iOn May 7, 2024, the Federal Trade Commission (FTC) published a final rule that effectively bans all non-compete agreements between employers and “workers” as “unfair method[s] of competition” and requires employers to refrain from enforcing most existing non-compete agreements.
Quick Hits
- The FTC’s final rule prohibiting most non-compete agreements involving “workers” applies to terms and conditions of employment that “prohibit[] a worker from, penalize[] a worker for, or function[] to prevent a worker” from seeking or accepting work in the United States or from operating a business.
- The exceptions to the rule pertain to existing agreements with senior executives, sale-of-business non-competes, and causes of action that accrue before the rule’s effective date of September 4, 2024.
- The rule also contains notice requirements that employers must send to their employees who have non-competes, advising the employees that the non-competes are no longer enforceable.
The rule is being challenged in two lawsuits seeking, among other things, a temporary stay of the rule’s effective date. In one case, in the U.S. District Court for the Northern District of Texas, the court has indicated it will rule on whether to issue a stay by July 3, 2024.
If a stay is not issued by August 1, 2024, employers should begin planning for the rule to take effect by September 4, 2024 (120 days from the rule’s May 7 publication date 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 purports to preempt all state laws addressing non-competes. According to the FTC, a “non-compete” is “a term or condition of employment that prevents the worker from, penalizes a worker for, or functions to prevent a worker from” seeking or accepting work in the United States, or operating a business in the United States. A “worker” is anyone from the CEO of a company to its mail room employees, and the term includes independent contractors. Also, it appears that the FTC does not view “garden leave” provisions or other provisions that continue employment as non-competes because those employments are not post-employment restrictions.
“Non-compete” redefined. Clearly, the FTC broadened the traditional definition of “non-compete” by using the phrase “term or condition of employment,” which is expanded from the phrase “contractual term” in the proposed version of the rule. The “penalizes” and “functions to prevent” language also seems designed to expand the traditional non-compete definition. In the previous iteration of the proposed rule, as examples of provisions that may function as non-competes, the FTC identified: (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. The FTC’s expansive definition of “non-compete” in the final rule indicates that its examples under the proposed rule remain relevant.
Non-solicits are probably “non-competes.” Given the examples from the proposed rule, the FTC’s expanded definition of non-competes likely extends to clauses that restrain the solicitation of customers if those provisions are broad enough to be construed as functioning to prevent “a worker from seeking or accepting” employment. Since non-solicits do not, textually, prohibit a worker from seeking competitive employment, this will be an area of intense litigation.
Largely retroactive effect. The FTC rule will be retroactive—invalidating non-competes that existed prior to the rule, except for existing agreements with senior executives (see below) and causes of action that accrue before the effective date of the rule. The FTC claims that it is an act of unfair competition to “enforce or attempt to enforce a non-compete clause.” Accordingly, existing non-competes, other than those with senior executives and those for which a cause of action accrues before the rule’s effective date, will be retroactively invalidated by the rule.
Senior executive exception for existing agreements. Agreements with senior executives that preexist the rule’s effective date remain in place. “Senior executives” are defined as employees in policymaking positions who have annualized compensation of over $151,164. It appears that the FTC’s definition of “policymaking authority” will be very narrow, requiring “final” policymaking authority over more than just a segment of a business. New agreements with senior executives will be prohibited after the effective date of the rule.
What Does It Mean to “Function to Prevent a Worker From Seeking or Accepting Employment”?
It is unclear whether the FTC intends this phrase to apply objectively (does the provision actually “function to prevent” the worker from seeking or accepting employment) or subjectively (based on the worker’s 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 nondisclosure 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 objectively 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 prevents is part of the definition. But even if not, there is no question that certain provisions, even if applied narrowly, would prevent an employee from calling on the same relationships for a competitor that she served during her employment. These situations will likely produce litigation with the FTC as employers resist its broad definition of “non-compete.”
What About Forfeiture Provisions and Clawbacks Based on Non-Competes?
The FTC’s rule preempts previously well-settled authority holding 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 non-competes, since leaving money on the table “penalizes” an employee for seeking or accepting work. 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 Rule Affect Trade Secret Protection?
Technically, it does not. State and federal trade secret laws remain in place and employers will retain the same rights to protect trade secrets under those laws. Practically, however, the 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 will likely eliminate a contractual protection for trade secret information, and for confidential information that may not rise to the level of a 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 significantly. 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 and its “rule” purports to preempt all state laws governing non-competes.
If the federal courts permit the FTC to regulate any activity it declares to be an “unfair method of competition,” this would constitute a significant expansion of the FTC’s power. Although the Constitution grants the 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 the power to decide a “major question” that arguably is within congressional authority, rather than executive branch authority, is a question that will not be resolved quickly. That said, as noted above, there are pending requests seeking a stay of the effective date of the rule that could result in a stay until the issue reaches the Supreme Court.
What Should Employers Do Now?
Employers have several options to consider:
Do nothing. Wait and see what happens. As noted, worst case, the rule’s effective date is September 4, 2024. It is likely that the legal challenges to the rule will result in a stay of its effective date, meaning that 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 held on April 23, 2024. But even under this option, employers should narrowly tailor 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 on September 4, 2024, by rewriting template contracts to remove non-competes. Employers can retain nondisclosure and customer non-solicit provisions, but should narrow them as much as practicable. Employers should do the same with other provisions that are at risk of functioning to prevent workers from seeking new employment.
Occupy a middle ground. Retain non-competes 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 associated with each of these approaches, and each employer will decide what best suits its legitimate business interests moving forward.
