This week, the Federal Trade Commission (“FTC”) voted
3-2 along party lines to finalize a rule that bans noncompete clauses in
employment agreements as a per se illegal “unfair method of
competition” (“UMC”) under Section 5 of the FTC Act.
The Chamber of Commerce and others already have filed lawsuits
seeking to invalidate the rule, and those lawsuits could result in
a stay of the rule as the cases proceed. In this White
Paper, we summarize the ban and provide guidance for
businesses about how to react to the uncertainty that the FTC’s
recent actions have created.
WHAT DOES THE FTC’S FINAL NONCOMPETE RULE SAY?
- The final rule creates a comprehensive ban on new
postemployment noncompetes with virtually all workers (defined
broadly), including senior executives, regardless of wage or skill
level - For existing noncompetes, the final rule creates a narrow
exception for “senior executives,” who are defined to
include only workers earning more than $151,164 who have
“final authority to make policy decisions that control
significant aspects of a business entity or common
enterprise.” Workers with final authority for “only a
subsidiary or affiliate of a common enterprise” are not
subject to the exception. The FTC estimates that approximately
0.75% of workers are likely to fall within this exception. - On its face, the rule does not prohibit non-solicit agreements
(of customers or employees) or non-disclosure agreements. However,
the rule broadly defines noncompetes to include any contractual
term between employers and workers that would “function to
prevent” or penalize a worker from competing with a prior
employer. - The rule does not apply to entities that are exempt from the
FTC’s jurisdiction, such as certain nonprofit organizations,
financial institutions (banks, credit unions, savings and loans),
air carriers, other common carriers, and corporations subject to
the Packers and Stockyards Act, 1921, as amended. Although the FTC
acknowledges it lacks authority to enforce the ban against
non-profit entities, it reserved the right to investigate whether
non-profits qualify for that exemption. - The rule will become effective 120 days after its publication
in the Federal Register, which is expected soon. - By the effective date, the rule requires employers to notify
workers (other than “senior executives”) that their
noncompetes are no longer in effect and will not be enforced. The
FTC included a model notice, which is available here. - The FTC is facing serious challenges in court that it lacks
authority to engage in rulemaking with respect to unfair methods of
competition, among other arguments. Those courts are likely to
address whether to issue a stay within several weeks or a few
months, before the 120-day effective date. - The final rule expands the M&A exception from the draft
rule, permitting noncompete clauses entered into 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.”
WHAT SHOULD I DO NOW IF MY COMPANY HAS NONCOMPETES?
The ban will not take effect until 120 days after the FTC
publishes the rule in the Federal Register, which is
likely to happen in the coming days. Therefore, even if courts
decline to stay the rule, there is time to develop a plan for
compliance. However, until we know if a stay will be issued,
companies should begin outlining a plan for compliance in case it
becomes necessary. They should understand the universe of existing
noncompete agreements; develop a plan for recission notices; and
consider alternative provisions, such as installment payments,
non-solicitation agreements, and garden leave while ensuring that
such alternatives do not constitute “de facto”
noncompetes. Similarly, companies should review agreements offered
to new hires and consider whether to include alternative
protections until we know if the rule will be stayed.
WHAT ARE THE EXCEPTIONS TO THE FTC RULE?
Subject to the exceptions below, the final rule bans most
employer/ worker noncompete clauses nationwide, superseding state
laws that are less restrictive than the FTC rule. The broad
definition of “worker” covers both employees and
independent contractors, and other workers whether or not
classified as employees, including externs, interns, volunteers,
apprentices, or sole proprietors who provide a service to a client
or customer.
“Senior Executive” Exception
The “senior executive” exception (allowing only
existing noncompetes to remain in effect)
is narrow, applying only to workers earning more than $151,164 who
have “final authority to make policy decisions that control
significant aspects of a business entity or common
enterprise.” Only CEOs and presidents are presumed to be in a
policy-making position, but others might qualify too. For example,
the FTC states that “many executives in what is often called
the ‘C-suite’ will likely be senior executives if they are
making decisions that have a significant impact on the business,
such as important policies that affect most or all of the
business.”
The “senior executive” definition excludes workers
with final authority for “only a subsidiary or affiliate of a
common enterprise.” “Common enterprise” is not
defined. Rather, the FTC states that it will look “beyond
legal corporate entities to whether there is a common enterprise of
“‘integrated business entities.'” The example
provided is having “one or more of the following
characteristics: maintain officers, directors, and workers in
common; operate under common control; share offices; commingle
funds; and share advertising and marketing.”
The supplemental information to the rule provides the following
examples:
- If the head of a marketing division in a manufacturing company
makes policy decisions only for the marketing division, and those
decisions do not control “significant aspects of the business
(which would likely be decisions that impact the business outside
the marketing division),” the FTC would not consider that
worker to be a senior executive. - In a hospital system, neither the head of a hospital’s
surgery practice nor a physician who runs an internal medical
practice that is part of a hospital system would be “senior
executives,” assuming they are decision-makers only for their
particular division. - Partners in a business, such as physician partners of an
independent physician practice, would qualify as senior executives
under the duties prong, assuming the partners have authority to
make policy decisions about the business. In contrast, a physician
who works within a hospital system but does not have policymaking
authority over the organization as a whole would not qualify.
The stated intention of the narrow definition is “to
isolate the workers who are least likely to have experienced
exploitation and coercion and most likely to have bargained for
meaningful compensation for their noncompete.” The FTC
concluded that “the only group of workers that is likely to
have bargained for meaningful compensation in exchange for their
noncompete is senior executives who are both highly paid and, as a
functional matter, exercise the highest levels of authority in an
organization.” The FTC estimates that approximately 0.75% of
workers qualify under the “senior executive”
exception.
Additional Limited Exceptions
- Bona fide sale of a business. The rule does
not apply “to a noncompete clause that is 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.” - Existing causes of action. The rule “does
not apply where a cause of action related to a noncompete clause
accrued prior to the effective date.” - Good faith. “It is not an unfair method
of competition to enforce or attempt to enforce a noncompete clause
or to make representations about a noncompete clause where a person
has a good-faith basis to believe that [the rule is]
inapplicable.”
Notably, unlike the various state laws prohibiting or
restricting noncompetes, the FTC’s rule is a competition-based
rule prescribing novel per se illegal treatment for UMC. Although
the approach is consistent with the Biden administration’s
desire to return to pre-1970s antitrust law, the U.S. Supreme Court
has long since held that per se illegal treatment is reserved for
conduct that is “so plainly anticompetitive” that
“the economic impact” is “immediately
obvious.”
DOES THE BAN APPLY TO OTHER RESTRICTIVE COVENANTS, SUCH AS
NON-SOLICIT AGREEMENTS OR NON-DISCLOSURE AGREEMENTS
(“NDA”)?
The FTC’s ban on noncompetes does not extend to non-solicit
agreements of employees or customers unless a non-solicit would
“function to prevent” a worker from competing with a
prior employer.
The FTC’s comments on the rule acknowledge that non-solicits
“do not by their terms or necessarily” prevent an
employee from seeking or accepting alternative employment. However,
the rule defines noncompete clauses to include any term that
“prohibits a worker from, penalizes a worker for, or functions
to prevent a worker from” seeking or accepting work with a
different person or operating a business after the conclusion of
that worker’s employment. According to the FTC, a contractual
term, including, for example, non-solicits, training-repayment
agreements, or non-disclosure agreements, could be “so
overbroad” as to have the same effect as a prohibited
noncompete. The FTC commented that “unlike non-solicitation of
client agreements, [coworker non-solicitation agreements] do not
frustrate workers’ ability to build up a client base after
moving to a new employer.” The ban’s coverage of
non-solicits is therefore subject to a “fact-specific
inquiry.”
According to the FTC, an NDA also can be a de facto noncompete
if it defines “confidential information that is “usable
in” or “relates to” a particular industry or
prevents disclosure of even publicly available information obtained
during employment.
Contractual terms that “penalize” a worker for
accepting other work or starting a business post-employment also
are subject to the ban. Examples from the FTC include liquidated
damage clauses, an agreement that extinguishes an “obligation
to provide promised compensation or to pay benefits,” or
severance agreements paid only if the worker “refrain[s] from
competing.”
WHAT DID THE FTC SAY ABOUT NONCOMPETES AND NONPROFIT
ENTITIES?
The FTC’s comments on the rule acknowledge that non-profit
entities are outside the reach of Section 5 (and the noncompete
ban) unless their non-profit status is a sham or the nonprofit
entity is organized by and operates for the benefit of for-profit
members. However, the FTC reserved the right to evaluate an
entity’s non-profit status and noted that some “entities
that claim tax-exempt nonprofit status may in fact fall under the
FTC’s jurisdiction.” Specifically, the FTC stated that
“some portion of the 58% of hospitals that claim tax-exempt
status as nonprofits and the 19% of hospitals that are identified
as State or local government hospitals . . . likely fall under the
Commission’s jurisdiction and the final rule’s
purview.”
ARE NONCOMPETES ALLOWED IN CONNECTION WITH M&A
TRANSACTIONS?
Yes, in certain circumstances. The FTC’s ban does not apply
to noncompetes between a buyer and 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.” Unlike the draft
rule, which excepted only “substantial” owners of a
business (defined as a 25% ownership interest), there is no minimum
threshold in the final rule. The FTC warns that noncompetes subject
to the sale of a business are still subject to state laws and
federal antitrust law that, in the FTC’s view, require “a
showing that a noncompete is necessary to protect the value of the
business being sold.”
The FTC’s comments on the rule indicate that a “bona
fide sale” is made in good faith, made between independent
parties at arm’s length, and one in which the seller has a
reasonable opportunity to negotiate the sale. According to the FTC,
a transaction whose “sole purpose is to evade” the ban is
not a bona fide sale. The FTC further stated that
“springing” noncompetes and noncompetes arising out of
repurchase rights or mandatory stock redemption programs do not
qualify for the M&A exception.
Although the expanded M&A exception is a welcome change,
there are often non-shareholder employees that may contribute
substantially to the value a buyer derives from a deal. Buyers and
sellers may want to consider alternative arrangements (e.g.,
long-term vesting of equity interests) to protect deal value.
ARE THERE WAYS TO CHALLENGE THE FTC’S RULE?
Industry groups already have challenged the rule, and courts are
likely to consider the need for a stay while the case proceeds. A
decision granting or denying a stay would likely be issued within
several weeks to a few months, before the 120- day effective date.
Full litigation, however, will include review by the court of
appeals and potentially the Supreme Court, and could last more than
a year.
The FTC will face serious arguments that the rule is invalid,
likely focused on:
- The FTC’s lack of substantive rulemaking authority under
Section 6(g) of the FTC Act, which is a narrow grant of authority
to make procedural rules. This is confirmed by a 1975 amendment to
the FTC Act in which Congress added separate rulemaking provisions
expressly authorizing the FTC to define unfair or deceptive acts or
practices, but not UMC. - Constitutional challenges such as the nondelegation doctrine
and major questions doctrine, which could potentially operate as a
brake on the FTC’s expansive views of its own power. - A variety of arguments that the rule is arbitrary and
capricious under the Administrative Procedure Act. For example, the
rule lacks a record that noncompete agreements result (or are
likely to result) in systematic harm, particularly given that the
empirical evidence is mixed with respect to effects on low-wage
workers, and that the best evidence with respect to higher-paid
skilled workers is that noncompetes tend to make both employees and
employers better off. - Court challenges may also seek to reign-in the FTC’s recent
attempt to significantly expand the scope of its UMC
authority.
One of the Biden administration’s first actions was to
withdraw the Obama administration’s bipartisan 2015 UMC Policy
Statement, which tethered UMC analysis to the consumer welfare
standard and the rule of reason framework applied under traditional
antitrust laws. The consumer welfare standard focuses antitrust
analysis on whether there is harm to consumers as distinct from
competing producers. In late 2022, the FTC issued a new statement, setting forth theories that
extend beyond actual or threatened harm to competition. The main
alleged support for the new approach is a line of cases decided at
the end of the period of extremely aggressive enforcement
approaches (1937–1973), which was characterized by per se
rules. At “peak per se” in 1972, the Supreme Court openly
mocked the use of economic analysis. Since then, the Supreme Court
has issued a number of landmark decisions aimed at bringing
antitrust law in line with modern economic learnings. While those
modern decisions were decided under the antitrust laws and did not
explicitly address the FTC Act, appellate court decisions on the
reach of UMC, the makeup of the current Supreme Court, and modern
economics support a more limited reach for UMC.
The decision regarding a stay should arrive in a matter of weeks
to a few months and will provide a key initial look at the
landscape. In the meantime, companies should consider a
wait-and-see approach while also outlining a plan for compliance if
it becomes necessary.
The content of this article is intended to provide a general
guide to the subject matter. Specialist advice should be sought
about your specific circumstances.
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