Working Together

On April 23, 2024, the Federal Trade Commission (the “FTC” or “Commission”) held an open meeting on noncompetition agreements, at which they voted 3-2 to approve a proposed final Noncompete Rule. The final Rule is a comprehensive ban on new post-employment noncompete agreements with all employees.

Quick Takeaways: 

• The FTC’s Noncompete Rule – which bans noncompetes for “workers” – will be effective September 4, 2024.
• The Commission found that the use of a noncompete is an “unfair method of competition” for various reasons, and that banning them will benefit workers and the economy.
• The FTC defined “noncompete” broadly as any term or condition of employment (including workplace policies) which “prohibits,” “penalizes,” or “functions to prevent” a worker from seeking employment or opening a business post-employment.
• After September 4, 2024, existing noncompetes with workers (other than senior executives) will be retroactively unenforceable, and employers will be barred from entering into any new noncompetes. Existing noncompetes will still be effective for senior executives.
• Employers still have viable alternatives to protect their legitimate business interests, such as non-disclosure agreements and statutory trade secret protections.
• Three lawsuits are currently pending to contest the Rule.

Congress empowered the Commission to “prevent persons, partnerships, or corporations” from engaging in unfair methods of competition. Section 5 of the Federal Trade Commission Act (“FTC Act”) prohibits “unfair methods of competition” and empowers the Commission to enforce that prohibition. Under this authority, the Commission ruled that it is an unfair method of competition, and therefore a violation of Section 5, for employers to enter into noncompetes with workers, and to enforce certain currently existing noncompetes after the effective date.

The uniform ban is scheduled to take effect 120 days after publication in the Federal Register. The Rule was published on May 7, 2024,  (89 FR 38342), and will therefore be effective September 4, 2024, unless it is delayed by a court (see discussion below).

To whom does the Rule apply?

The Noncompete Rule applies differently to “workers” and to “senior executives” with existing noncompetes. Under the final Rule, existing noncompetes with “workers” become unenforceable after the effective date of the Rule – September 4, 2024. “Worker” is defined broadly, regardless of industry, pay rate, or worker classification. Existing noncompetes with “senior executives” – defined as those in “policy-making positions” making more than $151,164.00 annually – will remain enforceable.

After September 4, 2024, however, employers are banned from entering into any new noncompetes with employees, even with senior executives.

The Noncompete Rule is subject to some exceptions:

• The Rule does not apply to noncompetes that prohibit an employee from competing against the employer while still employed.
• It does not apply to noncompetes entered into pursuant to a bona fide sale of a business entity, regardless of ownership share.
• The final Rule also does not apply to franchisee/franchisor relationships, although Commissioners called for more research on the issue.

What about non-profit or tax-exempt corporations? Are they subject to this Rule?

The Commission considered the application of the Noncompete Rule to tax-exempt and nonprofit entities, and referenced judicial and FTC precedent which recognizes that not all entities claiming tax-exempt status are outside of the Commission’s reach.

To determine whether a corporation is subject to the Noncompete Rule, the Commission looks to both “the source of the income, i.e., to whether the corporation is organized for and actually engaged in business for only charitable purposes, and to the destination of the income, i.e., to whether either the corporation or its members derive a profit.” Any entity satisfying the two-prong test falls within the Commission’s jurisdiction and subject to the Rule.

What restrictive covenants did the Commission consider in its rulemaking?

Jurisdictions vary widely in their treatment and enforcement of restrictive covenants. Non-competes are broadly prohibited in four states: California, North Dakota, Oklahoma, and Minnesota. In other states, noncompetes are prohibited for some, but not all, workers. For noncompetes that are not prohibited expressly by statute, state courts use some version of a “reasonableness” test to evaluate whether a given noncompete is enforceable. These reasonableness tests examine whether the restraint is greater than needed to protect an employer’s purported legitimate business interest. Noncompetes can be found unreasonable where the employer’s need for the noncompete is outweighed by the hardship to the worker or the injury to the public.

To understand how the Commission’s new Noncompete Rule applies, we should first distinguish the restrictive covenants that the Commission considered in its rulemaking: noncompetes, nonsolicitation agreements, nondisclosure agreements, “garden leave” arrangements, and training repayment agreement provisions (or “TRAPs”).

Generally, noncompete agreements or provisions legally bar employees from working for a competitor or starting a competing business after the employment relationship ends. A noncompete typically sets forth restrictions that prevent an employee from competing with their former employer or providing certain services within a certain geographic area, market, and period of time.

Nondisclosure or confidentiality agreements are sometimes associated with noncompete agreements but do not generally prevent an employee from working for a competitor. Employment-related nondisclosure agreements (NDAs) restrict the disclosure of proprietary or confidential information, like trade secrets or client lists.

A “garden leave” arrangement typically means the employee is prohibited from working elsewhere for a certain period of time in exchange for continued payments from the employer. Garden leave may occur prior to the end of the employment relationship where an employee continues to collect paychecks but their access to company facilities is restricted, or post-termination in the form of severance pay (but see below for the Rule’s impact on garden leave arrangements).

Noncompete agreements may be accompanied by nonsolicitation agreements, which prohibit workers from doing business with clients or customers from a former employer. Nonsolicitation agreements are also used as “no-poach” or “no hire” agreements to restrict workers from recruiting former co-workers.

TRAPs are agreements in which the worker agrees to pay the employer for purported training expenses if the worker leaves their job before a certain date. Equipment loans are similar to TRAPs, where employers provide employees with a loan to purchase equipment that the worker needs in order to perform their job. The Commission also considered damages provisions in the same category, which require workers to pay open-ended costs related to their departures – including the cost of hiring and training replacements, or compensation for harms such as reputational damage, loss of good will, or lost profits.

How does the Commission define “noncompete clauses” that are affected by the Rule?

In response to many comments on the proposed Rule’s application to specific kinds of restrictive covenants, the Commission modified the definition of “noncompete clause” to clarify its scope.

In the final Rule, § 910.1 defines “non-compete clause” as a term or condition of employment that either “prohibits” a worker from, “penalizes” a worker for, or “functions to prevent” a worker from (A) 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 (B) operating a business in the United States after the conclusion of the employment that includes the term or condition. The final Rule further provides that “term or condition of employment” includes a contractual term or workplace policy, whether written or oral.

The term “prohibits” means the Rule applies to terms or conditions that expressly prohibit a worker from seeking or accepting other work, or starting a business, after their employment ends. For example, the Rule applies to a contractual provision for workers at a national sandwich shop chain that states that for two years after termination, they cannot work at any sandwich shop located within three miles of any shop in the chain.

The term “penalizes” means the Rule applies to terms or conditions that require a worker to pay a penalty for seeking other work or starting a new business after their employment ends. For example, a term that says that a worker cannot engage in any business within a certain area that competes with the employer, unless the worker pays liquidated damages, would be prohibited under the Rule. Another example is a term that imposes any adverse financial consequences on a former employee as a result of the termination of the relationship, or a severance agreement in which the worker is paid only if they refrain from competing. On the other hand, a garden leave agreement where the worker is still employed and receiving compensation would not be a non-compete, because the agreement is not a post-employment restriction.

“Prohibit” and “penalize” apply to the majority of non-compete agreements mentioned previously. For good measure, the Rule also applies to contracts that “function to prevent” a worker from competing after their employment ends. The term “functions to prevent” clarifies that, if an employer adopts a term or condition that is so broad or onerous that it has the same effect as a prohibition or penalty, such a term is a noncompete clause under the Rule. Whether a restrictive covenant rises to the level of a “functional” noncompete will rely on the individual facts and circumstances. To demonstrate, the Commission cited examples of NDAs, non-solicitation agreements, and TRAPs that functioned to restrict workers in violation of the Rule. For example, if an NDA includes any information that “relates to” the industry or bars the use of any information the worker obtained during their employment, including publicly available information, such agreements are so broad and beyond the definition of a trade secret that they are the functional equivalents of noncompetes.

Why ban noncompete agreements, anyway?

In adopting the Rule, the Commission found that the use of noncompete clauses constitutes an unfair trade practice on several grounds. First, the Commission found that the use of noncompetes qualifies as “restrictive and exclusionary” conduct which negatively affects competition: “restrictive” because they restrict workers’ opportunities after they leave a job, and “exclusionary” because they impair the opportunities of rival firms to hire workers. Second, the use of noncompetes for workers other than senior executives qualifies as “exploitative and coercive” conduct based on the Commission’s assessment that they are unilaterally imposed and effectively trap workers or force them to otherwise bear significant cost.

The Commission also found that noncompetes tend to negatively affect competitive conditions: inhibiting labor mobility and new business formation, suppressing workers’ earnings, and reducing job quality. The Commission estimated that one in five American workers is subject to a noncompete, and that banning noncompetes will result in higher worker earnings, reduced healthcare costs, increased new business formation, and a rise in innovation.

The Commission noted that employers still have viable alternatives to protect their legitimate business interests, such as non-disclosure agreements and statutory trade secret protections.

What are some of the legal challenges to the Rule?

Unsurprisingly, at least three lawsuits challenging the Noncompete Rule have been filed in federal district court. On the same day the Rule was issued, tax and software firm Ryan, LLC filed the first lawsuit in the U.S. District Court for the Northern District of Texas, and the U.S. Chamber of Commerce filed suit in the U.S. District Court for the Easter District of Texas. A small business, ATS Tree Services, also filed suit in U.S. District Court in Pennsylvania on April 25, 2024. The lawsuits each offer similar grounds for challenging the Noncompete Rule, namely that: (1) the Commission lacked or exceeded its statutory authority to issue the Noncompete Rule, (2) the Noncompete Rule is an unconstitutional delegation of legislative power, and (3) the Noncompete Rule is arbitrary and capricious. It remains to be seen whether the pendency of this litigation will postpone the Rule’s effective date.  

This is a lot. What do I do next?

• Identify the restrictive covenants you currently have between your business and your employees. Even if the provision it is not a clear prohibition or penalty, it may still be impacted by this Rule. Seek help from an attorney to identify whether your agreements will be subject to the Rule’s requirements.
• Employers must provide notice to workers (other than senior executives) bound to an existing noncompete that their agreements will not be enforced against them in the future. The Commission has included model language in the final Rule that employers can use as a template to aid compliance with the notice requirement.
• Consider the goals of a desired restrictive covenant. What are you trying to protect the business from? Seek help on how to protect those interests in light of the new Rule.

You can find the full published text of the final Rule here.