Background

On January 5, 2023, the Federal Trade Commission (“FTC”) published a proposed rule (the “Proposed Rule”) that would have had the effect of banning nearly all employee non-competes throughout the United States and invalidate all such existing agreements subject to a few exceptions.[1] We wrote about the Proposed Rule at the time of publication and are providing an update on the Final Rule that was released by the FTC on April 23, 2024 (the “Final Rule”) after a lengthy review and comment period.[2] The Final Rule will become effective 120 days after its publication in the Federal Register, but remains subject to challenge through litigation. The Final Rule is already subject to two legal challenges in Texas calling into question whether the effective date will be stayed, as well as whether the Final Rule will survive litigation.

From an M&A perspective, the Final Rule represents an improvement over the Proposed Rule as it preserves the validity of non-competes in the sale of a business context and removes the “substantial” ownership test (which required a twenty five percent (25%) ownership in the business to apply). In particular, the Final Rule allows a sale-based non-compete to be valid for any individual entering into such non-compete clause pursuant to a “bona fide” sale, including such individual selling their ownership interest in the business entity, seemingly regardless of the size of their interest.

From an employment agreement perspective, the Final Rule invalidates all new non-competes and restricts enforcement of existing non-competes subject to a few exceptions. Our colleagues discuss the employment aspects of the Final Rule in more detail here.

Historically, non-compete agreements executed by sellers in connection with the sale of a business have garnered less scrutiny from agencies and courts than employment-based non-competes, and the Final Rule maintains this lineage. The Final Rule’s removal of the twenty five percent (25%) threshold test to qualify for the sale of business exception (as was proposed in the Proposed Rule) and allowance of the sale of business exception to apply to any “bona fide” sale of an interest in a business entity is a welcome development for acquirers. Below, we discuss further how the interpretation of “bona fide” may impact the application of the Final Rule, but at the highest level, business principals and in-house counsel should be aware that the sale of business exception is preserved in the Final Rule and can apply to any seller in a sale of a business entity (regardless of the size of the ownership interest sold or the purchase price paid for such interest) so long as the exception is utilized in connection with a “bona fide” sale.

Another notable point in the Final Rule for transactional professionals is the inability of firms to enforce employment-based non-competes that were in existence prior to the implementation of the Final Rule if such non-competes would be prohibited under the Final Rule. This means that almost all non-competes entered into in a context other than the sale of a business will no longer be enforceable, with the sole limited exception in the employment context applying to existing non-competes with “senior executives.”[3]

M&A Transactions and Implications of the Final Rule

M&A transactions where the continued employment of key individuals at the target is a component of the purchaser’s value will be most impacted by the Final Rule. While traditional seller non-competes entered into in connection with a bona fide sale will remain unaffected by the Final Rule, M&A professionals will need to be creative in retaining employees who are not sellers in a sale of a business transaction and with respect to restrictive covenants for employees who “rollover” some portion of their existing equity in transactions or receive equity awards. Below, we highlight certain key issues that we expect M&A professionals to grapple with as the Final Rule is implemented and addressed by dealmakers in the marketplace:

1. Employment Agreements:

While non-compete clauses in employment agreements will no longer be permissible for individuals upon implementation of the Final Rule (other than those applicable to “senior executives” prior to the effective date of the Final Rule), employment agreements remain powerful and straightforward tools to align incentives between key employees of the target and buyers after the closing of a transaction. To incentivize performance and promote retention of key employees, employment agreements may provide for increased deferred compensation, the issuance of equity or payment of bonuses based on certain performance metrics of the business. Our expectation is that the Final Rule will lead to a slight shift in employment agreements that previously may have emphasized the “stick” of a non-compete to retain employees to agreements that instead rely on “carrots” designed to incentivize the employee’s retention through compensation and other enticements. As has always been the case, employers will also need to consider state law with respect to the enforceability of existing non-competes and other related restrictive covenants even if the non-compete in question would be permitted under the Final Rule.

2. Grants of Rollover Equity:

The issuance of rollover equity to selling equityholders is not a new tool, but the prevalence of, and importance of structuring, rollover equity arrangements may increase as a means of creating incentive for key employees to remain with a company following a change of control transaction.

Many sponsors include a non-compete in the stockholders agreement, limited liability company agreement or other governing document tied to the ownership of rollover equity or equity grants. These non-compete provisions typically apply for some period of time after the subject equity is no longer held by the individual in question. While sale of business non-competes are explicitly permitted under the Final Rule, we suspect that the use of “springing” non-competes applicable to minority equityholders who may be “dragged” or forced to sell their equity as part of a larger transaction may draw additional scrutiny if not clearly within the “bona fide” sale exception.

While the Final Rule does not explicitly discuss “drag-along” rights, the Final Rule includes a discussion which expresses skepticism towards “springing” non-competes, which the Final Rule describes as a non-compete provision in which a worker “must agree at the time of hiring to a non-compete in the event of some future sale” and “repurchase rights, mandatory stock redemption programs, or similar stock-transfer schemes” (pursuant to which a worker may be required to sell their shares if a certain event occurs).[4] Given the FTC’s general focus on preventing non-competes and the Final Rule’s lack of a bright line safe harbor for these types of restrictions, dealmakers should not trust non-competes in equity documents to serve as a silver bullet in preventing equity-holding employees (or other individuals from competing after the sale of equity).

To the contrary, the Final Rule makes clear that “springing” non-competes and non-competes arising out of repurchase rights or mandatory stock redemption programs are not entered into pursuant to a bona fide sale because “in each case, the worker has no good will that they are exchanging for the non-compete or knowledge of or ability to negotiate the terms or conditions of the sale at the time of contracting.”[5] The FTC declined to further delineate which kinds of sales transactions would not constitute a “bona fide” sale under the exception, but noted that courts have identified and prohibited such schemes in the past.[6] In particular, the FTC cited a California Court of Appeals decision in which the court refused to enforce a non-compete imposed on a physician under an agreement which required the physician to purchase nine percent (9%) of the stock at hiring and resell the stock to the corporation upon termination because the agreement “was devised to permit plaintiffs to accomplish that which the law otherwise prohibited: an agreement to prevent defendant from leaving plaintiff medical group and opening a competitive practice.”[7]

Without the benefit of challenges to the Final Rule, our initial view is that sponsors and other majority equityholders need to be mindful that non-competes in equity documentation are unlikely to be honored unless the individual subject to such non-compete plays a role in negotiating the terms of the transaction giving rise to the “springing” right or forced redemption or sale. Even worse, such non-competes could be deemed an “unfair method of competition” under the FTC Act that could subject the issuing entity to an FTC enforcement action and penalties. It’s possible that a court or agency interpreting this piece of the Final Rule might view, for example, a CEO subject to an equity-based non-compete who is intimately involved in negotiating the sale of equity that gives rise to a “springing” non-compete much differently than an employee who holds equity and is subject to the same “springing” non-compete but is not closely involved in the negotiation of the equity sale.

Nothing in the Final Rule or the ambiguity around application of the bona fide sale test should discourage sponsors from using equity as a tool to incentivize retention and reward growth, but any reliance on post-sale non-competes that arise due to a drag-along right or other forced sale provision should be tempered by the Final Rule’s fairly strong negative presumption against these provisions.

Sponsors and other investors may also increase their focus on enforcing and clarifying traditional corporate law doctrines which touch on similar concepts addressed by employment-based non-compete clauses. In particular, sponsors may choose to emphasize the application of traditional fiduciary duties such as the duty of loyalty and the related corporate opportunities doctrine to management directors and officers. While these doctrines typically apply to directors and officers of a company, in certain instances, they may also apply to equityholders and therefore may extend beyond the individual’s employment with the company. 

Looking Forward

The Final Rule will face significant legal challenges, which could further delay effectiveness of the Final Rule for months, or even years. Despite the potential for delay, M&A practitioners should begin to familiarize themselves with the nuance of the Final Rule as they evaluate structures in current and future deals, keeping in mind that any existing non-competes that are not enforceable under the Final Rule will lose effectiveness upon implementation of the Final Rule.

 [1] Non-Compete Clause Rulemaking, FTC Federal Register Notices (Jan. 5, 2023), https://www.ftc.gov/legal-library/browse/federal-register-notices/non-compete-clause-rulemaking.

[2] The full text of the Final Rule can be accessed here: https://www.ftc.gov/system/files/ftc_gov/pdf/noncompete-rule.pdf (hereinafter referred to as the “Final Rule”).

[3] A “senior executive” for purposes of the Final Rule is generally defined as an employee who received total compensation of at least $151,164 in the preceding year (with the ability to annualize for employees who worked less than a complete year) and is in a “policy-making position.” See Final Rule at 563.

[4] Final Rule at 342.

[5] Final Rule at 342.

[6] Final Rule at 343.

[7] Final Rule at 343 (citing Bosley Med. Grp. V. Abramson, 161 Cal. App. 3d 284, 291 (Cal. Ct. App. 1984).