The End of Non-Competes?

On April 23, 2024, the Federal Trade Commission (FTC) introduced a sweeping new regulation prohibiting all new non-compete clauses across various employment sectors. This eagerly awaited regulation, initially put forward as a draft in January 2023, is poised to substantially affect employers in numerous industries who have historically used non-compete agreements to safeguard trade secrets and intellectual property, and to motivate investment in employee training. The rule is expected to encounter opposition from the U.S. Chamber of Commerce and other organizations, and its enforcement by courts is yet uncertain.

In this article, we dive in – analyzing the new rule and its impact on companies.

Highlights

• A new rule issued by the Federal Trade Commission bans for-profit employers from establishing new non-compete agreements with all employees, including those at the senior executive level.
• Current non-compete agreements involving senior executives will still be enforceable. However, employers are required to inform all other employees that any existing non-competes will no longer be enforceable by the rule’s effective date.
• This regulation will take effect 120 days after it is published in the Federal Register. Immediate legal challenges are anticipated, which could delay or potentially prevent the rule from being enforced.
• The final rule would apply to any contractual provisions that have the effect of prohibiting a worker from seeking employment.

Subsequently, the FTC declared its plan to reinforce Section 5 of the FTC Act, which enables the agency to prohibit businesses from employing “unfair methods of competition.” In her endorsement of the rule, Chair Lina Khan stated, “The ability to switch jobs is fundamental to economic freedom and a competitive, robust economy. Non-compete agreements prevent workers from moving freely between jobs, which can lead to lower wages and poorer working conditions, and restrict businesses from accessing the talent necessary for growth and expansion. This new rule aims to enhance dynamism, innovation, and fair competition by terminating such practices.” However, there has been significant opposition from employers and others, arguing that the FTC lacks the legal authority to regulate competition in this manner and that the rule could lead to excessive regulatory interference in economic matters.

The rule, which passed the FTC’s Commissioners by a 3-2 vote along partisan lines, affects all workers at for-profit entities, including paid, unpaid, and independent contractors. It specifically bans these employers from forming new non-compete agreements with any workers, including senior executives—a shift from the proposed version—and from claiming any employee is under a non-compete.

While employers can still enforce existing non-competes with senior executives, they must inform all other current and former employees that such agreements will no longer be enforceable before the rule’s implementation. Employers can use model language provided in the rule to meet their notification requirements, and those who do will be considered in “safe harbor” for compliance.

The rule solely applies to for-profit entities, so non-profit organization workers’ employment agreements remain unaffected. It also allows limited non-compete clauses between franchisees and franchisors.

The rule does not cover non-compete agreements made in connection with the genuine sale of a business, an individual’s ownership stake in a business entity, or nearly all of a business’s operational assets.

It purports to ban all non-competes for nearly all employees of for-profit employers

The FTC rule aims to override all state regulations related to non-compete agreements. The FTC defines a “non-compete” as a contractual clause between an employer and an employee that prohibits the employee from pursuing or accepting employment with another entity, or starting a business, following the termination of their employment. This definition applies to all employees, from the CEO to the mailroom staff, and also includes independent contractors. The rule provides an exception for legitimate business sales and has removed the 25 percent threshold initially suggested in the draft rule. Employers are given a 120-day period from the date the FTC publishes the final rule to ensure compliance.

It redefines non-competes

The FTC clarifies that the definition of “non-compete” not only covers explicit non-compete clauses but also includes terms that serve a similar restrictive function—any contractual term that effectively prevents an employee from seeking or accepting subsequent employment. The FTC highlights specific examples of terms that may act as non-competes: (1) a nondisclosure agreement so broadly defined that it prevents an employee from working in the same role with another employer, and (2) a clause obligating an employee to reimburse training costs that are disproportionately high compared to the actual costs of the training provided.

It may effect non-solicits – no one is sure yet

The FTC’s expanded definition of non-competes could extend to customer and employee non-solicits if those provisions are broad enough to be construed as preventing “a worker from seeking or accepting” employment.

It is retroactive

The FTC rule has retroactive effects—it nullifies existing non-compete agreements except those with senior executives. Once the rule takes effect, employers must inform their current and former employees in writing that their non-compete agreements are no longer valid, using a model notification provided by the FTC. Additionally, the FTC considers an employer’s attempt to uphold a non-compete, including ongoing litigation to enforce such agreements, as an act of unfair competition. According to the FTC, if the rule is in effect, employers involved in such litigation would need to either drop the lawsuits or at least the claims related to the non-compete agreements to avoid being deemed as engaging in unfair competition.

It has an exception for senior executives for existing agreements

Existing agreements may remain in place for senior executives, defined as employees in a policy-making position and annualized compensation of over $151,164. New agreements will be prohibited after the effective date.

What does “Prevent the Worker from Seeking or Accepting Employment?” mean?

The short answer is: it’s unclear. It remains uncertain whether the FTC’s interpretation of certain contractual provisions as non-competes is based on an objective standard (whether the provision actually restricts the worker from seeking or accepting employment) or a subjective one (whether the worker believes the provision restricts them from seeking or accepting employment). This ambiguity could lead to significant complications. For instance, a narrowly tailored non-disclosure agreement might still dissuade an employee from pursuing competitive employment opportunities. Similarly, a carefully crafted customer non-solicitation agreement could discourage an employee from accepting a competitive position, although technically, such agreements do not prohibit working competitively.

Given the FTC’s broad interpretation of what constitutes a non-compete, it seems likely that the agency might consider the employee’s subjective perception of the restrictions imposed by a provision as part of its definition. Regardless, certain provisions, even if narrowly applied, could effectively prevent an employee from leveraging the same professional relationships for a competitor that were established during her previous employment. Therefore, even from an objective standpoint, under the FTC’s definition, these could be considered “de facto” non-competes.

How does it effect forfeiture provisions and clawbacks based on non-competes?

The FTC’s rule challenges the longstanding understanding that provisions allowing employees to choose between competing for a new role and retaining a deferred benefit (such as money or equity) do not restrict competition. The FTC is inclined to interpret these forfeiture and clawback arrangements as “de facto” non-competes, reasoning that the potential loss of financial benefits could deter employees from pursuing or accepting positions with competitors. The situation becomes more complex when these provisions are included in an Employee Retirement Income Security Act (ERISA) plan, as the FTC does not assert that its rule supersedes ERISA. This introduces a nuanced legal question regarding the interplay between the FTC’s rule and ERISA protections.

How does this affect trade secret protections?

Technically, the new rule does not alter state and federal trade secret laws, allowing employers to continue protecting trade secrets as before under these statutes. However, the practical implications of the proposed rule could significantly undermine the protection of trade secrets for several reasons: (1) Non-compete agreements and similar provisions play a vital role in preventing employees from using trade secret information to compete unfairly. Detecting trade secret theft can be challenging, but enforcing a non-compete can preclude such actions; (2) The rule’s invalidation of nondisclosure agreements will remove a layer of contractual defense for trade secrets and other confidential information that might not qualify as a trade secret under the law.

Does the FTC even have the power to do this?

Here’s the big question, and one we expect will be heavily tested in the courts in the coming year(s). 

The FTC has deemed non-compete agreements as an “unfair method of competition,” suggesting an attempt to extend its regulatory scope. Traditionally, such clauses have been under state jurisdiction, not federal, with various states adopting different stances—from outright bans (e.g., California, Minnesota, Oklahoma) to specific restrictions like bans on non-competes for “low wage” workers (e.g., Colorado, District of Columbia, Illinois, Washington) to general allowances (e.g., Florida, Missouri, Ohio, Texas). Thus, the FTC’s move to regulate these agreements on a federal level is unprecedented.

Additionally, allowing the FTC to regulate any practice it labels as an “unfair method of competition” could significantly broaden its authority. While the U.S. Constitution empowers Congress to regulate interstate commerce, it does not explicitly extend this power to the executive branch, which includes the FTC. The determination of whether the FTC can address such a “major question,” traditionally within congressional purview, remains open and potentially contentious.

Legal challenges to the FTC’s new rule are expected soon, indicating that a resolution in the courts may take considerable time.

As an employer, you have several options:

Do Nothing

Wait and see how things unfold. As previously mentioned, in the worst-case scenario, employers will have 120 days from when the rule is published to comply. Moreover, it’s more probable that legal objections will delay the rule’s implementation, possibly stalling it for years, if it ever takes effect. New FTC Commissioners Holyoak and Ferguson addressed several related topics during the Open Commission Meeting. However, even with this possibility, employers should remain cautious and ensure that non-competes, non-solicits, and non-disclosure agreements are specifically and narrowly defined. Should federal initiatives by the FTC falter, many states continue to move towards restricting these types of agreements.

Shift Fast and Embrace It

Get ready for the new rule, which will be in place in 120 days, by revising template contracts to exclude noncompete clauses. Employers can keep nondisclosure and customer non-solicitation provisions but must substantially limit their scope. Similarly, narrow down any other clauses that might be considered “de facto” non-competes.

Take the Middle Path

Keep non-compete clauses (and those that function similarly) for high-level executives and other highly compensated employees, relying on the judiciary to revise the FTC rule so that it differentiates among various categories of workers.

Choosing which path is right for an employer is best determined on a case-by-case basis. As our firm continues to monitor developments and provide updates / additional information, we are available to assess individual businesses and determine what path is best for them.

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