Employment Bonds / Indemnity Bonds: Can one truly lock-in their key employees?

Employers undertake various approaches to secure themselves from any harm caused by the acts of their employees. Requiring an employee to execute an indemnity bond, inclusion of negative covenants in the employment agreement and confidentiality clauses is some of the practices generally adopted by employers as measures to protect from employee attrition. Whereas confidentiality clauses are largely considered valid and necessary for the protection of employers’ interests, negative covenants in an employment agreement and indemnity bonds have attracted a number of disputes and differing opinions as regards their enforceability.

Negative covenants in an employment contract

Agreement or contract preventing, the one agreeing, from doing certain activities is a negative covenant. Negative covenants in employment contracts largely include the ones which restrict the employees from working for other organisations involved in similar business, during the course of employment and some even after the course of employment. It would also include restrictions on employees from terminating the employment prior to the expiry of a specified period of time.

Employers include negative covenants in the employment agreement for the purpose of protecting the trade secrets of the organisation. A negative covenant will prevent the employee from using the confidential or proprietary information acquired by him and/or the skill sets developed in the course of his employment for his personal gain.

On the other hand, these tactics can be said to evidence the dominating position of the employer in the contract of employment. Such covenants are often perceived as restrictions on an employees’ freedom to profess any profession under article 19 (1) (g) of the Constitution of India.

The Supreme Court[1] has observed that a negative covenant is generally valid during the course of employment. It implies ‘a servant’s duty of fidelity.’ A restriction of this sort is held as reasonable and valid in law.

While certain negative covenants are valid in law, a clause restricting the employee from taking up a career or job of his choice, which exceeds the course of employment or in other words which operates even after the termination of employment, may not be enforceable in a court of law. The Madras High Court has observed in Dr. S. Gobu v. State of Tamil Nadu[2] that a negative covenant that operates after the termination of the employment is generally regarded as a restraint to trade practices under section 27 of the Indian Contract Act, 1872.[3] For a detailed discussion on restraint of trade please see our previous blog post on this subject.

Unlike other jurisdictions in India, there is no protection offered to any restraint, whether or not such restraint is reasonable as to the time period after completion of employment or the geography where such limitation operates.

Indemnity Bond

Indemnity bond or undertaking is a really a misnomer for most documents of this nature requrie the employee to compensate the holder for the loss, pre-determined, incurred by the holder as a result of the actions of the issuer or any other person. Such a contract is governed by the Indian Contract Act, 1872 and comes under the purview of section 74 of the said Act, which provides for compensation for breach by way of liquidated damages. Liquidated damages is a sum pre-agreed between parties to a contract to be paid by the breaching party irrespective of whether actual damage has been incurred by the non-breaching party as a genuine pre-estimate of damages.

By executing the bond the employee agrees to remain in the service of the employer for a fixed duration. The employee may leave the employer’s service earlier by tendering his resignation, but in doing so he is obliged to compensate the employer with the amount specified in the bond.

Section 74 requires the compensation amount claimed either by way of damages or penalty to be reasonable. Exorbitant compensation, even though agreed by the employee, will not be enforceable. The compensation amount must be in accordance with the benefits provided to the employee and the loss and inconvenience caused to the organisation as a result of the employee’s premature exit from the organisation.

While the courts have never gone into the question of whether an indemnity bond which imposes excessive amounts of liquidated damages / penalty is in fact in restraint of trade, the Supreme Court has held in the past that neither the test of reasonableness nor the principle that the restraint being partial was reasonable are applicable to a case governed by Section 27 of the Contract Act, unless it falls within Exception 1.

Judicial pronouncements on this point

The Supreme Court has not thus far reviewed and responded to a question on validity of fixed period contract with an employee. However in a 2013[4] judgment the Supreme Court had extended the validity of a study bond which was not honoured by a lecturer and awarded reasonable damages to the employer. This case can be distinguished on the fact that the government servant was sent for study with full pay and other service conditions and he did not bother to complete his course. The Supreme Court while frowning upon the attitude of the employee did not however enforce the indemnity bond to its fullest extent.

In recent case before the Bombay High Court[5], the Hon’ble Court, set aside 3 awards passed in three separate arbitrations in favour of Godrej Infotech Limited. The Bombay High Court found no merit in the case of the company against employees who did not serve the stipulated period of 2 years under the employment bond as it was found that no specialised training was given to employees. The training provided by the company was not of a specialised nature and was a general training of about 5 days in all.

The Bombay High Court however refrained from going into the legality of such employment bonds.

In the case of Scipa India Limited v. Manas Pratim Deb[6] before the Delhi High Court, the Respondent had signed some bonds in the course of his employment with the Plaintiff. As per the bonds, the Respondent was bound to serve for five years or pay a sum of Rs.2 lakhs per bond, if he left the service before the period of bond ended. The Respondent resigned three years prior to the expiration of the second bond and a few months prior to the expiration of the first bond. The Plaintiff claimed two lakhs each for both the bonds and other Rs.17, 290 as notice period money plus a certain sum as medical expenses. The trial court dismissed the suit and awarded an adjusted compensation of Rs.44, 300. An appeal was filed before the Delhi High Court for the recovery of the balance amount claimed by the Plaintiff. The learned Judge ruled in favour of the Respondent and dismissed the appeal. The court observed that:

  • The period of first bond had almost expired, hence claiming Rs.2 lakhs for the same was unreasonable. Hence the bond was unenforceable.
  • The compensation in regard to the second bond was claimed to be reasonable by the Plaintiff on the basis of contended training given to the Respondent. In absence of any proof to back the contended training, the compensation was viewed as unreasonable. Hence the bond was unenforceable.
  • The adjusted compensation awarded by the trial court was considered adequate.

The Hon’ble Delhi High Court however refrained from going to the legality of such a bond per se i.e. whether such bonds are at all enforceable

In a case before the Andhra Pradesh High Court[7] the facts varied from the above case. The company provided proper training to the employee who had joined as a trainee and later was absorbed in the company as a software engineer. A bond was signed between the company and the employee by which made the employee liable to pay a sum of Rs.2 lakhs in case he decided to leave the company before the bond period. The court was of the opinion that since the Company had invested time and money in the training of the employee, the compensation under the bond was held to be reasonable. The bond was valid and enforceable.

The Madras High Court[8] has observed that in cases where there is an indemnity bond between the employer and employee, the Court is of the opinion that though a clause in an employment agreement obliges the employee to work for the organization for a fixed period of time, paying compensation and leaving the organization makes that obligation disappear. If the employee leaves the service abruptly by handing in his resignation, he will be bound by the agreement or bond and will be liable to pay to the organization the damages as per the agreement.

Sum and Substance

Comfort may be drawn by employers, that in cases where any training has been provided or any other benefit offered to the employee, which the employee having enjoyed did not reciprocate by continuing for the minimum period of employment, the courts might offer relief.

Care must be taken while drafting an indemnity bond together with an employment agreement. The indemnity bond and employment agreement tend to leave a sense of ambiguity when not drafted in a lucid manner. Often it is difficult to identify the true scope of the instruments. The question as to which instrument supersedes the other is left to interpretation, resulting in disputes.

There are many questions that arise. The most common being – ‘where the employment agreement allows the employee to terminate his services anytime by giving a notice, would it be valid for any other agreement (i.e. indemnity bond) to impose additional liability on the employee if he chose to leave the organisation before a stipulated period?

In order to overcome such interpretational issues, it is imperative that these instruments are worded clearly and in such a way so that they are read together.

The positive of the negative

Enforceability of an employment bond is fraught with disputes. It is advisable for the employers to use other methods to lure their employees into remaining in their service for longer periods of time.

Negative covenants in employment agreements deployed by the employers to prevent the employees from gaining any unfair advantage at the employer’s expense may be viewed as restraint on the rights of the employee in order to safeguard the interests of the employer where such restraint operates beyond the period of employment.

Benefits awarded to the employees such as retention bonuses are a positive and effective alternative to indemnity bonds. Pay packages may be structured intelligently to offer better rewards for employees that last longer with attractive stock options etc. particularly in an early stage enterprise.

[1] Superintendence Co. of India v. Krishna Murgai : 1980 AIR 1717

[2] 2010 SCC Mad 3389

[3] Section 27 states that, “Every agreement by which any one is restrained from exercising a lawful profession, trade or business of any kind, is to that extent void.

[4] Sant Langowal Institute of Engineering and Technology and Another v. Suresh Chandra Verma (2013) 10 SCC 411

[5] (2015) 2 AIR Bom R 745

[6] 2011 SCC Del 4805

[7] Ladella Ravichandar v. Satyam Computer Services Limited: 2011 AIR CC 2827 : 2011 SCC AP 76

[8] In Dr. S. Gobu. v. the State of Tamil Nadu : 2010 SCC Mad 3389

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