The Federal Trade Commission (FTC) implemented a final rule on April 23, 2024, effectively banning the use of nearly all non-compete provisions.

Key Insights:

• The FTC has approved a final rule that will effectively prohibit employers from using non-compete clauses and mandate the revocation of existing agreements, except those with senior executives.
• This regulation pertains to any contractual terms preventing employees from pursuing employment opportunities.
• Exceptions to the rule include non-compete agreements made during business sales.
• The rule is scheduled to become effective 120 days after publication, although legal challenges may delay its implementation.

The FTC voted 3-2 in favor of approving the final regulations, commonly known as the Non-Compete Clause Rule. This approval occurred fifteen months after the FTC issued its proposed rule in January 2023. Implemented under President Biden’s 2021 “Executive Order on Promoting Competition in the American Economy,” the rule effectively bans the usage of nearly all non-compete clauses.

Employers are barred from entering into new non-compete agreements and must retract existing ones. The rule’s preamble states that it constitutes an unfair competitive practice, and hence a violation of section 5, for employers to execute non-compete agreements with employees on or after the effective date of the final rule. The rule becomes effective 120 days after its publication in the Federal Register.

What Does the FTC Rule Do?

FTC Rule Aims to Prohibit Non-Compete Agreements:

The FTC intends to ban almost all non-compete agreements for employees of for-profit companies and preempt state laws on the matter.

According to the FTC, a “non-compete” refers to a contractual provision between an employer and an employee that restricts the employee from seeking or accepting employment with another entity or operating a business after the termination of the employee’s tenure with the employer. The term “employee” encompasses individuals ranging from CEOs to mailroom staff and includes independent contractors. The FTC rule provides an exception for legitimate business sales and removes the 25 percent threshold outlined in the proposed rule. Employers have 120 days from the publication of the final rule by the FTC to comply with its provisions.

Expanded Definition of Non-Compete and Its Implications:

The FTC redefines “non-compete” to include any contractual provision that restricts a worker from seeking or accepting employment. This expanded definition encompasses nondisclosure provisions and repayment clauses for training costs, potentially limiting a worker’s job prospects.

Potential Impact on Nonsolicitation Agreements:

There is a possibility that nonsolicitation agreements may fall under the scope of the rule if they excessively hinder a worker from pursuing employment opportunities.

Retroactive Effect and Enforcement of the Rule:

The FTC’s rule will mostly have a retroactive effect, rendering existing non-compete agreements invalid upon its enactment, except for those involving senior executives. Employers must inform their employees and former employees in writing that their non-compete agreements are no longer enforceable, with a provided model notice. Additionally, the FTC views employers who uphold non-compete agreements as engaging in unfair competition.

Exception for Senior Executives:

An exception is made for existing agreements with senior executives, defined as employees in policy-making roles with annual compensation exceeding $151,164. However, new agreements for senior executives will be prohibited after the rule takes effect.

What is the significance of “preventing the worker from seeking or accepting employment”?

FTC’s Ambiguity on Objective vs. Subjective Interpretation:

The FTC’s intention regarding whether this phrase objectively prevents the worker from seeking or accepting employment, or subjectively based on the worker’s belief, is unclear. This potential ambiguity poses a significant and problematic issue.

Potential Impact of Ambiguity on Provisions:

Even a narrowly worded non-disclosure provision could lead an employee to decline competitive employment. Similarly, a well-crafted customer nonsolicitation provision might deter an employee from pursuing competitive opportunities. However, both provisions would explicitly allow competitive employment.

FTC’s Broad Interpretation and Its Ramifications:

Considering the FTC’s broad interpretation of non-compete agreements, it is likely that the agency will include the employee’s subjective interpretation of what a provision prohibits within its definition. Nevertheless, even without this consideration, certain provisions, even when narrowly applied, could prevent an employee from leveraging relationships developed during employment for a competitor. Thus, objectively, according to the FTC’s definition, these provisions would effectively function as non-compete clauses.

What about forfeiture clauses and clawback arrangements predicated on non-compete agreements?

The FTC’s regulation overrides previously established precedent that when an employee can choose between competing and retaining a deferred benefit (be it monetary or equity-based), the provision in question does not inhibit competition. The FTC is highly likely to consider these forfeiture and clawback arrangements as effectively functioning as non-compete agreements, as declining the offered benefits could dissuade an employee from pursuing opportunities with a competitor. When these forfeiture and/or clawback provisions are integrated into an Employee Retirement Income Security Act (ERISA) plan, the matter becomes more complex, as the FTC does not assert that its regulation supersedes ERISA.

What impact does the proposed rule have on the safeguarding of trade secrets?

In essence, the proposed rule doesn’t technically alter this. State and federal laws concerning trade secrets will persist, and employers will maintain their rights to safeguard trade secrets under these laws. However, practically speaking, the proposed rule could significantly impact trade secret protection for a couple of reasons:

Firstly, non-compete agreements and similar clauses play a vital role in preventing employees from unfairly using trade secret information to compete. Detecting someone who has illicitly acquired trade secrets is often challenging, but enforcing a non-compete can mitigate this risk.

Secondly, nullifying nondisclosure provisions would obviously remove a contractual safeguard for trade secret and confidential information that may not meet the threshold of trade secret status.

Does the FTC have the authority to prohibit non-compete agreements?

FTC’s Assertion of Jurisdiction over Non-Compete Agreements:

The FTC’s determination that non-compete agreements are an “unfair method of competition” aims to extend its jurisdiction. Traditionally, these agreements, being contracts, fall under state, not federal, law. Consequently, states have varied in their approaches, from outright prohibition (e.g., California, Minnesota, Oklahoma) to addressing specific issues like restrictions on non-competes for low-wage workers (e.g., Colorado, the District of Columbia, Illinois, Washington) to generally permitting such agreements (e.g., Florida, Missouri, Ohio, Texas).

Potential Expansion of FTC’s Authority:

Furthermore, if the FTC is granted authority to regulate any activity it deems an “unfair method of competition,” it would signify a significant expansion of its power. While the U.S. Constitution assigns Congress the authority to regulate matters impacting interstate commerce, such authority isn’t granted to the executive branch, which includes the FTC. Whether the FTC possesses this power to address a “major question” potentially within congressional jurisdiction rather than executive branch jurisdiction is a matter likely to undergo prolonged legal scrutiny.

Anticipated Legal Challenges and Protracted Resolution:

Immediate legal challenges against the rule are expected, and it may take considerable time before this issue is settled in the courts.

What options do employers currently have?

Employers have several options to consider:

• Do nothing and adopt a wait-and-see approach. In the worst-case scenario, employers will have 120 days after the rule is published to comply with it. It’s more probable that legal challenges to the rule will lead to a postponement of its effective date, potentially delaying its implementation for years, if it ever comes into effect. New FTC Commissioners Holyoak and Ferguson discussed various aspects of these issues during the Open Commission Meeting. However, even under this approach, employers should continue to be cautious about narrowly tailoring non-compete, non-solicitation, and non-disclosure agreements. If FTC or federal efforts prove unsuccessful, many states are still moving towards restricting the use of restrictive covenants.
• Prepare for potential future changes. Assume that the rule will take effect in 120 days and revise standard contracts to eliminate non-compete clauses. Employers can still include provisions for non-disclosure and non-solicitation of customers but should significantly narrow their scope. The same approach should be taken with any other provisions that could be considered as de facto non-compete clauses.
• Adopt a middle-ground stance. Keep non-compete agreements (including de facto non-compete clauses) for high-level executives and other highly compensated employees, relying on the courts to compel a modification of the FTC rule that doesn’t treat all workers equally.

Clearly, there are advantages and disadvantages to each of these strategies, and every employer will determine which aligns most effectively with its genuine business objectives going forward.