April 24, 2024 at 4:00 AM
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On April 23, 2024, by a 3-2 margin, the FTC voted to finalize its controversial NON COMPETE RULE which will generally prohibit businesses from entering into non-compete agreements with nearly all workers across the U.S. going forward and invalidate the existing non-competes of nearly 30 million workers.

The Rule Is Already Subject to Legal Challenges.

Unsurprisingly, a lawsuit was filed immediately in a Texas federal court (and others have since followed).  The suit was anticipated by the FTC Commissioners voting in favor of the rule.  The draft Federal Register Notice is 570 pages long, with the first 561 pages consisting of an exec summary explaining the factual and legal support for finalizing the rule, including a section addressing the Supreme Court’s recent deployment of the “major questions” doctrine, which signaled to Federal regulatory agencies to hesitate before concluding they have the authority to issue regulations on significant political and economic issues.

The two dissenters, newly-confirmed Commissioners Holyoak and Ferguson, noted they expect the rule to run into the “major questions” doctrine, and they also contend: (i) the Commission lacked the statutory authority to issue competition rules; (ii) the action upset the federalism balance, since the non-compete question has been principally a matter of state law; and (iii) adopting the rule on the record compiled was arbitrary and capricious under applicable administrative law. 

If the Rule Survives the Legal Challenges, It Will Ban Nearly All Non-Competes and Become Effective as Early as the End of Summer 2024. 

Essentially, the rule states that it is an unfair method of competition under Section 5 of the Federal Trade Commission Act for businesses to take any of the three following acts with respect to a worker:

  1. To enter into or attempt to enter into a non-compete clause;
  2. To enforce or attempt to enforce a non-compete clause; or
  3. To represent that the worker is subject to a non-compete clause.

There are some noteworthy limitations.  The most notable being that existing non-competes with “senior executives” can remain in effect – a notable change from the original proposed rule.  The final rule also does not prohibit the use of non-competes in connection with a bona fide sale of a business entity, of a person’s ownership interest in a business entity, or of all or substantially all of a business entity’s operating assets.  The original proposed rule had included a 25% ownership threshold which the FTC eliminated in the final version.  We discuss these exemptions further below. 

The rule also only extends as far as the FTC’s reach.  For the most part, the FTC lacks jurisdiction over non-profit entities, which the rule does not impact.  The Commission cautioned, however, that it does not view the tax-exempt status of any such entity as dispositive when considering an exemption.  The rule also does not extend to restrictions on working for, or operating, a business outside of the U.S. and it does not stop businesses from pursuing non-compete legal claims against a worker that accrued before the rule’s effective date. 

At present, the rule is scheduled to become effective 120 days after its publication in the Federal Register.  That typically takes a few weeks, which would place the effective date at around late August or early-to-mid September. 

Employers Should Pay Close Attention to the Rule’s Definition of Non-Compete.

The rule defines a “non-compete clause” broadly as a “term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from: (i) 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 (ii) operating a business in the United States after the conclusion of the employment that includes the term or condition.”  The rule makes clear that it extends not just to written contracts, but also to verbal ones along with workplace policies.  Critically, the rule only bars post-employment non-competes, not ones that bar other competitive employment during the existing employment relationship. 

The Commission spends much time focusing on definitions: “prohibits,” “penalizes,” and “functions to prevent,” to help employers understand the ban’s reach.  More specifically:

  1. The rule does not prohibit employers from utilizing a “garden leave” concept – in other words, an employer can place an employee on a non-working notice period in which the employee receives compensation (and benefits) on a pro rata basis until the relationship terminates. 
  2. At the same time, the Commission took the controversial position that employers may no longer utilize “forfeiture for competition” provisions (e.g., where a business uses equity awards or other compensation to restrict an employee’s service on behalf of a competitor, and where the employee has the option to either compete or forfeit the promised equity/compensation) finding that they act as a penalty.  The Commission took the same position with respect to the loss of promised severance payments.  At the same time, the Commission noted that the rule does not bar employers from seeking repayment of a sign-on or similar bonus if an employee leaves before a certain period of time.  
  3. The sale of business exemption ultimately was broader than under the proposed rule, including by eliminating the 25% ownership threshold.  Businesses looking for wins under this new rule will welcome their continued ability to utilize these clauses as part of transactions, and to protect their purchase of goodwill. 
  4. The rule does not ban other types of restrictive covenants such as non-disclosure, non-solicitation, non-service and non-hire covenants, but the Commission warned that such covenants could convert into unlawful non-compete functional equivalents if they cover “such a large scope of activity that they function to prevent a worker from seeking or accepting other work or starting a new business after their employment ends, although they are not expressly triggered by these specific undertakings.”  The Commission noted that such covenants would need to be analyzed on a case by case basis and draw on applicable state law tests for enforcement. 

The Ban Extends Broadly to Nearly All Workers with Limited Exceptions (e.g., “Senior Executives”).

The rule extends broadly to all types of workers, whether paid or unpaid and regardless of the worker’s title or status under any law, including employees, independent contractors, externs, interns, volunteers, apprentices, or sole proprietors who provide a service to a business.  It also includes those who work for a franchisee or franchisor but excludes franchisees in the context of a franchisee-franchisor relationship. 

As mentioned above, it does not include existing non-competes for senior executives.  The Commission recognized that the non-compete provision is often a part of the give-and take of the negotiations, in the context of transactions, and may have affected the salary component of the existing agreements with these executives.  But the Commission estimates that fewer than 1% of the impacted workers would qualify as a senior executive under the final rule.  The reason for that low percentage is that the rule defines a senior executive as a worker who is in a “policy making position” and received total annual compensation of at least $151,164 in the preceding year.  The Rule defines “policy making position” very narrowly such that it will likely only apply to key decision-makers at a company. Furthermore, this already narrow exception is limited – businesses would be prohibited from entering into new non-competes with senior executives after the rule’s effective date.

As the final rule only applies to workers, the Commission confirmed that it does not apply to non-competes between two businesses (although such businesses should remain aware of other anti-competitive issues that may arise when utilizing such terms).

Employers Must Notify Workers of Their Non-Compete’s Invalidation.

The new rule requires employers to notify their workers no later than the rule’s effective date that the employer cannot and will not enforce their non-compete clause. The rule provides various ways in which the employer can notify the worker along with a form of notice. 

Regardless of the Outcome of Legal Challenges, This Issue is Not Going Away and Employers are Well-Advised to Consider Their Restrictive Covenant Approaches. 

Even if the rule is struck down, the story will not end there.  Non-competes are prevalent in American society but have come under increasing attack.  In recent years, there has been a significant push both judicially and in state legislatures against broad-based non-competes – some states now ban them altogether while others are considering doing the same; many more limit their use in other ways. Even before the FTC’s final rule was released, employers were already considering alternatives to the use of non-competes, and regardless of the outcome of the legal challenges to the rule, they will continue to do so. 

Even the FTC recognized this, noting that employers have a bevy of options to prevent post-employment unfair competition, including by using confidentiality, trade secret, and invention assignment agreements, implementing broad trade secret protection programs, and entering into appropriately tailored non-solicitation agreements.  It also highlighted the use of contracts for fixed terms or compensation schemes that reward continued service such as retention awards (as opposed to a forfeiture model), along with providing overall better pay and benefits.  In that regard, the FTC is not wrong – employers do have those tools at their disposal. 

Regardless of the outcome, employers are well-advised to carefully consider their continued use of restrictive covenants of all types, including:

  • reviewing and reshaping covenants contained in existing template agreements’ to ensure they are adequately designed to protect against unfair competition and are otherwise in compliance with applicable law;
  • assessing the compensation and equity-based impact the loss of a non-compete covenant will have, including in certain transactional contexts; 
  • preparing to come into compliance with the new rule should it survive a legal challenge, including providing the requisite notice to impacted workers; and
  • evaluating and enhancing policies and practices related to the protection of confidential and trade secret information. 
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