FTC ban on non-competes

Published on

Contributors

As we reported in January of 2023, the Federal Trade Commission (“FTC”) published a proposed rule (“Proposed Rule”) that would effectively ban U.S. employers from imposing non-compete clauses on workers or including such clauses in employment contracts. After publishing the proposed rule, the FTC allowed for interested groups to provide their comments. Approximately 26,000 comments were submitted by the public. As such, there was a lengthy delay in the FTC’s decision whether to finalize the proposed rule.

On April 23, 2024, the FTC announced its Final Non-Compete Clause Rule (“Final Rule”), which bans post-employment non-compete clauses between employers and their workers. The Final Rule becomes effective 120 days after being published in the Federal Register (“Effective Date”). As of the date of this article, the Final Rule has not yet been published in the Federal Register, and legal challenges are expected. During the 120-day period, it is expected that trade associations and businesses across the country will challenge the Final Rule and seek an injunction against it.

In fact, two lawsuits were filed on the same date the FTC announced the Final Rule. First, a company called Ryan, LLC, filed a lawsuit in the U.S. District Court for the Northern District of Texas seeking to vacate and set aside the Final Rule on several grounds including: (i) the FTC does not have the authority to issue the rule, and (ii) the rule itself is unconstitutional. Second, the U.S. Chamber of Commerce filed its promised federal lawsuit in the U.S. District Court for the Eastern District of Texas, seeking injunctive relief from FTC’s enforcement of the Final Rule. An injunction, if granted, would halt the enforcement of the Final Rule and (at a minimum) extend the effective date of enforcement.

Key provisions of the final rule

In general, the Final Rule is virtually identical to the Proposed Rule issued in January of 2023.

Scope:

  • The Final Rule prohibits an employer from entering into, or attempting to enter into, a non-compete clause with a “worker” (including employees and independent contractors) or representing that a worker is subject to a non-compete clause. The Final Rule allows employers to maintain existing non-compete agreements with “senior executives” defined as those with over $151,164 annual compensation and in a policy making position for the business. However, the Final Rule bars an employer from entering into, or attempting to enter into, a non-compete clause with a senior executive after the Effective Date of the Final Rule.
  • The Final Rule does not apply to non-competes entered into by a person pursuant to a bona fide sale of a business entity.
  • The Final Rule does not prohibit employers from enforcing non-compete clauses where the cause of action related to the non-compete clause accrued prior to the Effective Date of the Final Rule.
  • The Final Rule further provides that it is not an unfair method of competition to enforce or attempt to enforce a non-compete or to make representations about a non-compete where a person has a good-faith basis to believe that the Final Rule is inapplicable.
  • The Final Rule supersedes all state laws to the extent, and only to the extent, that a state’s laws permit or authorize conduct prohibited under the Final Rule or conflict with the Final Rule’s notice requirements. (As an aside, California has long banned non-compete clauses in employment contracts, therefore, there is no real conflict between California law and the Final Rule. In fact, California’s ban is broader than the Final Rule, as discussed below.)

Notice of Non-Enforcement:

  • The Final Rule requires an employer to provide clear and conspicuous notice to workers subject to a prohibited non-compete, in an individualized communication, that the worker’s non-compete clause will not be, and cannot legally be, enforced against the worker.
  • The employer must provide notice by the Final Rule’s Effective Date by hand-delivery, by mail at the worker’s last known street address, by email, or by text message.

The Final Rule potentially bans non-disclosure and non-solicitation agreements

The Final Rule bans almost all non-competes between employers and workers, but does not explicitly ban non-disclosure agreements, customer non-solicitation agreements, or employee non-solicit agreements.

Regardless, the Final Rule makes clear that it bans these other forms of restrictive covenants when they have the same functional effects as non-compete clauses. The Final Rule provides that a non-disclosure clause operates as a non-compete clause “where [it spans] 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.” Such non-disclosure agreements are so broadly written, the FTC claims, that for practical purposes, “they function to prevent a worker from working for another employer in the same field and are therefore non-competes under [the Final Rule.]” Similarly, non-solicitation agreements can satisfy the definition of non-compete clause “where they function to prevent a worker from seeking or accepting other work or starting a business after their employment ends.”

How does the California law differ from the FTC’s Final Rule?

California has long banned non-compete clauses in employment contracts. As we reported here 2023 New Employment Laws

California enacted AB 1976 in January of 2023 which codified existing case law by specifying that the statutory provision voiding non-compete contracts is to be broadly construed to void the application of any non-compete agreement in an employment context, or any noncompete clause in an employment contract, no matter how narrowly tailored, that does not satisfy specified exceptions. How does the FTC’s Final Rule compare to California’s ban?

The Final Rule covers fewer non-compete clauses than California’s ban. First, the Final Rule contains the above-described exception for existing non-competes imposed on senior executives, while California’s ban has no similar exception. Second, like the Final Rule California’s ban also exempts certain buy/sell agreements. However, this exception under California law has a narrower scope and only allows non-competes against business owners who sell (i) the goodwill of a business, (ii) all of their ownership in a business entity, or (iii) all or substantially all of the assets of a business together with the goodwill of that business. (See Cal. Bus. & Prof. Code § 16601.)

What should employers do if the Final Rule becomes effective?

Employers that use restrictive covenants understandably are nervous about the Final Rule and have been since the FTC published the Proposed Rule in January of 2023. Importantly, it is not yet effective, and the legal challenges to it are significant. As a result, Final Rule will not become effective, if at all, for several months, if not years.

In the interim, employers should draft all restrictive covenants narrowly to protect a legitimate business interest of the employer, such as trade secrets, confidential information, or customer goodwill. The restrictions themselves should be no broader than necessary to protect those legitimate interests, and they must be reasonable in terms of duration, geography, and scope of activities prohibited. Agreements should be drafted in a way to increase the likelihood that any provisions found to be unlawful can be severed from the agreement, leaving other restrictions intact. In fact, any agreement should include a severance clause. Finally, restrictive covenants generally should not be used with lower-level workers absent legitimate reasons to do so.

Employers should bear in mind, of course, that the Final Rule may ultimately become effective. If so, as noted above, virtually all non-competes will be barred, as well as clauses that function to prevent a worker from competing or penalize a worker for competing.

Effect of the Final Rule on buy/sell agreements

As noted above, the Final Rule does not apply to non-competes entered into by a person pursuant to a bona fide sale of a business entity. Specifically, the Final Rule contains an exception for a non-competition agreement “entered into by a person pursuant to a bona fide sale of a business entity, of the person’s ownership interest in a business entity, or of all or substantially all of a business entity’s operating assets.” The FTC requires a bona fide sale to be a sale “made in good faith as opposed to, for example, a transaction whose sole purpose is to evade the final rule,” and generally considers a bona fide sale to be a sale between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale. The FTC’s commentary notes that “non-competes arising out of repurchase rights or mandatory stock redemption programs are not entered into pursuant to a bona fide sale” because “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.” The FTC otherwise expressly declined to delineate the types of “bona fide sales” that would qualify for the exception to the Final Rule’s ban.

California law, on the other hand, only permits non-competes for business owners who sell (i) the goodwill of a business, (ii) all of their ownership in a business entity, or (iii) all or substantially all of the assets of a business together with the goodwill of that business. (See Cal. Bus. & Prof. Code § 16601.)

Under preemption principles, the Final Rule should supersede any state statute, regulation, order, or interpretation to the extent that such statute, regulation, order, or interpretation is inconsistent with the Final Rule except that, if the protection that any such state law affords any worker is greater than the protection provided under the Final Rule, then the state law would continue to apply. Since California’s buy/sell exception is narrower than the Final Rule, California’s rule would not be preempted or superseded by the Final Rule.

In light of the Final Rule, parties to sale transactions that involve noncompetes should ensure transactions are structured as an arm’s length sale between two independent parties and that sellers subject to a post-sale noncompete are represented by counsel in connection with negotiation of the terms of the sale and the noncompete.

Additionally, given the FTC’s focus in the commentary to the final rules on the importance of goodwill in a bona fide sale, ideally a material portion of the consideration received in exchange for the interest of a party bound by a noncompete should be based on the goodwill in the business being sold by the restricted party. This is particularly true for buy/sell agreements governed by California law.