Editor’s Note: The information reflected below was accurate at the time of publication.
On April 23, the Federal Trade Commission (FTC) announced a new rule that, once in effect, would effectively prohibit employers from entering into new noncompete agreements with workers and invalidate most existing noncompete agreements nationwide. The final rule was scheduled to go into effect 120 days after being published in the Federal Register, or Sept. 4. However, on Aug. 20, a Texas federal district court ruled that the FTC exceeded its authority in issuing the final rule and effectively blocked its enforcement nationwide (known as the “Texas court suspension”). On Oct. 18, the FTC appealed the decision, setting the stage for the Fifth Circuit Court of Appeals to consider the case.
While the FTC may not win this battle on noncompetes, the rule has brought up the issue of noncompetes on a national level, and many state legislatures have either passed or are introducing legislation that bans noncompete agreements in their states. Unless the U.S. Court of Appeals for the Fifth Circuit reverses the decision of the district court, the rule will remain unenforceable during the appeal process. There are other cases to be decided in other district courts, and a split in the circuits' decisions could lead the Supreme Court to weigh in on the final rule. However, based on recent rulings by both the U.S. Court of Appeals for the Fifth Circuit and the Supreme Court, the FTC’s success on appeal seems doubtful.
This article will provide an overview of the rule, the reasoning behind it and its implications for employees and employers, as well as what employers can do to minimize its impact, should the rule be upheld.
In announcing the final rule, FTC Chair Lina M. Khan said, “Noncompete clauses keep wages low, suppress new ideas and rob the American economy of dynamism, including from the more than 8,500 new startups that would be created a year once noncompetes are banned. The FTC’s final rule to ban noncompetes will ensure Americans have the freedom to pursue a new job, start a new business or bring a new idea to market.”
Once the rule goes into effect, it will supersede state laws on noncompetes if a state law permits or authorizes conduct that conflicts with it. If an employer tries to enforce a noncompete after the effective date, it will be considered an “unfair method of competition” and a violation of Section 5 of the FTC Act, which may result in penalties or injunctive relief. In cases of noncompliance, the FTC cannot fine a company directly. However, it can issue an enforcement action to order compliance, requiring the employer to provide notice to employees in an individual manner that their noncompete cannot be enforced. If the order is not acted on, the FTC can file an action in court seeking to enforce the compliance order. Failure to follow the compliance order could result in fines of up to $51,744 for each violation.
The rule makes it easier for employees to leave their current employer and work for a competitor or start a new business without the fear of legal action being taken against them for violating a noncompete agreement. Indeed, providing workers with the freedom to change jobs, which could lead to more innovation and more new companies being formed, was part of the rationale for the rule. The FTC believes that wages for employees will increase, as employers will need to offer competitive compensation to hire and retain employees. It is important to note that a breach or violation of an existing noncompete agreement that was in place before the effective date may be enforced if the action related to the noncompete violation occurred prior to the effective date.
However, the final rule does not prohibit noncompete agreements in all situations. Exceptions exist for senior executives and business owners. Under the rule, a senior executive is defined as an employee earning over $151,164 in the prior year and in a policy-making position in the business. While noncompete agreements with senior executives are permitted and are enforceable by an employer after the effective date, employers may not enter or attempt to enter into such agreements after the effective date. Additionally, the final rule does not apply to owners who enter into a noncompete agreement in relation to a bona fide sale of their business, regardless of their ownership percentage, and such noncompete agreements are enforceable after the effective date.
A key aspect of the final rule may have an immediate impact on businesses. Employers were originally required to inform employees in writing—except for senior executives—before the effective date that their noncompetes are no longer enforceable. This notice must be clearly communicated if the employer has either a mailing address, email address or cellphone number of the affected employee. The rule provides model language for such notice. In the meantime, though, due to the Texas court suspension, employers are not required to discontinue noncompetes or issue notices to employees with noncompete agreements, as previously mandated.
Updating Agreements
Although the final rule provides more freedom for employees, there are certain steps that employers can take to protect their business. One way to mitigate the impact is through restrictive covenants with employees and independent contractors. Nondisclosure agreements are used to protect trade secrets, and nonsolicitation agreements for customers and employees are used to prevent former employees from poaching customers and employees of the employer. Employers should carefully review, with the assistance of legal counsel, the current restrictive covenant agreements they have with their employees. Such reviews should be done so that any changes made to the agreements are enforceable and do not violate the requirements of the final rule. Although it does not prohibit the use of the restrictive covenant agreements mentioned above, it does establish that such agreements need to be narrowly tailored, so that they do not have the same effect as a noncompete agreement.
The rule provides that nondisclosure agreements can function as noncompete agreements when they “span such a large scope of information that they function to prevent workers from seeking or accepting other work or starting a business after they leave their job.” The FTC states that such agreements “prevent a worker from working for another employer in the same field and are, therefore, noncompetes under the final rule.”
The FTC has used the same line of reasoning for nonsolicitation agreements for customers and employees. A nonsolicitation agreement of customers will be considered to function as a noncompete if it imposes undue restrictions on an employee’s ability to find future employment. For instance, if the employee’s nonsolicitation agreement for customers extended to all the company’s customers—not only the customers whom the employee had relationships with—this agreement would violate the final rule, as it does not allow the employee to work in the same industry, thus acting as a noncompete.
Using Diverse Retention Tools
Other practices can help companies mitigate the effects of this or other noncompete rules. Besides updating existing nondisclosure and nonsolicitation agreements, companies can use different tools to help hire and retain employees.
Employees will be more inclined to stay with their current employer if the company maintains retention tools, such as bonuses, deferred compensation plans that require continued employment to receive payouts and equity rewards that vest over lengthy periods. Companies may consider which senior executives do not have noncompetes and enter into a noncompete agreement before the effective date.
Companies may also invest in internal training and development so that the required skills needed to replace a departed employee are acquired by current in-house employees. By investing in training, employers can avoid hiring outside employees from competitors who may bring in noncompete issues.
Another suggestion would be to invest in and maintain customer relationships so that the relationship is independent of individual employees.
The FTC's final rule introduces a major change by banning most noncompete agreements nationwide. While this can increase employee freedom, it presents a challenge to employers who rely on noncompetes to help protect their business interests. Although a
Texas court has blocked implementation (at the time of publication), employers should still prepare by reassessing their restrictive covenants with legal counsel and adopting alternative strategies, including increased use of restrictive covenants and retention tools, as well as investing in training and customer relationships, to adapt to the new regulatory landscape.
Employers or their legal counsel should carefully follow the final rule as it moves through the appeals process, which could take up to 18 months. Companies, in the meantime, should identify which employees and former employees have active noncompete agreements in place and be prepared to notify them—should the rule be upheld—that their noncompete agreements are no longer enforceable by the company. With proper planning, businesses can navigate these changes and remain competitive.
What the FTC Final Rule Said
“The final rule provides that it is an unfair method of competition—and therefore a violation of section five—for employers to (…) enter into noncompete clauses with workers on or after the final rule’s effective date. The commission thus adopts a comprehensive ban on new noncompetes with all workers.
“The final rule contains separate provisions defining unfair methods of competition for the two subcategories of workers. Specifically, the final rule provides that, with respect to a worker other than a senior executive, it is an unfair method of competition for a person to enter into or attempt to enter into a noncompete clause; to enforce or attempt to enforce a noncompete clause; or to represent that the worker is subject to a noncompete clause.
“The final rule defines a ‘noncompete clause’ as ‘a term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from (1) seeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment that includes the term or condition; or (2) operating a business in the United States after the conclusion of the employment that includes the term or condition.’ The final rule further provides that, for purposes of the final rule, ‘term or condition of employment’ includes, but is not limited to, a contractual term or workplace policy, whether written or oral. The final rule further defines ‘employment’ as ‘work for a person.’”
What the Texas Federal Court Said
“The record does not support the rule. In enacting the rule, the Commission relied on a handful of studies that examined the economic effects of various state policies toward noncompetes. (…) The record shows no state has enacted a noncompete rule as broad as the FTC’s rule. (…) The FTC’s evidence compares different states’ approaches to enforcing noncompetes based on specific factual situations—completely inapposite to the rule’s imposition of a categorical ban. (…) As to this latter point, the FTC provides no evidence or reasoned basis. The Commission’s lack of evidence as to why they chose to impose such a sweeping prohibition—that prohibits entering or enforcing virtually all noncompetes—instead of targeting specific, harmful noncompetes, renders the rule arbitrary and capricious. (…) In sum, the rule is based on inconsistent and flawed empirical evidence, fails to consider the positive benefits of noncompete agreements and disregards the substantial body of evidence supporting these agreements.
“The FTC’s ‘compelling justifications’ for its decision to not consider other exceptions or alternatives does not adequately justify the rule. The FTC dismissed any possible alternatives, concluding that either the pro-competitive justifications outweighed the harms or that employers had other avenues to protect their interests. (…) The court cannot conclude the noncompete rule ‘fall(s) within a zone of reasonableness,’ nor is it ‘reasonably explained.’”
