Key Takeaway

The Federal Trade Commission began the new year by issuing a sweeping proposed rule banning all non-compete agreements between employers and employees. The proposed rule would add a new subchapter to the FTC Act, and would not only prohibit employers from entering into non-compete agreements with employees prospectively but would also require employers to rescind all current non-compete agreements. The FTC is currently seeking public comments on the proposed rule, which could have expansive implications for employers.

The proposed rule was met with a swift chorus of opposing voices, including FTC Commissioner Christine S. Wilson, who published a letter dissenting from the proposed rule. While the proposed rule, if adopted, will certainly face legal challenges, employers should be prepared to implement practices to comply with the rule in the event that a final rule similar to the proposed rule is published.

Full Text

The Federal Trade Commission (FTC) released a Notice of Proposed Rulemaking on January 5, 2023, that would prohibit employers from entering into non-compete agreements with their employees and require all pre-existing non-competes to be rescinded. The Notice was issued in response to President Biden’s July 2021 Executive Order on Promoting Competition in the American Economy, which directed the FTC to use its rulemaking authority “to curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.” In the Notice, the FTC announced its preliminary finding that non-compete agreements constitute an unfair method of competition under Section 5 of the Federal Trade Commission Act (the “FTC Act”). The proposed rule represents the FTC’s latest effort to exercise its powers under Section 5 after allowing its authority to “lay dormant” for decades,¹ and is also the latest effort by the FTC to test an expansive vision of its authority, including with respect to labor and employment issues.

Overview of the Proposed Rule

The FTC rule proposes adding a new subchapter to the Code of Federal Regulations (Part 910) that would make it unlawful for an employer to enter into, or attempt to enter into, non-compete agreements with any “worker.” The term “worker” is defined broadly to include not only common law employees, but also any “individual classified as an independent contractor, extern, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer.” The rule would also require employers to rescind any existing non-compete agreements no later than the "compliance date" of 180 days after the publication date of the final rule. The proposed rule would supersede all state laws and regulations regarding non-compete agreements that are inconsistent with the rule, but would permit state laws and regulations that provide greater protections than the proposed rule provides.

The proposed rule defines non-compete agreements broadly, stating that a non-compete clause is “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.” The rule would implement a “functional test” for determining whether an agreement constitutes a non-compete agreement. According to the FTC, a de facto non-compete agreement would be a contractual term which “has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.” Thus, this broad definition may cover not only traditional non-compete agreements that prohibit employees from engaging in competitive activity after their employment is terminated, but may also capture agreements, such as broadly written non-disclosure agreements and customer non-solicitation agreements, that are not typically considered “non-compete” agreements.

The proposed rule contains some narrow exceptions and would not apply to non-compete agreements entered into by individuals selling a business entity or otherwise disposing of their ownership interest in a business entity. The rule states that the ban on non-compete agreements would also not apply to a business entity’s asset sale. The rule clarifies, however, that non-competes covered by these exceptions remain subject to federal antitrust law as well as all other applicable laws.

The FTC is seeking public comment on the proposed rule, with comments due within sixty days of the date the proposed rule is published in the Federal Register. The FTC noted that it was seeking specific comment on a number of issues, including: comments on whether the rule should allow employers to use “clear and convincing evidence” that the non-compete agreement is not likely to cause harm to consumers, or that the agreement provides some competitive benefit to rebut the presumption that the agreement is unlawful; and comments on whether the rule should apply different standards to certain categories of employees, such as senior executives, rather than applying to all employees subject to non-compete agreements. After this sixty-day comment period has passed, the FTC may publish a final rule. If adopted, the rule would require compliance within 180 days.

Disagreement Over Non-Compete Agreements

The debate concerning the utility and fairness of non-compete agreements has been raging for decades and the views on each side of the issue are strongly held and loudly voiced. According to the FTC, approximately 30 million employees in the United States are currently covered by non-compete agreements. The FTC has argued that non-compete agreements inhibit innovation and result in lower wages for employees. Among other things, the FTC stated in the proposed rule that “research has shown the use of non-compete clauses by employers has negatively affected competition in labor markets, resulting in reduced wages for workers across the labor force—including workers not bound by non-compete clauses.”

Employers and industry groups note, however, that businesses often rely on non-compete agreements to protect company trade secrets and other confidential information when employees’ employment is terminated. Opponents of the rule have also expressed concerns about the detrimental impact such a rule may have on employee training. Because non-compete agreements often result in higher employee retention, they argue, employers are more dedicated to promoting and providing robust training for employees. Banning non-compete agreements would therefore disincentivize employers from investing in employee training. Opponents of the proposed rule have also argued that the FTC’s concerns about the impact of non-compete agreements is overstated, as such agreements are primarily enforced with highly compensated employees who have access to trade secrets and confidential company information.

Practical Information for Employers

The future of the proposed rule is very much unclear. However, employers that currently use non-compete provisions in their employment contracts or are contemplating doing so should keep in mind a number of key takeaways.

First, the proposed rule is another major step in the FTC’s intense interest in the labor and employment space dating back to the better part of a decade, including with respect to no-poach and non-solicitation agreements. We previously issued an on-point about ongoing challenges to no-poach agreements, including in the criminal context.² Thus, whether or not the proposed rule is enacted in its current form, the FTC is certain to remain an important player in the non-compete area.

Second, legal challenges to the rule are inevitable, which may delay its implementation or modify its scope. Indeed, FTC Commissioner Christine S. Wilson dissented from the issuing of the proposed rule, flagging significant questions about whether the proposed rule exceeds the FTC’s statutory or constitutional authority. Commissioner Wilson noted in her Dissenting Statement that the question of whether a non-compete agreement is unreasonable is a fact-specific inquiry that depends on the context of the specific agreement, and this rule rendering all non-compete agreements unenforceable regardless of context would be a “radical departure” from centuries of precedent. She also argued that there are significant questions concerning whether the FTC has the authority to engage in substantive competition rulemaking; whether it has Congressional authorization to enforce this rule; and, even if the FTC has the authority to engage in such rulemaking, the rule is an impermissible delegation of Congressional authority under the principle that Congress cannot delegate its legislative authority to other governmental branches, including federal agencies such as the FTC.

Third, if enacted and found to be valid, the proposed rule would have expansive implications. Not only would the millions of traditional non-competes currently in effect be deemed invalid, and future agreements prohibited, but the validity of many types of contractual provisions not typically thought of as non-competes could potentially be brought into question. For example, so-called “forfeiture for competition” agreements providing for the claw-back of severance pay, stock incentives, or other forms of compensation might be deemed as potentially unlawful “de facto” non-competes under the rule.

Finally, despite these legal challenges, there is some chance that the proposed rule could go into effect before the end of 2023. Employers who use non-compete provisions in their employment contracts should therefore consider making plans now to change their practices to account for that possibility and avoid the risk of the FTC seeking cease-and-desist orders and pursuing civil penalties. Those plans should include: (1) revisiting employment contracts (as well as revising any associated materials, such as employee handbooks) to identify any express non-compete provisions or other provisions that might be considered de facto non-compete provisions; and (2) preparing to issue notice to current and former employees that any applicable non-compete provisions are no longer in effect.

Footnotes

1) Statement of Chair Lina M. Khan On the Adoption of the Statement of Enforcement Policy Regarding Unfair Methods of Competition Under Section 5 of the FTC Act

2) Criminal guilty plea in nurse staffing case shows labor market antitrust concerns are not going away (October 31, 2022).