Avantika Kakran is a fourth-year student at Dr. Ram Manohar Lohiya National Law University, Lucknow.
In a recent judgment delivered on 14th May 2025, the Supreme Court, after considering the validity of indemnity bonds providing compensation for breach of a minimum service clause in employment contracts, upheld the enforceability of such bonds. Indemnity bonds in employment contracts usually stipulate that an employee must serve an employer for a minimum period and pay a specified amount if they leave before the expiry of that period. These bonds are designed to secure the employer against pecuniary losses incurred due to early resignation of employees. The decision came in the backdrop of the Karnataka High Court quashing a clause contained in the appointment letter whereby the respondent-employee was required to pay liquidated damages of Rs. 2 lakhs in the event of leaving employment of the appellant-bank prior to three years. The court held the clause to be in restraint of trade under Section 27 of the Indian Contract Act, 1872.
Questions of law before the court
- Whether the clause contained in the appointment letter amounts to restraint of trade in terms of Section 27 of the Indian Contract Act, 1872 and/or
- Whether it is opposed to public policy and thereby contrary to Section 23 of the Indian Contract Act, 1872 and violative of articles 14 and 19 of the Constitution.
Findings and rationale
On the first question of law, the court, while discussing the distinction between restrictive covenants operating during the subsistence of an employment contract and those operating after its termination[1] reiterated the law that a restrictive covenant operating during the subsistence of an employment contract does not put a clog on the freedom of a contracting party to trade or employment.
On the second question of law, the court, after a discussion of several previous judgments[2], held that the contours of public policy are ever evolving and, therefore, the standard of what is just, reasonable or fair in the eyes of society keeps varying with the growth of knowledge and evolving standards. It was the view of the court that PSUs (the appellant-bank in the present case) are required to compete with the private players in the market and therefore need to retain efficient and experienced staff.
Views and suggestions
The court noted that indemnity bonds operating during the employment differ from post-employment restraint on trade and, therefore, are not barred under Section 27 of the Indian Contract Act, 1872. However, it is important to consider whether, even though such bonds prima facie do not put a restraint on trade, they could have a similar effect as that of post-employment restraint contracts by reducing job mobility and limiting an employee’s freedom to switch jobs.
Protection of employee interests is ensured when there exists a way for them to exit a job for better opportunities, and when pressure exists on the employer to provide humane working conditions. Negative covenants in an employment contract create high exit barriers that might result in reduced incentive for the employer to provide quality post-bond training and competitive salaries, depending on the field. It is also to be noted that such covenants might restrict a fresher’s freedom to explore other career options in their initial years if the minimum period of service provided in such a contract is too high.
Such clauses in an employment contract may cause a reduction in the quality of work due to the employee feeling tied down to one job; hence, such a negative covenant might prove to be counterproductive to the employer. They also lead to stagnation of skills due to limited exposure to diversity and a restriction on the cross-pollination of ideas among various industries.
Moreover, such indemnity bonds are, prima facie, one-sided. When compared to compensation schemes or provisions for lay-offs and retrenchment, indemnity bonds provide an edge to the employer since similar compensatory benefits do not exist for the employees when employees are laid off or retrenched by an employer, or if they exist, the amount is minimal . Therefore, instead of introducing or endorsing a system of such negative covenants by way of indemnity contracts, the introduction of positive covenants such as retention bonuses might prove to be more helpful by incentivising the employees to remain in a particular job.
Additionally, a major logical flaw that the proponents of indemnity bonds ignore when citing attrition as the cause of bringing such bonds is that attrition is caused mainly due to factors like job dissatisfaction, work-pay disparity, poor management, etc. Thus, introducing indemnity bonds into the market does not seem to address the root causes of attrition.
Another justification cited for the validity of indemnity bonds is the voluntariness of the employee to enter into such a contract. Such voluntariness or consent of an employee needs to be construed keeping in mind the economy of a country and the disproportionate bargaining power that exists in standard form contracts.[3] In a struggling economy like India’s, with an unemployment rate of 3.2% , many individuals are forced to take up or stay in unsatisfactory jobs with subpar working conditions. Therefore, even though prima facie an employee enters into a contract containing a negative covenant by his/her consent, whether such consent comes truly without any undue influence also needs to be considered.
Moreover, there needs to be a set standard of reasonableness of the compensation amount in an indemnity bond, since an exorbitant amount of damages with little to no regard to the current salary of an employee might open room for arbitrariness and exploitation of an employee at the hands of an employer. The compensation amount should be calculated with regard to both the employee’s current salary and the documented expense in that employee’s training. Such a set method will help ensure the interests of both the employer and the employee.
Conclusion
In my view, the court’s decision in upholding the validity of indemnity bonds based on the reason that such bonds do not act as a restraint on post-employment opportunities of an employee and, therefore, are not violative of Section 27 of the Indian Contract Act, 1872 is legally sound but warrants scrutiny in terms of its socio-economic implications. The judgment correctly identifies the technical validity of indemnity bonds, but without required safeguards like penalties proportional to the income and the investment in the training process, in-service indemnity bonds risk becoming tools of exploitation rather than legitimate strategies to tackle attrition and safeguard employer interest. Additionally, since the judgment caters only to PSUs, it leaves scope for uncertainties with respect to the validity of such bonds in the private sector. In conclusion, the court is right in pointing out the changing landscape of public policy with the onset of liberalisation; however, going forward, effective job security regulations that help strike a balance between employer and employee interests should be given priority over one-sided mechanisms.
[1] Niranjan Shankar Golikari v Century Spg and Mfg Co Ltd, 1967 SCC OnLine SC 72; Superintendence Co of India v Krishan Murgai, (1981) 2 SCC 246.
[2] Central Inland Water Transport Corpn v Brojo Nath Ganguly, (1986) 3 SCC 156; Niranjan Shankar Golikari v Century Spg and Mfg Co Ltd, 1967 SCC OnLine SC 72.
[3] Central Inland Water Transport Corpn v Brojo Nath Ganguly, (1986) 3 SCC 156.
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