February 06, 2023
Will employment non-competes soon be banned nationally? Perhaps, if the Federal Trade Commission gets its way. Last month, the FTC issued a Notice of Proposed Rulemaking (the “NPRM”) that would prohibit just about all employment non-competes. The proposal is now going through a 60-day comment period. If ultimately adopted in anything close to its current form and survives inevitable legal challenges, the ban will significantly impede the ability of employers to safeguard proprietary information.
Once upon a time, non-competition covenants were imposed only on senior executives and limited others who had access to proprietary company information. But over time, employers have expanded the use of non-competes and imposed them on rank-and-file employees as well. According to the FTC, 30 million workers are subject to non-competes. Many of these employees don’t even know it applies to them. The clauses are often buried in on-boarding documents which are often glossed over or not read at all. Even if employees are mindful of it, they typically don’t have the leverage to do anything about it.
There are certain limited exceptions built into the proposed rule. Most notably, the ban would not apply in the context of a sale of a business, a concession that non-competition covenants from sellers of a business may be necessary to protect the value of the business acquired by the buyer. But the exception is limited to “substantial” owners of the business entity being acquired. The rule would define “substantial” as owning at least a 25% ownership interest. The NPRM states that designating a percentage provides more certainly to selling business owners and their buyers but provides no rationale for the arbitrary percentage threshold other than to say that “51% may be too high” and that 25% strikes the right balance. Sounds like Goldilocks.
The ban would also except out those in franchiser/franchisee relationships, certain banks, savings and loan institutions, federal credit unions, common carriers, air carriers, non-profits and state and local governments.
In reaction to the proposed ban on non-competes, employers may seek to protect their proprietary information through other post-termination restrictive covenants. These include non-disclosure agreements, non-solicitation agreements and no-business agreements, the latter of which prohibit an employee from doing business with former clients or customers of the employer, whether or not solicited by the employee. These other restrictive covenants affect the way an employee may compete with a former employer post-termination, but don’t prevent the employee from competing with the former employer altogether or other employers from competing for that employee. Nevertheless, the FTC in the NPRM expressed concern that some employers may seek to evade the requirements of the proposed rule by implementing other restrictive covenants that are so restrictive as to constitute “de facto non-compete clauses”. Accordingly, under the proposed rule, these “functional equivalents” would also be included within the scope of the ban, whether drafted for purposes of evasion or not.
Notably, there would be no grandfathering of existing agreements. The proposed rule would also prohibit maintaining existing non-compete covenants and require companies to rescind any previously executed non-compete agreements. If companies do not do so, they would be found to be engaged in unfair competition. To lessen the burden of the rescission requirement, however, the FTC is proposing a safe harbor under which employers would satisfy the requirement by notifying relevant employees that their non-compete is no longer valid, and offers the following proposed language that could be included in the notice:
“A new rule enforced by the Federal Trade Commission makes it unlawful for us to maintain a non-compete clause in your employment contract. As of [180 days after date of publication of the final rule], the non-compete clause in your contract is no longer in effect. This means that once you stop working for [Employer Name]:
· You may seek or accept a job with any company or any person—even if they compete with [Employer Name].
· You may run your own business—even if it competes with [Employer Name].
· You may compete with [EMPLOYER NAME] at any time following your employment with [Employer Name].
The FTC’s new rule does not affect any other terms of your employment contract.
For more information about the rule, visit [link to final rule landing page].”
The proposed rule is not unanimously supported within the FTC. In her dissenting statement, Commissioner Christine S. Wilson questioned the FTC’s authority to issue the rule and asserted the proposed federal ban would constitute a sharp departure from hundreds of years of precedent for fact-specific inquiry. Only three states – California, North Dakota and Oklahoma – have made employment non-competes unenforceable for nearly all workers. The other 47 states apply a fact specific reasonableness analysis and recognize as a legitimate interest the protection of an employer’s trade secrets. These states generally recognize an employer’s interest in protecting its investment in training or in preventing a worker who provides “unique” services from working for a competitor. On the other hand, courts in these states will generally not enforce non-competes that prohibit a greater scope of activity than necessary to protect the employer’s legitimate interests, generally when the covenants cover a geographic area more extensive, or last longer than needed, to protect those interests. Some states, including Illinois and Washington, have passed laws limiting the use of non-competes among low-wage workers.
The substantive arguments cut both ways. The FTC contends that non-compete clauses decrease competition for workers resulting in lower wages, prevent new businesses from forming and stifle entrepreneurship and innovation. According to dissenting Commissioner Wilson, however, studies in this area are scant and have produced mixed results. The FTC also contends that employers can use NDA’s and non-solicitation covenants to protect proprietary information which don’t generally prevent workers from competing with former employers. But NDAs and non-solicitation covenants in the absence of non-competes are largely effective only in theory. In the real world, proprietary information could be disclosed by a former employee to a competitor long before the former employer discovers it, if he discovers it at all.
The public is encouraged to communicate comments to the FTC during the comment period which expires March 10, 2023. Comments may be submitted here. The FTC appears to have the necessary majority to adopt the new rule and will likely do so with some modifications based on submitted comments. Litigation will certainly follow, if not commenced even before adoption. Nevertheless, employers should perform a review of their employment agreements and other documents containing restrictive covenants to determine what modifications will need to be made in light of the proposed non-compete ban. Employers should also be mindful that NDAs and non-solicitation covenants may also be prohibited if they are deemed too restrictive under the standards set forth in the rule.