Despite the unprecedented and sweeping proposal by the Federal Trade Commission (the “FTC”) to ban post-employment noncompetes, employers should continue to look to applicable state law regarding drafting and enforcing noncompete agreements for the time being. Not only is the FTC seeking comments on the proposed rule, commentators and even FTC Commissioner Christine Wilson (in a dissenting opinion) agree that substantial legal challenges to the proposed rule are inevitable. Commissioner Wilson even opined that the proposed rule is “vulnerable to meritorious challenges”. Moreover, the FTC invited comments on 4 proposed alternatives to the wide-ranging ban, including whether highly paid workers should be treated differently than lower earners and whether a rebuttable presumption against enforceability rather than a complete ban is more appropriate for all or some workers. Thus, by the time a rule is finalized, and legal challenges have been resolved, the FTC rule may look quite different.
Restrictive covenants, notwithstanding antitrust laws and the state and federal governments’ policies of encouraging free competition, have been used by employers for centuries. Restrictive covenants include noncompetition, nonsolicitation of employees and/or customers, confidentiality, and nondisparagement agreements. The most controversial and disfavored among employees is the post-employment noncompete. The courts have developed robust standards regarding the enforceability of such restrictive covenants through hundreds of years of jurisprudence and voluminous litigation. Generally, the standards strive to balance the employers’ legitimate business interests in safeguarding confidential information, relationship goodwill, and other valuable investments, on the one hand, with workers’ abilities to work in their chosen profession, on the other hand. Nonetheless, it is this post-employment noncompete that has been under more scrutiny recently and is the subject of the proposed rule.
The Proposed Rule
On January 4, 2023, the FTC proposed a rule that would render virtually all post-employment noncompete clauses an “unfair method of competition”. Specifically, “entering into” or “maintaining” noncompetes with a worker is prohibited. Notably, the proposed rule seeks retroactive application and rescission of all noncompetes. Further, it requires employers to provide current and former employees with notice that their noncompete clause is not in effect and may not be enforced.
The ban applies to all workers (employees, independent contractors, interns, volunteers). Employers need not employ a certain number of workers or have a minimum revenue to be covered. However, because the proposed rule attempts to rely on section 5 of the Federal Trade Commission Act for its authority, entities not covered by section 5 are excluded by the proposed rule, such as certain banks, savings and loan institutions, federal credit unions, common carriers, and entities not organized to carry on business for their own profit or that of their members.
Nonsolicits and Confidentiality Agreements – “de facto” Noncompetes
The proposed rule does not purport to ban post-employment nonsolicitation or confidentiality agreements. Such restrictive covenants may in fact be banned by the proposed rule, however, if they have “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”. Interestingly, the proposed rule does not identify a nonsolicit as an example. Depending on how such clauses are written and the specific facts, litigation over whether nonsolicitation clauses are “functional” noncompetes seems inevitable. For example, a nonsolicit that prevents a salesman from doing business with current and prospective clients may wind up preventing him from obtaining other employment, especially if there are only a limited number of potential clients within the given market.
Sale of Business Exception:
There is a limited exception for a person selling or transferring ownership of a business or operating assets. This is consistent with long-standing state statutes and common law, which acknowledge the necessity for robust noncompetition protections in the sale of a business context. The proposed rule allows for this exception when the owner, partner, or member, as the case may be, owns at least a 25 percent interest. It is unclear how this particular threshold was selected or why a buyer might have any less interest in (for example) preventing a former 24 percent owner from competing with the buyer.
The proposed rule expressly preempts state or local laws and supersedes all inconsistent law or rules. Currently, state statutes and common law set forth the standards for the enforcement of restrictive covenants. If the proposed rule goes into effect, presumably, these standards would apply only to the businesses excepted from the proposed FTC rule. How the preemption may impact other restrictive covenants, particularly those that may be “de facto” noncompetes, remains to be seen.
The proposed rule does not address noncompetition restrictions in connection with equity grants or deferred compensation (typically provided to higher earners). Presumably, such restrictions are less offensive for three reasons: 1) their remedy tends to be forfeiture of certain deferred compensation rather than an injunction preventing the employee from working for a competitor; 2) whether to accept the competitive position and forfeit the compensation is the employee’s choice; and 3) employees receiving such grants tend to have more bargaining power. That said, the fate of these compensation-based restrictions remains unclear.
Seeking Proposed Comments; Proposed Alternatives:
In the supplementary material, the FTC specifically seeks public comment on these topics:
- Whether senior executives should be exempted from the rule, or subject to a rebuttable presumption of unenforceability (instead of a ban)
- Whether workers should be treated differently based on their rate of pay (e.g., high or low)
- Whether “no-poach” agreements (when employers agree not to solicit or hire each other’s workers) and wage-fixing agreements (when employers agree to cap compensation) should be barred
- Whether franchisees should be covered by the proposed rule
- Whether employers should be obligated to provide advance notice of the noncompete to employees and/or disclose them to the FTC
Similarly, the FTC seeks comment on these 4 less aggressive alternatives to the proposed rule:
- Categorical Ban Below Threshold, Rebuttable Presumption Above Threshold. Employees who earn under a certain amount cannot be subject to a noncompete while those who earn above that amount will have only the benefit of a rebuttable presumption that the noncompete is unenforceable. The thresholds that are mentioned are employees who earn $100,000 per year or those who are exempt under the Fair Labor Standards Act.
- Categorical Ban Below Threshold, No Requirements Above. Employees earning above a certain threshold would be exempt from coverage and therefore subject to post-employment noncompetes.
- Rebuttable Presumption for All Workers. All post-employment noncompetes would be presumed unenforceable which employers could overcome.
- Rebuttable Presumption Below Threshold, No Requirements Above. Rebuttable presumption of unlawfulness of noncompetes for workers below a certain threshold and all others can be subject to noncompetes.
State Law Governs
Unless and until the FTC proposed rule and its preemption clause is effective, state law continues to govern the enforceability of noncompetes. Prior to the FTC proposed rule, a growing number of states had enacted legislation to prevent or curtail the use of post-employment noncompetes. Other states are now considering similar legislation. This, in fact, may have been a motivating factor behind the FTC’s actions, i.e., spurring a national discussion of the topic and state legislatures to act.
The fate of the FTC’s proposed rule is far from certain, and even if the rule survives the anticipated serious legal challenges, its final form may look quite different from its current iteration. Accordingly, at this time we do not believe that it would be a productive exercise for most employers to engage in extensive planning with respect to the FTC’s specific proposal.
However, it may be the case that part of the FTC’s motivation was to initiate a national conversation about the fairness, necessity, and appropriateness of restrictive covenants, generally. In that regard, we agree that the discussion is appropriate – as it always has been. Employers would be well-served to carefully consider the restrictive covenants they currently use, which employees are bound by them, and whether those restrictions are truly necessary to protect a business interest, such as confidential information or customer goodwill. For example, businesses may decide that they do not need full-blown noncompete restrictions, and rather that narrowly-tailored and carefully-considered nondisclosure and nonsolicitation provisions are sufficient. Finally, employers must continue to monitor state and local law for any related legislative developments, especially given that the final say on this topic might come from the various state legislatures. Indeed, bills banning and/or curtaining noncompetes are currently pending 13 states, including New York.