On April 23, the Federal Trade Commission (FTC) approved a long-anticipated final rule that will effectively ban the use of noncompete clauses by employers, with a few limited exceptions. The rule preempts all inconsistent state and local laws or regulations, reasoning that noncompetes violate longstanding federal law prohibiting unfair methods of competition, and relying on President Biden’s 2021 "Executive Order on Promoting Competition in the American Economy" to support this position.
Noncompete agreements have long been used in the health care sector as a mechanism for ensuring continuity of care for patients and mitigating the risk of losing a highly skilled and specialized work force as well as proprietary knowledge of clinical practices and hospitals. The FTC’s new rule is anticipated to cause a major shift in an industry which has long utilized noncompetes.
Physicians and physician practices should be aware of certain nuances, exceptions, and legal challenges to the final rule, which have notable implications on the industry. Here are some key questions for consideration.
When Will the Rule Take Effect?
The rule goes into effect 120 days after publication in the Federal Register (likely September 2024, at the earliest). However, as our firm has previously covered, legal challenges seeking to halt enforcement of the rule have already been initiated, and in jurisdictions where an injunction is widely expected to be granted. Notably, the U.S. Chamber of Commerce has filed a lawsuit seeking to overturn the rule.
Legal challenges may take years to work through the courts, especially if they reach the U.S. Supreme Court, which is likely given the gravity of the issues.
Will the Rule be Retroactive?
The final rule will be retroactive — invalidating noncompetes that existed prior to the rule. However, the rule does not apply if a cause of action related to a noncompete provision accrued prior to the rule’s effective date. This includes, for example, where an employer alleges that an employee accepted employment in breach of a noncompete, if the alleged breach occurred prior to the effective date.
What is the Exception for Senior Executives?
The rule nullifies existing noncompetes for all workers who are not senior executives. Senior executive means a worker who was in a policy making position and received compensation of at least $151,164 in the prior year, per the rule.
A few examples of policy making positions include presidents, CEOs, or an equivalent role where the person has final authority to make policy decisions that control significant aspects of an entity or enterprise. Existing noncompetes for senior executives may remain in place, and new noncompete agreements for these executives entered into prior to the rule’s effective date will still be allowed. However, new noncompetes with senior executives entered into after the effective date will not be allowed.
Most clinicians, by definition, will not be considered senior executives. There are some important factors to take into consideration when evaluating the effect of the senior executive carve-out. For example, it is unclear whether senior executives could include physician partners of an independent practice if they are serving in executive roles in the practice. There is a possibility some physicians may refuse to serve in those roles if they are subject to a noncompete. What is highly expected, however, is that hospitals and large physician practices will see increased competition, and likely higher salaries, to retain top talent of physicians who do not hold any policymaking authority.
Non-senior executives who are currently under a noncompete must be given notice by the rule’s effective date that their noncompete cannot and will not be legally enforceable. Model language for such notices can be found in the final rule.
What is the Exception for the Sale of a Business?
The rule has a limited impact with respect to mergers and acquisitions. That’s because, as a general matter, the rule does not apply to noncompete arrangements entered into pursuant to a bona fide sale of a business entity, sale of the person’s ownership interest in the business entity, or sale of all or substantially all the assets of a business entity’s operating assets. Unlike an earlier proposed rule, the final rule does not require the seller to have a 25% ownership to rely on the bona fide sale exception. The language of the final rule, however, is still unclear on whether "sale of a business entity" requires sale of 100% of the interests in the business entity or whether a smaller stake, perhaps a mere majority interest, is sufficient to qualify as a "sale of a business entity." Further, noncompete agreements that stem from repurchase rights or mandatory stock redemption programs are not considered bona fide sales.
It is anticipated that the elimination of post-employment noncompetes will still heavily influence the approach and structuring of health care transactions. Noncompetes typically assure potential buyers that the practice’s workforce is stable and that a skilled and successful staff will remain post-closing, validating their investment. The final rule could result in lower business valuations and general caution when practices and investors approach acquisition opportunities.
Additionally, there are several nuances which will affect the use of restrictive covenants in transaction structuring, including noncompetes related to repurchase rights in operating agreements and "drag provision" implications for springing noncompetes. Health care practices and future investors should work with counsel to navigate fact-specific situations regarding current or future sale related covenants.
Does the Rule Apply to Noncompetes With Tax-Exempt Hospitals?
Notably, the rule does not apply to nonprofits. Therefore, a nonprofit health system with noncompetes in place for physicians or other employees will not be impacted by the rule. The FTC acknowledged that 58% of hospitals in the United States are tax-exempt organizations. However, practices should be cautious about their status as "nonprofit." The FTC has explicitly stated that merely claiming tax-exempt status in tax filings is not dispositive, specifically noting that some hospitals claiming tax-exempt status as nonprofits are under increasing public scrutiny due to operations designed to maximize profits, highly compensate executives, create aggressive collection tactics, and spend less on community benefits than they receive in tax exemptions. The rule explains that tax-exempt organizations "are not categorically beyond the Commission's jurisdiction," suggesting that the FTC may challenge whether a nonprofit health care practice is in fact operating as a for-profit business subject to the FTC’s jurisdiction.
Does the Rule Apply to Monetary Penalties for Competing (Not Outright Prohibitions)?
Yes, employee benefit plans and other compensatory arrangements between employees and employers (such as bonus programs, incentive pay, equity-based compensation, and severance payments) often include forfeiture clauses or clawback provisions if a worker competes with their former employer.
The FTC rule appears to invalidate these provisions by nullifying terms or conditions of employment that "penalize" employees for engaging in competition, including those that absolve employers from fulfilling compensation or benefits obligations when employees engage in competition.
Will the Challenges to the Rule Prevail?
While attempting to divine the ultimate outcome of the rule may be a fool’s errand, legitimate concerns exist regarding the scope of the rule and the FTC’s authority to enact it. These concerns are laid out in the U.S. Chamber of Commerce’s lawsuit challenging the rule.
First, the lawsuit states that the FTC lacks the authority to issue regulations as to "unfair methods of competition" because Congress has never empowered the FTC with general rulemaking authority. The legal challenge to the rule specifically cites to the major-questions doctrine, which the U.S. Supreme Court has repeatedly invoked in recent years to reject similar attempts by administrative agencies to take unprecedented actions with vast economic and political significance based on ambiguous statutory text.
Second, the US Chamber of commerce argues that, even if Congress had given the FTC authority to adopt rules banning conduct that it deems to be an unfair method of competition, the rule is invalid because the FTC failed to consider narrower limitations on noncompetes.
Third, the lawsuit alleges that the rule is impermissibly retroactive because it invalidates agreements entered into prior to the enactment of the rule.
If the Rule is Invalidated, What Happens Next?
If the rule is invalidated, noncompete agreements will continue to be governed by the same state-specific statutes and case law that has regulated these agreements for centuries. State laws regarding noncompetes vary widely. Four states — California, Minnesota, North Dakota, and Oklahoma — and Washington, DC ban noncompetes with only narrow exceptions while another handful of states prohibit noncompete agreements unless the worker earns a salary above a certain threshold (Colorado, Illinois, Maine, Maryland, New Hampshire, Oregon, Rhode Island, Virginia and Washington). Many states allow somewhat expansive restrictive covenants for most employees.
Ultimately, the FTC rule may aim to cultivate public endorsement for the idea of overthrowing restrictive covenants, fostering the possibility that legislators will enact comprehensive laws prohibiting noncompetition agreements at the state level.
In sum, even if the rule is invalidated, there will still be a widely felt impact on the health care industry. Clinical practitioners, hospitals, health care practices, and investors should be aware of and prepare for the immediate and future effects of the FTC’s final rule, including monitoring developments, determining whether any providers are considered senior executives, evaluating their nonprofit practices, and notifying employees, when and if necessary.
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