, Dadiba Boatwalla was one of the eight partners of m/s Meghji Thoban & co. Boatwalla died and by virtue of clause 8 of the deed of partnership; the business of the firm was continued by surviving partners.

Now, his widow and son obtained the letter of administration and commenced an action in the High Court.

This was resisted by the surviving partners and the High Court held that the plaintiff (widow and son) were not entitled to an account of profits and losses after the death of Boatwalla. However the court held that the plaintiff was entitled to 6% interest per annum on Boatwalla’s share including the goodwill.

In return the defendants appealed again, contending that the plaintiffs as legal representatives were not entitled to a share in the goodwill. The reason being that the goodwill may be taken into account only when there is dissolution of the firm and in any event because Boatwalla had already agreed the interest on goodwill would cease on his death and the business would be continued by the surviving partners. The Supreme Court through Justice Shah, opined that”

‘Section 55 does not allow the interpretation, that, goodwill may be taken into account only when there is a general dissolution of the firm, and not when the representatives of the partner claim their share in the firm , which by express stipulate is to continue notwithstanding death of a partner. The provision deals with the concept and consequences of dissolution of the firm. The Act does not operate to extinguish the right in the assets of the firm of a partner who dies, when the partnership agreement provides that on his death, the partnership continues.’

The court also laid down the guidelines of interpretation of the deed of partnership.

‘The court must insist upon some indication that the right to a share in the assets is by virtue of an agreement; that the surviving partners are entitled to carry on business on the death of the partner to be extinguished. In the absence of a provision expressly made or clearly implied, the normal rule that the share of a partner in the assets devolves upon his legal representatives will apply to the goodwill as to other assets.’

Sale of Goodwill:

Although a restraint seeking to protect the convenantee[14] against competition per se is not upheld in the case of other contracts[15], a purchaser of a business is entitled to protect himself against competition per se on the part of vendor.

a)      As per Indian Contract Act 1872….?

X agreed to become as assistant for 5 years to Y who was a Doctor practising as Delhi. It was also agreed that during the term of agreement X will not practise on his own account in Delhi. At the end of one year, X left the assistant ship of Y and began to practise on his own account. Referring to the provisions of the Indian Contract Act 1872. Decide whether X could be restrained from doing so?

The previous answers has rightly quoted the provision of the Indian Contract Act, 1872 but wrongly explained it. Section 27 of the Act provides: – Every agreement by which anyone is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void.

Saving of agreement not to carry on business of which goodwill is sold.—

Exception – One who sells the goodwill of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits, so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business, therein :

Provided that such limits appear to the Court reasonable, regard being had to the nature of the business.

‘Any agreement/contract’ which ‘restrained the party’ from exercising a ‘lawful profession, trade or business of any kind’, is to ‘that extent void’, if the agreement/contract which is restraining the trade or profession as in this case, then how that contract be legally enforced? No one can restrain X for doing his own professional practise independently. The contract between X & Y was void from inception itself as per provision of this section & cannot be legally enforced through the court of law.

This exception deals with a class of cases which had a leading part in causing the old rule against agreements in restraint of trade to be relaxed in England. The rule apparently arose from a popular dislike of all combinations tending to raise prices, which may be compared with the agitation in America against the modern system of ‘trust’. It has been laid down in quite modern cases, as the governing principle, that ‘no power short of the general law’, not even the party’s own bargain, should be allowed to restrain a man’s discretion as to the manner in which he shall carry on the business[16], and originally the rule was without expectations. ‘In time, however, it was found that a rule so rigid and far-reaching must seriously interfere with transactions of everyday occurrence[17], and from the early the 16th century onwards, restrictions for a time certain to prevent the seller of a business from competing with the buyer, were allowed. In the 19th century, it was settled that a limit of time was not necessary, and contracts for the preservations of trade secrets were held to be outside the rule all together, and finally, the House of Lords declared that there was no hard and fast rule as such, at all. The question is always whether the restraint objected to is reasonable with reference to the particular case, and not manifestly injurious to public interest.

This exception enables the purchaser of goodwill of a business to exact a covenant from the vendor of the business and has a limit as to area and as to time. This exception imposes a limit on the area when it provides that it can operate only when the restraint is within specified local limits. This provision, made when general restraints were void under the common law, appears very stringent when under that law, even worldwide covenants have been enforced as reasonable. The third limitation of this exception is that a restraint can operate only so long as the buyer or any person deriving title to the goodwill from him carries on a like business therein. This shows that the benefit of the covenant is assignable and available to the successor in the title of the covenantee. It also provides that the covenant is extinguished once the goodwill comes to an end.

The kind of cases covered by this exception may be illustrated by a decision before the act. A covenant by the defendants on the sale of the goodwill of their business of carriers to the plaintiff not to convey passengers to and fro on the road between ootacamund and mettapalayam was not in restraint of trade. So, partial restraint is not really adverse to the interests of the public at large[18].

The covenant may be justified even when the business is in an embryonic stage. In Chandra kanta Das V parasullah mullick[19], a covenantor running a ferry for only a few months in competition with a long established business of the covenantee was held to possess goodwill for the purpose of restraining him from carrying on that business for 3 years. One view is that in a case like Nordenfelt[20], where the goodwill was sold by a company, but the restrictive covenant agreed by its managing director, the strict wording of this section should not deprive the covenantee of the benefit of the covenant given by the director[21].

Limits of Restraint –

The agreement has to specify the local limits of the restraint. The seller can be restrained within certain territorial or geographical limits and the limits must be reasonable. Reasonableness of restrictions will depend upon many factors, for example, the area in which the goodwill is effectively enjoyed and the price paid for it.[22]

The seller can only be restrained from carrying on a similar business and also only for such period for which the business sold is actually carried on either by the buyer or by any person deriving title to the goodwill from him.

Case laws:

a)     Vancouver Malt & Sake Brewing Co v. Vancouver Breweries Ltd[23]

In this case the Appellants were Vancouver Malt and Sake Brewing Co., Ltd the appellants were incorporated under the Companies Act of British Columbia as a private limited company under the name of the Vancouver Malt and Sake Brewing Company, Limited and the Respondent was Vancouver Breweries, Ltd who purchased the business and goodwill of the appellants.

In this case the appellant By virtue of the definitions contained in §5, Excise Act, and this licence authorised them to manufacture beer, ale, porter, lager beer and all other fermented liquor made in whole or in part from malt, grain or any saccharine matter. In point of fact, however, they had never brewed any liquor other than sake, Japanese liquor made from rice, and their plant was adapted to the manufacture of this liquor only. Their business was apparently confined to the Province of British Columbia, where the only permitted customer within the Province was the Government Liquor Control Board. The company entered into an agreement[24] with another wine and beer manufacturing company Vancouver Breweries, Ltd by which it sold its business and goodwill of manufacturing wine and beer, but it did not give the other company the right to produce sake.

The agreement was held to be devoid of any content. The only business in which the appellant was engaged was brewing of sake and the goodwill of its license so far as relating to sake was not included in the sale to the respondents. It had no goodwill to sell so far as regards the brewing of beer.

Nothing has been sold. It is simply the case of the appellant undertaking to the respondent in consideration a sum of money that it will not for 15 years carry on a particular branch of business. If there was any sale, it was a sale by the appellant of its liberty to brew beer and a purchase by the respondent of protection against the possible competition of the appellant in the brewing of beer. Lord Macmillan then referred to the judgement of Lord Chancellor Birkenhead in McEllistrim v. Ballymacelligott Cooperative Agriculture & Diary Society[25], that the respondents were not entitled to be protected against mere competition, and continued to say that covenants restrictive of competition which have been sustained have all been ancillary to some main transactions, and have been found justified because they were reasonably necessary to render that transaction effective. The seller can only be restrained from carrying on a similar business and also only for such period for which the business sold is actually carried on either by the buyer or by any person deriving title to the goodwill from him.

b)     Nordenfelt v. Maxim Nordenfelt Guns and Ammunition co ltd[26]

This is a 19th century English case decided by the House of Lords. It defines the “blue pencil test” as a method for deciding whether contractual obligations can be partially enforced when the obligation as drafted in the contract has an element of illegality. In this case Thorsten Nordenfelt, a manufacturer specialising in armaments, had sold his business to Hiram Stevens Maxim. They had agreed that Nordenfelt ‘would not make guns or ammunition anywhere in the world, and would not compete with Maxim in any way for a period of 25 years’.

The House of Lords held that:

  • The provision prohibiting Nordenfelt from making guns or ammunition was reasonable.
  • The providing banning competition ‘in any way’ was unenforceable as an unreasonable restraint of trade.

The question on severability was whether the reasonable restriction could be enforced when it was in the same contract as an unreasonable and unenforceable restriction. The court used the test of striking out (with a blue pencil) words containing unreasonable provisions would leave behind a contractual obligation that still made sense. If it did, then the amended contract would be enforced by the court.

In this case, the unreasonable restraint was severable, and the court enforced the amended agreement that Nordenfelt  for the next 25 years, would not make guns or ammunition anywhere in the world, and would not compete with Maxim in any way.

Conclusion

Despite availability of very scarce case law on the issue it can still be concluded, that the position on Section 55 is well settled and that goodwill is a saleable asset at the time of dissolution and renders certain obligations on part of both the buyer and the seller. The restraint under this section is similar to the one under Section 27 of the Indian Contract Act. The situation tackled by this section, is essentially one that falls within the exceptions of section 27. The said provision reads: ‘One who sells the goodwill of a business may agree with the buyer to refrain from carrying on a similar business, within specified local limits, so long as the buyer, or any person deriving title to the goodwill from him, carries on a like business therein; provided that such limits appear to the court reasonable, regard being had to the nature of the business.’ Litigation under this section would essentially involve determination of goodwill and thereafter the duties connected and to ensure that they are in ‘consonance with the common understanding of mankind and the rudiments of commercial morality.’ The underlying principle of this section is benefit of the buyer of goodwill which here is assured by a relative restraint on trade by the seller.

Article By: Anjali Agarwal


[1] Pragji Soorji v. Parasullah Mullick, AIR 1922 PC 167:65 IC 271

[2] As defined in §.2(g) of the Indian contract act,1872

[3] Niranjan Shankar Golikari v. Century Spinning and Manufacturing Co. Ltd, 1967 INDLAW SC 383

[4] The Law Commission of India in its 13 report has recommended that § 7 of the Indian Contract Act, 1872 should be suitably amended to allow such restrictions and all contracts in restraint general or partial, as were reasonable in the interest of the parties time and a restraint imposed in order to give effect to such a contract would apparently be treated in the same way.

[5] (1959) Ch 108: (1958) 2 WLR 858: (1958) 2 All ER.

[6] AIR 1967 SC 1098

[7] As defined in §55 of The Indian Partnership Act, 1932.

[8] [1981] 128 ITR 294.

[9] (Eng.) 174

[10]Approbation ‘ was one of the original meaning of goodwill before it was used as commercial slang.

[11] AIR. 1964 SC 11: [1965] 1 SCJ 1

[12] (Latin) A legal presumption which means on the face of it or at first sight.

[13] [1970] 3 SCR 689

[14] § 11(2) of the Indian Partnership Act

[15] Vancouver Malt and Sake Brewing Co., Ltd. Vs. Vancouver Breweries, Ltd (AIR1934PC101, 150Ind. Cas.232)

[16] Hilton Vs.eckersley(1856) 6 E&B 47.

[17] Nordenfelt Vs. maxim nordenfelt guns and ammunition co ltd [1891-94] All ER Rep 1.

[18] Auchterlonie vs. Charles bill (1868) 4 MHC 77.

[19] 48 IA 508.

[20] [1891-94] All ER Rep 1

[21] Gooderson (1963) 79 LQR 410.

[22]  Damodar Laxman Lele v Kashinath Waman lele, (1906) 9 BOM LR 312; Dev Sharma v Laxmi Narain, AIR 1956 punj 49

[23] AIR 1934 PC 101

[24] As defined §2(e) of the Indian Contract Act, 1872

[25] (1919) AC 548,563 HL.

[26] [1894] AC 535

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