United States: Employer Considerations While Awaiting The FTC's Impending Ban On Non-Competes

A non-compete regulates an individual's actions after termination of an employee-employer relationship. Sounds a bit possessive right? Depends on who you ask. Employees and the Federal Trades Commission would most likely agree. Yet, most employers defend non-competes and view them as a tool to protect their business interests once an employee leaves. Regardless of which stance you have, non-competes have found themselves up for debate following the FTC's proposed rule which would ban enforcement of existing and future non-competes. Understandably, employers are concerned about the appropriate next steps. This article prepares employers and businesses for what they should consider and address while awaiting the FTC's finalized rule on non-competes.

Start with the basics: a non-compete's purpose and elements

A non-compete restricts workers from seeking employment with a competitor or from starting a competing business. Non-competes date all the way back to 1414.¹ Dyer's Case is the first known case involving a non-compete. John Dyer, an apprentice to a master tradesman, promised to refrain from his trade for six months in the town he was trained in. Reasonable, right? The Judge thought so and held that the apprentice "would go to prison until he paid a fine to the King" for violating his non-compete with the master tradesman.² The only problem was that the master tradesman failed to show up for the hearing so the apprentice was spared from the King's wrath. Dyer's Case provides an accurate illustration of litigation surrounding violations of non-competes today - there is none unless the former employer asserts its rights found in the non-compete.

Fast forward to modern day and its evident non-competes aren't as straightforward as the King's Judge may have wanted them. Specifically, when referring to a non-compete, what exactly are we referring to? A non-compete is a restrictive covenant not to compete with a former employer.³ The siblings of the non-compete: the non-solicitation agreement and nondisclosure agreement ("NDA") have different meanings. Whether you are an employee, employer, or professional advisor, it's essential to recognize and understand the differences between the three clauses so all parties are entering into a valid contract through mutual assent.

A non-solicitation agreement involves restriction of a former employee from soliciting current employees or customers after the employee's departure from a business.⁴ Similar to non-compete, non-solicitation agreements cover a certain period and a particular region. An NDA prohibits one party from disclosing confidential information to others.⁵ NDAs also attempt to protect a business's trade secrets and intellectual property, much like a non-compete. Most employment contracts contain a non-compete alongside a non-solicitation agreement and an NDA. However, the three agreements are analyzed by courts differently depending on which state is scrutinizing the contract, at least for now.

A non-compete focuses on an employee's actions after employment and attempts to ensure the employee doesn't compete with a business directly or indirectly for a specific duration of time and within a geographic location after employment has ended. A non-compete is usually signed at the beginning of employment and tends to prohibit the employee from engaging in things such as: working for a competitor, starting a competing company, developing competing products/services, and recruiting former colleagues to join the former employee's business.⁶

Further, non-competes affect wages in two ways. First, it can prohibit an employee from accepting a better job elsewhere. Limiting an employee's ability to make strides in wage growth.⁷ Second, if an employee is subject to a non-compete yet receives a job offer, the employee most likely will not be able to use the offer as leverage to raise their wages at their current job.⁸ As a whole, industries with enforceable non-competes suffer. Non-competes cause slower-moving labor markets with fewer job offers, lower wages and job mobility, and dwindling job satisfaction. All concerns and motivators for the FTC to propose a new rule.

Non-competes cover 18% of U. S. workers - about 30 million workers.⁹ Companies use non-competes across industries and job levels. Non-competes cover anywhere from dog walkers to financial services executives and hair stylists to doctors.¹⁰ If a non-compete is overly broad, it prevents workers from leaving jobs and decreases competition for workers. Americans have a right to change employers, whether it be "to pursue a better opportunity, to escape harassment, or to express disagreement with new workplace policies."¹¹ Yet workers may be deterred from exiting because of unenforceable or overly broad non-competes. Many junior employees or low-wage earners don't possess the resources to hire an attorney to review a non-compete or the ability to risk violating a non-compete to leave a bad work environment.

Enforceability of non-competes:

Just like most laws, non-compete precedent and laws vary state to state. A few states have banned non-competes in their entirety. California went as far as codifying the ban.¹² For the states still recognizing non-competes, the enforceability of non-competes turns on their reasonableness.¹³ A majority of states follow a general rule to assess reasonableness: a non-compete is necessary to protect the employer's legitimate interests; the agreement won't impose an undue hardship on the employee; and it won't cause public harm.¹⁴ If a non-compete can survive this inquiry, it is considered reasonable and therefore enforceable within the state. A trend has moved towards limiting non-competes by setting a compensation threshold or requiring advance notice.¹⁵ Additionally, non-competes have received more scrutiny than other contractual language in employment agreements because of the concerns about unequal bargaining power between employers and employees.¹⁶ Most employees' only bargaining chip is their labor.

What is the FTC doing about non-competes?

Banning non-competes with limited exceptions.¹⁷ The FTC is attempting to provide the U.S. with a uniform policy regarding non-competes in an effort to protect individual employees from anti-competitive business tactics. Many businesses span across multiple state lines and a contract dealing with non-competes presents drafters, challengers, and enforcers of a non-compete with multiple problems such as: choice of law clauses, enforceability for each state, liquidated damages clauses, and the reasonableness of restrictions. The FTC presented a new proposed rule through Sections 5 and 6(g) of the Federal Trade Commission Act to combat these challenges for employees and employers.¹⁸

On January 5, 2023, the FTC released a Notice of Proposed Rulemaking to prohibit employers from imposing non-compete clauses on workers.¹⁹ The proposed rule deems non-competes as an "unfair method of competition" and would ban employers from entering non-compete clauses with workers, including independent contractors.²⁰ Additionally, the rule would require employers to rescind existing non-compete clauses with workers and educate their employees that the contracts are no longer in effect. The FTC hopes the rule will: increase workers' earning by nearly $300 billion per year; save consumers up to $148 billion annually on health care costs; and double the number of companies founded by a former worker in the same industry.²¹

The FTC held the public comment responses open until April 19, 2023 upon an agreement to extend the initial public comment period. The comments highlighted many businesses' distaste in the proposed rule and revealed the likelihood of legal challenge to any finalized ban on non-competes. The legal challenges will center on FTC's rulemaking history, amendments to the FTC Act, administrative law and constitutional law. The FTC most likely faces continuous legal battles if the rule is finalized. Specifically, the Supreme Court "typically greet[s] assertions of 'extravagant statutory power over the national economy' with skepticism" and may find the FTC's actions outside the scope of its agency power.²²

The final FTC Rule on non-competes is not expected before April 2024.

What am I supposed to do in the interim?

Depends. If you're an employee, review your current non-compete to educate yourself on your responsibilities to your current employer. Existing reasonable non-competes are still enforceable depending on the state. If you're a business, start brainstorming alternatives to the non-compete. If you're the FTC, finalize your proposed rule.

Employer alternatives:

Double check that you are using the right non-competes for the right people: check the state's non-compete laws and whom the agreement actually applies to. It's wise to avoid including a non-compete for junior employees or low-wage earners. Restructure any existing non-competes to cover a substantial owner, partner, or member within the business.²³ The choice of law provision needs to be included and aligned with the rest of the agreement. Many businesses state where the contract applies based on where the business is incorporated or where the employee lives or works. Substantial amounts of non-competes are stuck in litigation surrounding a choice of law clause to determine which state's non-compete precedent applies before the language itself is analyzed. Avoid this hurdle by providing appropriate choice of law clauses to proper non-compete candidates under the FTC's proposed rule.

Strengthen existing non-solicitation and NDA clauses. As a business, it's essential to employee retention of senior and experienced employees to face the reality that non-competes may be unenforceable across the US in a year's time and start planning for alternatives. The focus of the alternatives should surround a legitimate business interest. Coercive agreements will be struck down as a measly attempt to skirt FTC's finalized rule. But strengthening legitimate and not overly broad non-solicitation and NDA clauses within an employment agreement may accomplish similar goals to the non-compete without the cons.²⁴

Strategize with an experienced employment attorney about the language in the employment agreement to save you from future litigation. Legal research revolving around enforceable contract language regarding non-solicitation agreements and NDAs within the applicable state will provide guidance on this issue. This most likely isn't a problem for Human Resources to address because most departments lack the legal education to select enforceable contract language for an employment agreement. Soliciting advice from an attorney with statutory interpretation and construction experience is the best use of your money.

Implement an amendment to employees' current employment agreements. Businesses that have existing non-competes for employees may explore options of implementing an amendment to their employment agreements. So if non-competes are banned by FTC's finalized rule, the business has prepared an amendment containing language that will lay out new contract clauses to address the now banned non-compete and may amend other elements of the contract to address potential gaps in the agreement.

To implement this strategy, businesses have to abide by contract law and provide mutual consideration to make the change.²⁵ Attaching the amendment to the employment agreement and receiving the employee's consent isn't sufficient because it's considered a unilateral change. Fresh consideration or an "additional advantage" is required.²⁶ Suggestions include increase of vacation pay, notice requirements, life insurance, severance pay, or health and dental benefits. A modification isn't ideal and implementing the amendment at the time of hire is advised where possible.

Provide current employees information regarding your amendment plan so it isn't viewed as confusing, or worse, coercive. Implementing the new language and informing employees of the amendment is an appropriate opportunity to involve Human Resources. Their involvement provides an outlet for employees to gain more information regarding the ban, the amendment to their contract, and implications of the changes. A prudent employer may want to consider materializing this plan of action immediately while the FTC is still finalizing its proposed rule.

Include a "clawback" provision in the employee agreement. Businesses usually pride themselves in the resources provided to train employees. As an alternative to non-competes, businesses can explore opportunities to "clawback" money dedicated for training of a senior or executive employee. A clawback provision specifies a set of factors or situations in which money already paid to an employee must be returned to the company.²⁷ This allows the business a mechanism to recover costs associated with training or education if an employee leaves shortly after completion.²⁸ Additionally, clawbacks incentivize employees to stay for a certain period. Consider including a clawback in an amendment to employee agreements as discussed above.

Research other mechanisms to enforce confidentiality. Explore federal laws such as the Uniform Trade Secrets Act and the Economic Espionage Act that both protect companies from usage or misappropriation of trade secrets.²⁹ Analyze applicable state regulations and enforce common law fiduciary duties and duties of loyalty on directors and officers. Shifting the focus away from junior and low-wage employees.

The overall goal of these alternatives is to protect the employer from harm, not to punish the employee for leaving. The FTC's proposed rule isn't the death of an employer's bargaining power but a positive step forward to enhancing the labor and employment market. An objective employees and employers can (hopefully) support.

Footnotes

1. See Catherine L. Fisk, "Working Knowledge: Trade Secrets, Restrictive Covenants in Employment, and the Rise of Corporate Intellectual Property, 1800-1920," 52 Hastings L.J. 441, 455 n.33 (2001).

2. Id.

3. A restrictive covenant is generally used to protect an employer or business owner from unfair competition. It includes a non-compete, a non-solicitation agreement, and an NDA.

4. Sydney Pereira, Your Questions About Non-Solicitation Agreements, Answered, The Muse, Dec. 15, 2021, https://www.themuse.com/advice/non-solicitation-agreement-clause.

5. Lexis Nexis, Uncovering Hidden Pitfalls: A Deep Dive into 5 Challenges of Non-Disclosure Agreements (NDAs), Feb. 14, 2023, https://www.lexisnexis.com/community/insights/legal/b/thought-leadership/posts/challenges-with-non-disclosure-agreements.

6. 5 things you need to know about non-compete agreements, Thomson Reuters, March 11, 2022, https://legal.thomsonreuters.com/en/insights/articles/the-basics-of-non-compete-agreements.

7. Non-competes may indirectly cause difficulties for employees to take advantage of new opportunities within their skill set or industry because the non-compete may apply to companies hiring employees. Non-competes are contractual rights that are expected to be respected by other companies and may subject a company to potential liability if a potential new employer attempts to circumvent the employee's obligations to the former employer. Constructively, requiring new employers to carry the burden of employees' non-compete restrictions limits competitiveness business to business.

8. Isaac Chotiner, What a ban on non-compete agreement could mean for american workers, The New Yorker, January 10, 2023, https://www.newyorker.com/news/q-and-a/what-a-ban-on-non-compete-agreements-could-mean-for-american-workers#:~:text=And%20we%20do%20have%20a,and%20job%20satisfaction%20is%20lower.

9. White House, Fact Sheet: Executive Order on Promoting Competition in the American Economy, July 9, 2021, https://www.whitehouse.gov/briefing-room/statements-releases/2021/07/09/fact-sheet-executive-order-on-promoting-competition-in-the-american-economy/.

10. In re Prudential Security, Inc., File No. 221-0026 (Jan. 4, 2022), Prudential, a security company in Michigan, enforced non-competes against its workers, including security guards earning near-minimum wage. The non-competes included a $100,000 liquidated damages clause. Prudential sued multiple employees and even pressured a competitor to fire one of those new hires.

11. Statement of Chair Lina M. Khan Regarding the Notice of Proposed Rulemaking to Restrict Employers' Use of Noncompete Clauses, Commission File No. P201200, FTC at pg. 1, Jan. 5, 2023, https://www.ftc.gov/news-events/news/press-releases/2023/01/ftc-proposes-rule-ban-noncompete-clauses-which-hurt-workers-harm-competition.

12. California prohibits non-competes by law: Cal. Bus. & Prof. Code § 16600 and an employer can't require employees or applicants to agree in writing to any term or condition known to be prohibited by law: Cal. Lab. Code § 432.5.

13. Naja A. Farley, How Non-Competes Stifle Worker Power and Disproportionately Impede Women and Workers of Color, National Employment Law Project ("NELP"), May 18, 2022, https://www.nelp.org/publication/faq-on-non-compete-agreements/#_ftn30.

14 .Douglas Diaz & Mark Oberstaedt, Viewpoint: Dispelling Myths and Avoiding Common Mistakes for Noncompete Agreements, March 2, 2020, https://www.shrm.org/resourcesandtools/hr-topics/talent-acquisition/pages/myths-avoiding-common-mistakes-noncompete-agreements.aspx.

15. States such as Colorado, Illinois, Maine, Maryland, New Hampshire, Oregon, Rhode Island, Virginia, and Washington prohibit non-compete agreements unless the employee earns above a certain salary threshold.

16. Most Americans have nothing to sell but their labor and skills and so must work to subsist which ultimately places them at a disadvantage to employers regarding their bargaining position.

17. A substantial owner would be exempt from coverage under the FTC's proposed rule. Proposed § 910.1(e) would define a substantial owner, substantial member, and substantial partner as an owner, member, or partner holding at least 25% ownership interest in a business entity. The FTC supports the threshold of 25% ownership interest because it believes an exception should be available where a few entrepreneurs are sharing ownership interest. However, the FTC doesn't support an exception where the ownership interest in question is so small the transfer of ownership interest wouldn't be necessary to protect the value of the business acquired by the buyer.

18. 15 U.S.C. 45(a)(1). Section 5 declares "unfair methods of competition" to be unlawful. The Act authorizes the FTC to "make rules and regulations for the purpose of carrying out the provisions." Id. at (a)(2).

19. Fact Sheet: FTC Proposes Rule to Ban Noncompete Clauses, Which Hurt Workers and Harm Competition, FTC, accessed October 23, 2023, https://www.ftc.gov/legal-library/browse/federal-register-notices/non-compete-clause-rulemaking.

20. Proposed § 910.1(f) would define a worker as a natural person who works, whether paid or unpaid for an employer. Further the proposed rule states the term worker includes, without limitation, an employee, individual classified as an independent contractor, extern, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer.

21. Id.

22. W. Virginia v. Envt'l Prot. Agency, 142 S.Ct. 2587, 2609 (2022).

23. The FTC proposed rule would define a "substantial" owner, member, or partner as someone with at least 25% ownership interest in the business entity. See § 9101(e).

24. Restrictive employment covenants that are too broad in scope may serve as de facto non-compete clauses. See, e.g., Wegmann v. London, 648 F.2d 1072, 1073 (5th Cir. 1981); Brown v. TGS Mgmt. Co., LLC, 57 Cal. App. 5th 303, 306, 319 (Cal. Ct. App. 2020).

25. Shafik Bhallo & Devin Lucas, Employment Contracts and Fresh Consideration, Kornfeld LLP, Accessed October 23, 2023 10:14 AM, https://kornfeldllp.com/2013/09/employment-contracts-and-fresh-consideration/.

26. What is a fresh consideration when modifying an employment contract? There isn't a direct answer according to case law. "Additional advantage" has been deemed the barometer for amending an employment contract. Yet, again, there is no clear indication of what that means. The consideration depends on the position of the employee.

27. Whitcomb Selinsky, Clawback Provisions and How They Might Impact Your Company, JDSUPRA, Dec. 15, 2022, https://www.jdsupra.com/legalnews/clawback-provisions-and-how-they-might-9715703/.

28. Clawbacks for educational or training assistance can be tax-deductible and not considered taxable income for the employee pursuant to Section 127 of the Internal Revenue Code. The employee can exclude up to $5,250 in employer-provided assistance from income for course instruction. An employer can choose to offer this option under Section 127 in a nondiscriminatory fashion that doesn't target highly compensated employees.

29. See e.g., Uniform Trade Secrets Act (making a uniform definition of trade secrets and creating claims that can be brought in federal court when there is a misappropriation of trade secrets); Economic Espionage Act, 18 U.S.C. § 1831-1839 (making it a federal crime to receive, purchase, or possess a misappropriated trade secret).

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