Quick Hits

• The FTC voted to approve a final rule that will effectively ban the use of non-compete clauses by employers and require employers to rescind existing such agreements, with the exception of existing agreements with senior executives.
• The final rule would apply to any contractual provisions that have the effect of prohibiting a worker from seeking employment.
• The rule includes an exception for non-compete agreements entered into as part of the sale of a business.
• The rule is set to take effect 120 days after publication, but it is likely to face legal challenges that could delay its effective date.

The FTC voted 3-2 to approve the final regulations, referred to as the Non-Compete Clause Rule, the approval coming fifteen months after the FTC released its proposed rule in January 2023. The rule, which was enacted pursuant to President Biden’s 2021 “Executive Order on Promoting Competition in the American Economy,” effectively prohibits the use of almost all non-compete clauses.

Employers will be prohibited from entering into non-compete clauses and will be required to rescind existing non-compete clauses. According to the rule’s preamble, “it is an unfair method of competition—and therefore a violation of section 5—for employers to, inter alia, enter into non-compete clauses with workers on or after the final rule’s effective date.” The rule goes into effect 120 days after publication in the Federal Register.

What Does the FTC Rule Do?

The FTC rule purports to ban all non-competes for nearly all employees of for-profit employers. The FTC rule will purport to preempt all state law addressing non-competes. According to the FTC, a “non-compete” 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.” A “worker” is anyone from the CEO of a company to its mail room, and the term includes independent contractors. The FTC rule allows an exception for a bona fide sale of business, and eliminates the 25 percent threshold that appeared in the proposed rule. Employers would have 120 days from the FTC’s publication of the final rule to comply with it.

“Non-compete” redefined. The FTC notes that this definition of “non-compete” applies not only to non-competes, but terms that function as non-competes—meaning any contractual provision that “has the effect of prohibiting the worker from seeking or accepting employment.” As examples of agreements/terms that may function as non-competes, the FTC identifies: (1) a nondisclosure provision that is “written so broadly that it effectively precludes the worker” from working in the same position for a new employer and (2) a provision that requires a worker to repay training costs where the repayment is not “reasonably related to the costs” of the training.

Nonsolicits COULD be implicated under the rule. The FTC’s expanded definition of non-competes could extend to customer and employee nonsolicits if those provisions are broad enough to be construed as preventing “a worker from seeking or accepting” employment.

Largely retroactive effect. The FTC rule will be retroactive—invalidating non-competes that existed prior to the rule, with the exception of existing agreements with senior executives. It requires that, once the rule is effective, employers advise their employees and former employees in writing that their non-competes are no longer enforceable, and provides a model form of notice to do so. The FTC also claims that an employer that “maintains” a non-compete is committing an act of unfair competition. This means that employers currently in litigation to enforce non-competes when/if the rule becomes effective will likely be—in the FTC’s view—committing unfair competition unless they dismiss the litigation, or at least the claims based on any non-compete for “de facto” noncompete.

Senior executive exception for existing agreements. Existing agreements may remain in place for senior executives, defined as employees in a policy-making position and annualized compensation of over $151,164. New agreements will be prohibited after the effective date.

What Does It Mean To “Prevent The Worker From Seeking Or Accepting Employment?”

It is unclear whether the FTC intends this phrase to apply objectively (does the provision actually prevent the worker from seeking or accepting employment) or subjectively (based on the workers’ belief that the provision prevents her from seeking or accepting employment). The potential ambiguity here is significant, and problematic. For example, even a narrowly drafted non-disclosure provision may cause an employee to reject competitive employment. And certainly, a well drafted customer nonsolicitation provision could cause an employee to reject competitive employment. But both provisions would clearly permit competitive employment.

Given its expansive approach to the definition of a non-compete, it seems most likely that the FTC will take the view that the employee’s subjective belief about what a provision prohibits is part of the definition. But even if not, there is no question that certain provisions, even applied narrowly, would prevent an employee from calling on the same relationships for a competitor that she served during her employment. Even objectively, then, under the FTC’s definition, these provisions would be “de facto” non-competes.

What About Forfeiture Provisions and Clawbacks Based on Non-competes?

The FTC’s rule preempts previously well-settled authority that where an employee has a choice between competing and retaining a deferred benefit (whether money or equity), the provision in question does not prevent the employee from competing. The FTC is very likely to view these forfeiture and clawback arrangements as “de facto” non-competes, since leaving money on the table could cause an employee not to “seek or accept” work from a competitor. Where these forfeiture and/or clawback provisions are part of an Employee Retirement Income Security Act (ERISA) plan, the question becomes more interesting, since the FTC does not claim its rule preempts ERISA.

How Does the Proposed Rule Affect Trade Secret Protection?

Technically, it does not. State and federal trade secret laws will remain in place and employers will retain the same rights to protect trade secrets under those laws. Practically, however, the proposed rule may have a devastating effect on trade secret protection for a couple of reasons: (1) non-competes and similar provisions are a critical part of ensuring employees do not use trade secret information to compete unfairly—it is often hard to catch someone who has stolen trade secrets, but the enforcement of a non-compete prevents this; (2) invalidating nondisclosure provisions obviously will eliminate a contractual protection for trade secret and confidential information that may not rise to the level of trade secret.

Does the FTC Possess the Power to Ban Non-competes?

The FTC has concluded that non-competes are an “unfair method of competition.” By articulating this characterization of all non-competes, it purports to expand its own jurisdiction. Because non-compete clauses are contracts, they have traditionally been governed by state—not federal—law. Consequently, different states have taken different approaches to the issue, from generally prohibiting their use (e.g., California, Minnesota, Oklahoma, etc.)—to restricting unique issues like prohibitions on non-competes with “low wage” workers (e.g., Colorado, the District of Columbia, Illinois, Washington, etc.)—to generally permitting such agreements (e.g., Florida, Missouri, Ohio, and Texas). Federal regulation by the FTC of non-compete clauses is therefore unprecedented.

Moreover, if the FTC is permitted to regulate any activity it declares to be an “unfair method of competition” this would constitute a significant expansion of its power. Although the U.S. Constitution grants the U.S. Congress the authority to regulate matters that affect interstate commerce, it does not grant such authority to the executive branch, of which the FTC is a part. Whether the FTC has this power, to decide a “major question” that may be within congressional authority, rather than executive branch authority, is a question that will not be resolved quickly.

Legal challenges are likely to be immediately filed against the rule, and it could be quite some time before this question is resolved in the courts.

What Could Employers Do Now?

Employers have several options to consider:

• Nothing. Wait and see what happens. As noted, worst case, employers will have 120 days after publication of the rule to comply with it. And it is more likely that the legal challenges to the rule will result in a stay of its effective date, meaning it may be years before the rule is effective, if ever. New FTC Commissioners Holyoak and Ferguson discussed several of these issues during the Open Commission Meeting. But even under this option, employers should continue to be thoughtful about narrowly tailoring non-competes, nonsolicits, and/or nondisclosure covenants. If the FTC / federal efforts fail, many states are still heading in the direction of limiting the use of restrictive covenants.
• Embrace the potential future. Prepare as though the rule will become effective in 120 days by rewriting template contracts to remove noncompetes. These employers can retain nondisclosure and nonsolicitation of customers provisions but should narrow them significantly. They should do the same with any other provisions that are at risk for being “de facto” noncompetes.
• Occupy a middle ground. Retain non-competes (and “de facto” noncompetes) for high level executives and other significantly compensated employees, counting on the courts to force a modification of the FTC rule that does not treat all “workers” the same.

Obviously, there are risks and benefits with all these approaches and each employer will decide what best suits its legitimate business interests moving forward.