Many people have experienced a non-compete agreement in their working life. In fact, at least one in every five working Americans is subject to some form of a non-compete agreement. On the other side of a non-compete agreement is an employer who uses the agreements as part of a box of tools to ensure the company’s investment – the employee – is not lost to competitors. Hiring can be challenging and costly, and in many states the courts acknowledge an employer’s right to protect those investments by enforcing “reasonable” constraints on labor mobility. However, the enforceability of non-compete agreements can lead to frustration for entrepreneurial individuals who are prevented from departing an employer to start a new business venture or join an emerging business in the same field.
The impact to startups and emerging companies is mixed. On the one hand, a contractual obligation that prohibits employees from working for a competitor insulates a young company from what could be an incredibly disruptive event. On the other hand, if an employee wants to leave then limiting his or her mobility may result in a dissatisfied employee whose value may diminish over time due to a lack of desire to perform their job function. This does not even factor in potential founders who may work for larger companies and want to leave to work on a new project but must analyze whether doing so will run afoul of an existing non-compete agreement that the potential founder may have signed years before starting the new project.
States are the primary battle grounds for non-compete agreements, which means there is a patchwork of various laws and applications across the country as each state inevitably takes its own approach to worker mobility. California, for example, has essentially eliminated non-competition agreements as a matter of public policy through legislation, whereas other states like Massachusetts and New Hampshire enforce non-compete agreements provided it meets certain restrictions. Generally, those restrictions are in the form of geographical and time-bound limitations. However, the federal government recently set its sights on the issue of labor mobility. President Biden issued Executive Order 14036 in the summer of 2021 directing certain agencies, including the Federal Trade Commission (“FTC”), to focus on the interest of “American workers, business, and consumers,” which, in part, includes a review of non-compete practices in the US.
And on January 5th, 2023, the FTC proposed a rule that will eliminate non-competition agreements for most workers (including employees and independent contractors). The FTC is the federal agency tasked with ensuring that the public is protected from deceptive or unfair business practices and from unfair methods of competition. To do so, the FTC issues and enforces rules designed to improve competition in the US markets, which now includes the proposed rule on non-compete agreements and clauses.
What qualifies as a non-compete agreement in the proposed rule?
The FTC focuses on function over form and takes a holistic approach to what amounts to a non-compete agreement or “non-compete clause.” A non-compete clause is a contractual term that prevents a worker from seeking or accepting employment after the conclusion of the worker’s employment with an employer. Any contract signed by a worker and an employer will fall under this rule, whether or not the agreement is titled or styled as a “non-compete,” if it has the effect of prohibiting the worker from seeking or accepting employment. This includes obligations that a worker pays training costs upon conclusion of employment or broadly drafted agreements that effectively preclude the worker from seeking future employment elsewhere.
Who is impacted by the proposed rule?
In short, all businesses and those who work for the businesses will be covered under the proposed rule.
The proposed rule includes a broad definition of “employer” taken from existing legislation and includes any person, partnership, corporation, association, LLCs, or other legal entities who hires or contracts a worker to work for the employer, so every business conceivably falls into this definition and would be subject the proposed rule.
The definition of who is a “worker” and subsequently protected under the proposed rule is equally broad and includes paid or unpaid work, volunteers, interns, independent contractors, apprentices, and externs, but excludes franchisees in the context of the franchisee-franchisor relationship, which would remain subject to other applicable laws.
Main Provisions of the Rule:
The FTC’s primary goal is to remove the barrier to labor mobility that non-compete agreements erect. To do this, the FTC focuses on three main issues. The text of the rule states the following: “It is an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker; maintain with a worker a non-compete clause; or represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe that the worker is subject to an enforceable non-compete clause.”
Taking these individually, the FTC seeks to strike at the heart of the entire concept of non-competition. First, by making it illegal to enter into or attempt to enter into non-competition agreements, the FTC will eliminate the use of all non-compete agreements for new hires. Individuals who are taking advantage of the great reshuffling of workers caused by the COVID pandemic to start their own business or move to an emerging company in the same field as their current employer would not have to worry about whether their next job will be impacted or disrupted by a non-compete agreement. Conversely, employers who include non-compete agreements as part of their onboarding package and employee retention program will not be able to leverage non-compete agreements to keep employees from switching jobs.
Secondly, the FTC doubles down on its efforts to remove constraints on job mobility by ensuring that non-compete agreements are not grandfathered into this new world order. The FTC’s logic is straightforward: If future non-compete agreements are an unfair method of competition, it follows that any existing non-compete agreements amount to equally unfair competition.
Lastly, the FTC seeks to make illegal the act of representing to a worker that they are subject to a non-compete. Evidence shows that many workers remain ignorant of the enforceability or non-enforceability of non-compete agreements in the worker’s state. Because of that ignorance, some employers either force workers to sign an unenforceable non-compete agreement or threaten workers with the agreements causing an artificial constraint on mobility.
The proposed rule includes an exception for the sale or a business or its assets or otherwise disposing of all of a person’s ownership interests in the business. Such an individual must hold at least a 25% interest in the business to be subject to the exception at the time she signed the non-compete, so this would eliminate individuals who signed non-compete agreements before she met the threshold for ownership but accreted interests over time. The FTC’s rule would preempt state laws, orders, regulations to the extent those offer less protection to any worker. The rule does not restrict those state laws that exceed the protections offered under the proposed rule. Should the rule pass as drafted, there is a 180-day compliance window to implement any changes required by the rule.
What can I do to protect my company?
First thing to do is understand that nothing is immediate. This rule is currently only in the comment stage, so any final determination is months away. The rule has a 60-day window for comments and then those comments will be reviewed, the process may be reopened, or the rule challenged, then a final rule is ultimately published, and then there is a 180-day compliance window after publication of the final rule (assuming that does not change from now until then). This is assuming that the version of the proposed rules remains materially the same throughout the entire process. All this is to say that there is time to develop a strategy around the use, and ultimately non-use, of non-compete agreements in the event that the proposed rule becomes enforceable.
Second is to consider whether there are other incentives and disincentives to prevent undesired employee turnover. Equity is a common lever used to attract employees away from more established companies into the startup ecosystem. Companies can examine current implementation of their incentive plans and analyze whether certain individuals are candidates to receive some or more equity in exchange for their commitment to the company, subject, of course, to appropriate levels of vesting. Another concern of employers is that departing workers will take trade secrets and confidential information with them and apply it in their new role, undercutting the employer’s business. The rule does not alter protections around trade secrets and confidential information, and companies should work with their attorney to ensure that their ”secret sauce” is protected against infringement or unauthorized use.
What will be the ultimate impact if the rule is implemented?
There is no way to predict with absolute certainty what would happen if non-compete agreements were effectively eliminated from the labor market. The FTC argues that complete labor mobility will increase wages and job satisfaction because the contractual impediment that currently restricts workers from seeking alternative employment will disappear. Employers who leverage non-compete agreements will need to devise alternative measures to attract and retain workers.
Those against the proposed rule argue that it will have a chilling effect on innovation, training, and investment because workers will be free to leave for other opportunities at their earliest convenience, which will increase the risk of trade secret and confidential information disclosure, whether purposeful or inadvertent.
If states are the laboratories of ideas for a larger democracy, then the FTC’s approach suggests an outcome that contains more net positives than negatives. California’s current legislation prohibiting employee non-compete agreements was enacted in 1941 and other laws date back to the 1870’s but is home to the largest and arguably the most innovative technology market in the world. It is by no means a perfect model, but the flexibility offered in California has contributed to Silicon Valley’s boom and the state’s continued prominence in technology. If worker flexibility expands to all parts of the country, then it could spur another innovation boom as the hyper mobility of workers frees entrepreneurs to rethink current systems and constructs.
If you are a founder deciding whether to implement a non-competition element to your employment package or want to better understand how to manage your existing non-compete agreements, then talk with an attorney about how to proceed. Additionally, you should speak with an attorney if you are an employee or independent contractor faced with a non-compete agreement and you want to understand your rights or whether such language is even enforceable. The landscape around non-compete agreements could be dramatically different in the next 6 to 12 months.
This article is for informational purposes only, and may not be considered legal advice.
Matt is a founding partner at Peak Corporate Counsel. He focuses his practice on outsourcing and tech licensing, corporate governance, and commercial agreements. When not in the office Matt enjoys spending time outdoors, paddling on the ocean and hiking in the White Mountains, or on walks with his wife and small pug.