Federal Trade Commission Bars Employers from Enforcing Non-Compete Agreements
On April 23, 2024, the United States Federal Trade Commission (FTC) announced a new rule to bar all U.S. employers from enforcing non-compete agreements. You can read the FTC's announcement regarding the rule here: FTC Announces Rule Banning Non-Competes.
What are Non-Compete Agreements?
Non-compete agreements, also known as restrictive covenants or non-competition clauses, are legal contracts between an employer and an employee (or sometimes between a company and a contractor) that restrict the employee's ability to work for a competitor or start a competing business for a certain period of time after leaving their current position.
These agreements typically specify the types of activities or industries that the employee is prohibited from engaging in for a specified duration and within a defined geographic area. The primary purpose of non-compete agreements is to protect the employer's trade secrets, confidential information, and competitive advantage.
Non-compete agreements are common in industries where employees have access to sensitive information, specialized skills, or client relationships that could be exploited by a competitor. However, their enforceability varies by jurisdiction, and many states and countries already have laws regulating the use of such agreements to ensure they are reasonable and not overly restrictive on employees' ability to find new employment.
Non-Competes are often used as one (of many) tools to protect a company’s intellectual property and the resources expended in training and developing its workforce. The idea is, if you spend time and money training someone in a particular field and provide them access to confidential company information, customer lists, market data, and business strategies, you want to prevent them from leaving and starting a competing business with the insight and training you provided at your company’s expense. Without the ability to enforce a non-compete agreement, the risk is higher that an employee leaves and takes company knowledge with them.
Restrictions on Non-Competes Are Not New.
The enforcement of non-compete agreements, as an aspect of contract law, has long been considered a matter reserved for each state (rather than a federal issue). As such, in the U.S., enforcement of non-compete provisions varies widely and is often influenced by the state where an employee or contractor lives.
As an example, California has long banned the enforcement of non-compete agreements. Under CA Business and Professions Code Section 16600, “every contract by which anyone is restrained from engaging in a lawful profession, trade, or business of any kind is to that extent void.” CA implemented further restrictions on non-compete agreements on January 1, 2024, including (1) banning enforcement of non-competes even if they were signed in or are governed by the laws of another state and (2) imposing civil penalties on an employer who attempts to enforce a non-compete.
Other states implement a “reasonableness test”, which aims to enforce non-competes only to the extent they are tied to the legitimate business interests of an employer. If a non-compete is not tailored to the geographic region where a company operates, extends beyond a reasonable time period, or covers too broad of industries of businesses that aren’t actually competitive to the company, a state court may refuse to enforce the non-compete entirely, or it might “edit” the non-compete to only apply to the extent the court deems appropriate.
Why is the FTC Taking Action?
Non-competes are controversial, and many business leaders, policy makers, and lawyers (myself included) find them problematic. Although there are undeniable short-term benefits to a company if it can enforce non-compete agreements with its workers, a government that enforces these types of agreements already empowers issues such as the following.
Stifling Innovation and Economic Growth: Critics argue that non-compete agreements can stifle innovation and economic growth by limiting employees' ability to move freely between companies and share their knowledge and skills. When employees are bound by non-compete agreements, they may be hesitant to pursue new opportunities or start their own ventures, thereby hindering the flow of talent and ideas in the marketplace.
Limiting Employee Mobility and Job Opportunities: Non-compete agreements can restrict employees' mobility and limit their job opportunities, particularly in industries where such agreements are widespread. Employees may feel trapped in their current positions due to fear of legal repercussions if they seek employment with a competitor or in a related field. This lack of mobility can have negative effects on career advancement, wages, and overall job satisfaction.
Magnifying Disproportionate Power Dynamics: Non-compete agreements are often presented to employees as take-it-or-leave-it contracts, leaving them with little bargaining power to negotiate the terms or challenge the agreement's enforceability. In many cases, employees may feel pressured to sign these agreements as a condition of employment, even if they are uncomfortable with the restrictions. This imbalance of power can lead to unfair outcomes and exploitation of workers, particularly those in lower-wage or less-skilled positions.
At a policy level, the FTC has reasoned that:
“Non-competes are a widespread and often exploitative practice imposing contractual conditions that prevent workers from taking a new job or starting a new business. Non-Competes often force workers to either stay in a job they want to leave or bear other significant harms and costs, such as being forced to switch to a lower-paying field, being forced to relocate, being forced to leave the workforce altogether, or being forced to defend against expensive litigation. An estimated 30 million workers—nearly one in five Americans—are subject to a non-compete.”
The FTC found that non-competes tend to negatively affect competitive conditions in labor markets by inhibiting efficient matching between workers and employers. The Commission also found that non-competes tend to negatively affect competitive conditions in product and service markets, inhibiting new business formation and innovation. There is also evidence that non-competes lead to increased market concentration and higher prices for consumers.
Accordingly, the FTC determined that it is an unfair method of competition for employers to enter into non-competes with workers and to enforce certain non-competes, and therefore a violation of Section 5 of the Federal Trade Commission Act of 1914.
What Does the FTC Rule Do?
Here are a few key highlights from the FTC’s latest announcement. We’ll update this information as more details are published about the final rule.
All existing non-competition provisions with “workers” (which includes both employees and contractors) are nullified within 120 days of publication of the final rule (which should be in a matter of days). There is an exception for “senior executives” (see below).
It is illegal to enter into a non-compete (or attempt to enter into a non-compete) with any worker other than a senior executive.
There is a two part test to determine which workers qualify as “senior executives”:
they must have policy-making authority (see below), and
they must have total compensation of at least $151,164 in the prior calendar year
“Policy-making authority” includes the company’s president, CEO, and other officers/workers with similar levels of authority.
Non-competes entered in connection with the sale of a business are still allowed, although it's unclear exactly who this applies to. It's common that company owners and officers sign non-competes as a condition to a buyer's acquisition of the company. The exemption may only apply to a person who owns a significant ownership interest and/or who serves as a senior executive in the company. The final rule will provide clarity here.
Non-competition litigation that is initiated prior to the rule going into effect is not affected by the rule.
This rule will likely be challenged in court. The FTC commissioners who voted for the rule seem aware of this, and have already begun articulating legal strategies for why the rule should survive.
How This Will Affect Your Company
The FTC ruling will undoubtedly shift how companies protect their confidential information and retain skilled workers. Specifically, companies will no longer be able to rely on non-competes as the primary or sole tool to retain skilled workers. Workers will be able to freely move to competing businesses and take on the same or similar roles at those competitors. Without other avenues to protect company and customer confidential information as well as business strategies and market insight, companies will face more risks to the misuse of their intellectual property and the loss of resources incurred in training and developing a team.
Additionally, if a company has raised capital through a fundraising round, the documents executed in connection with that round may impose obligations on a company to implement and enforce non-compete agreements with certain employees. Following implementation of the FTC, a company may not be able to comply with those obligations.
Finally, certain companies (especially those who rely on non-competes as an employee retention strategy) can expect to experience more employee turnover after the FTC ruling as more employees leave for similar jobs with better compensation, work-life balance, workplace culture, and other benefits.
There Are Other Ways to Protect Your Company
Employers can protect their sensitive information, specialized skills, and client relationships without relying solely on non-compete agreements by implementing the following strategies:
Confidentiality and Non-Disclosure Policies: Employers can establish clear policies and procedures for safeguarding sensitive information and trade secrets. Employees should be required to sign confidentiality and non-disclosure agreements (NDAs) that outline their obligations to protect confidential information both during and after their employment. These agreements can help deter employees from disclosing proprietary information to competitors.
Access Controls and Data Security Measures: Employers can implement access controls and data security measures to prevent unauthorized access to sensitive information. This may include restricting access to confidential data on a need-to-know basis, encrypting sensitive data, and implementing secure password protocols. Regular security audits and employee training on data protection best practices can also help mitigate the risk of data breaches.
Employee Training and Awareness Programs: Employers can invest in employee training and awareness programs to educate staff about the importance of protecting sensitive information and trade secrets. Training sessions can cover topics such as identifying confidential information, securely handling data, and recognizing potential security threats such as phishing attacks or social engineering tactics. By promoting a culture of security awareness, employers can empower employees to play an active role in protecting company assets.
Client Relationship Management: Employers can implement robust client relationship management (CRM) systems to track and manage interactions with clients. By maintaining detailed records of client communications, preferences, and transactions, employers can better understand client needs and preferences and strengthen client loyalty. Additionally, establishing strong relationships with clients based on trust and mutual respect can help mitigate the risk of clients being poached by competitors.
Employee Retention Strategies: Employers can implement employee retention strategies to reduce the likelihood of key employees leaving to work for competitors. This may include offering competitive salaries and benefits, providing opportunities for professional development and career advancement, and fostering a positive work environment. By investing in employee satisfaction and engagement, employers can increase employee loyalty and reduce turnover, thereby minimizing the risk of losing valuable talent to competitors.
By implementing these strategies, employers can effectively protect their sensitive information, specialized skills, and client relationships without solely relying on non-compete agreements, thereby promoting a more balanced and mutually beneficial relationship with their employees.
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