January 6, 2023

FTC Proposes a Sweeping Rule That Would Ban Nearly All US Noncompete Agreements

On January 5, 2023, the United States Federal Trade Commission (“FTC”) proposed a new rule (the “Proposed Rule”) that — if implemented — could dramatically restrict the use of non-compete agreements throughout the United States. This proposal follows on the heels of the FTC’s January 4, 2023 announcement of consent orders entered into with three companies and two individuals alleging that the companies and owners engaged in unfair methods of competition by imposing noncompete restrictions on workers in positions ranging from low-wage security guards to manufacturing workers to engineers. The orders prohibit the companies, and, where applicable, their individual owners, from enforcing, threatening, or imposing non-compete agreements against relevant employees.

The Proposed Rule would ban employers from entering into post-employment non-compete agreements with their workers, drastically limit the availability of sale-of-business non-compete agreements, and require employers to rescind many existing non-compete agreements. A 60-day comment period followed by a potentially lengthy response period must be completed before any version of the Proposed Rule becomes effective, and any final rule ultimately adopted by the FTC may be meaningfully less prohibitive than the near-absolute Proposed Rule. Even if finalized, this is the FTC’s first attempt to adopt a non-compete rule and fierce opposition about the scope of the FTC’s rule making authority is a near certainty, especially given the tremendous impact a non-compete ban would have on the American economy. In the meantime, here are answers to some of the most pressing questions employers may have about the Proposed Rule.

1. What are the key terms of the Proposed Rule?

The FTC has determined that an employer’s use of “non-compete clauses” with its workers is an unfair method of competition in violation of Section 5 of the Federal Trade Commission Act ("FTC Act"). Accordingly, its Proposed Rule would ban employers throughout the United States (i) from entering into or attempting to enter into non-compete clauses with their workers, (ii) from maintaining non-compete clauses with their workers, and (iii) in most circumstances, from representing to any worker that they are subject to a non-compete clause.

2. Does the Proposed Rule apply to all employers?

Effectively, yes. The Proposed Rule defines “employer” as any natural person, partnership, corporation, association, or other legal entity that hires or contracts with a worker to work for the person.

3. Does the Proposed Rule only apply to agreements with employees?

No. While the Proposed Rule refers to a worker’s “employment,” it defines “employment” to include any work of any kind for an employer. It further broadly defines “worker” as any natural person who works, whether paid or unpaid, for an employer, including employees, independent contractors (both individuals and sole proprietors, apparently irrespective of the contractor’s corporate form), interns, and volunteers. Notably, the Proposed Rule contains no exception for senior executives, highly paid workers, or highly skilled workers, although in the FTC’s lengthy Notice of Proposed Rulemaking (“NPRM”), the FTC describes and seeks comment on several alternatives to the Proposed Rule, including whether non-compete clauses between employers and senior executives should be subject to a different standard than non-compete clauses with other workers.

4. What does the Proposed Rule consider to be a non-compete clause?

The Proposed Rule would prohibit the use of “non-compete clauses” between “employers” and “workers” in various contexts. A “non-compete clause” is “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.” It would not bar the use of agreements that prohibit competition during the term of employment.

Under the Proposed Rule, a “non-compete clause” includes not only clauses that expressly prohibit competition, but also provisions that effectively function like non-compete clauses. According to the FTC, these so-called “de facto non-compete clauses” may include broadly-drafted non-disclosure provisions, clauses requiring workers to pay damages to their former employers if they work for a competitor, and other arrangements that have the practical effect of prohibiting a worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer. According to the NPRM, even a noncontractual statement in an employee handbook stating that a worker is prohibited from competing after the worker’s employment ends could be a de facto non-compete clause.

5. How could the Proposed Rule impact the following types of agreements:

a. Executive employment agreements and rank-and-file restrictive covenant agreements?

Under the Proposed Rule, post-employment non-competition clauses could not be used in any such agreements, regardless of the level of the employee.

b. Severance agreements, garden leave agreements, and similar contracts entered into in connection with the cessation of an employment relationship?

The Proposed Rule would also not allow post-employment non-compete clauses in separation agreements, even in exchange for severance pay or benefits. Moreover, while garden leave agreements technically apply during a period of continued employment, albeit during a time when no work functions are being performed, they at least arguably appear to be subject to the ban as “de facto non-compete clauses.”

c. LLC agreements, partnership agreements, equity grant agreements, and the like?

To the extent the member, partner, participant in the applicable plan, or other restricted party is an individual who qualifies as a “worker,” then the Proposed Rule would appear to prohibit any non-compete clause that extends beyond the cessation of their employment with the employer, even if they continue to hold their ownership position. This is an unusual result, because it treats individual owners who provide services for the employer differently from non-working owners (who would not qualify as workers). We anticipate comments to address this disparity.

d. Other types of restrictive covenant agreements, such as non-solicit and non-disclosure agreements?

According to the FTC’s comments in the NPRM, other types of restrictive employment covenants — such as non-disclosure clauses, customer non-solicit clauses, and employee non-solicit clauses — would not be prohibited, because these covenants generally do not prevent a worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer. Those covenants still would be permitted, subject to existing federal and state law.

However, if any such provisions were drafted so broadly so as to have the effect of prohibiting a worker from seeking or accepting new employment, they would be prohibited “de facto non-compete clauses.” The NPRM provides an example specific to non-disclosure provisions: a non-disclosure agreement that prohibited use or disclosure of any information that was “usable in” or that “relate[d] to” a specified industry was construed to prevent employment anywhere in that industry. A similar factual inquiry would apply under the Proposed Rule to determine whether any restrictive covenant constitutes a “de facto non-compete clause.”

e. Sale of business non-compete agreements?

Even though it seems to focus on employment-based non-compete clauses, the Proposed Rule would apply to sale of business non-compete agreements with individual sellers, like selling founders and other senior employees with ownership positions. The Proposed Rule has an exception for non-compete clauses entered into by a person who is selling a “business entity” (or otherwise disposing of all of the person’s ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets), when the person restricted by the non-compete clause is an owner, member, or partner holding at least a 25 percent ownership interest in the business entity. For owners above the material ownership threshold, typical sale of business non-competes could be obtained, subject to existing federal and state legal considerations, in the context of a full change-of-control transaction; but given the disposition-of-all-interests provision, non-compete clauses would not appear to be available against individual sellers in minority acquisitions, including seed and other early series investments. For owners below the material ownership threshold, non-compete clauses would appear to be permitted only in a full change-of-control transaction, and even then only until the earlier of the last day of the negotiated post-closing restricted period and the date on which the individual’s employment ceases, regardless of the reason for separation.

Notably, the FTC indicated in the NPRM that it believes that the 25 percent ownership threshold provides clarity and is appropriate in part because it would properly exclude situations when a worker with a small amount of company stock sells the stock back to the company when the employment relationship ends. The Proposed Rule does not address what types of ownership interests, e.g., unexercised options, are considered in calculating this threshold. Also in the NPRM, the FTC suggested the rule could simply use the term “substantial owner” and leave the interpretation to case by case adjudication. Substantial comments are expected on this point.

The Proposed Rule defines “business entity” to include partnerships, corporations, associations, limited liability companies, or other legal entities, as well as divisions or subsidiaries thereof. Accordingly, the sale-of-business exceptions above would appear to apply to corporate carveouts, discrete business-line asset acquisitions, and similar divisional acquisitions.

Because it only applies to agreements between employers and workers, the Proposed Rule would not prohibit sale-of-business non-compete clauses with institutional sellers, like corporations and private equity funds. Those sorts of agreements would remain available, subject to existing federal and state law, and regardless of whether the transaction is a full change of control or a minority investment (though we anticipate that non-compete clauses with or purporting to bind individuals who receive an indirect benefit from sale proceeds received by an institutional seller, like a trust, would be subject to the individual seller analysis reflected above).

f. Forfeiture-for-competition or liquidated damages (buyout) agreements?

The Proposed Rule could also impact agreements that do not explicitly prohibit competition, but merely require forfeiture of certain benefits, e.g., vested but unexercised options or vested units awarded under an incentive program, or require payment of specified sums if a separated employee engages in competitive activity. It appears that such agreements would be subject to the “de facto non-compete clause” analysis. The NPRM references a liquidated damages provision in a partnership agreement pursuant to which a terminated partner was required to pay specified damages if engaging in competitive activity after leaving the partnership, and the Proposed Rule specifically describes as a de facto non-compete clause a contractual term pursuant to which a worker has to pay the employer for the costs of training provided to the worker if the worker terminates within a specified period, if the amount to be repaid is not reasonably related to actual cost incurred for training the worker.

6. Does the Proposed Rule only apply to non-compete clauses executed after it becomes effective?

No. While the Proposed Rule prohibits future use of covered non-compete clauses, it also prohibits maintaining existing non-compete clauses, and requires employers to rescind all current non-compete agreements that fall within the scope of the Proposed Rule. Under a safe harbor provision in the Proposed Rule, an employer could comply with the requirement to rescind existing non-compete clauses by providing written notice to the affected workers.

7. If the Proposed Rule takes effect, what practical steps would an employer have to take?

If the Proposed Rule takes effect, employers would be required to: (i) revise their existing forms of restrictive covenant agreement, employment agreements, employee handbooks, and related arrangements to remove any non-compete clauses; (ii) issue notices to existing workers with non-compete clauses rescinding the non-compete clauses and inform the employees that those clauses are no longer in effect; (iii) identify (to the extent it has the contact information readily available) and issue notices to its former workers who have unexpired non-compete clauses; and (iv) be cognizant of the rule’s restrictions on non-compete clauses entered into in connection with the sale of a business entity.

Notably, in the context of sale-of-business non-compete clauses, this would appear to include identifying and notifying individual sellers whose ownership positions were below the materiality threshold (both active and inactive in the business) that the post-employment aspects of their non-compete agreements are rescinded. Similar considerations seem to apply to current and terminated partners, members, incentive plan participants, etc., who are subject to agreements with post-employment non-compete clauses.

8. How long would employers have to come into compliance with these notice and rescission requirements? And how should they be accomplished?

Under the Proposed Rule, all covered non-compete clauses would need to be rescinded by the date that is 180 days following the date of publication of the final rule in the Federal Register. Notice of rescission would need to be sent within 45 days of the rescission’s implementation. The Proposed Rule provides a specified form of notice, the use of which provides a safe harbor for compliance.

9. What would be the penalties for violating the Proposed Rule?

First and foremost, non-compete clauses would be unenforceable. Beyond that, the FTC would have the authority to issue cease and desist orders prohibiting the use or maintenance of non-compete clauses, to receive injunctive relief, to pursue redress, and to pursue civil penalties for violating any cease and desist order.

10. How would the Proposed Rule interact with existing state law, including in states that permit non-compete agreements?

The Proposed Rule purports to supersede any inconsistent state statute, regulation, order, or interpretation, except that, if the protection that any such state law affords any worker is greater than the protection provided under the Proposed Rule the state law would not be deemed to be inconsistent with the Proposed Rule and the state law would continue to apply.

11. Is the Proposed Rule subject to change?

Yes. There is a public comment period of 60 days following the date the Proposed Rule is published in the Federal Register (which has not yet occurred); following that, the FTC will consider the comments and whether to amend the Proposed Rule. Given the significance of the Proposed Rule, we anticipate that many comments will be submitted, which may result in material modification to the Proposed Rule.

12. When could the Proposed Rule become final and go into effect?

It will likely be at least a year from now and potentially much longer. In addition to the 60 day comment period, there is an as-yet unspecified period of time during which the FTC will consider the comments. Once the FTC finalizes its views, it will publish a final rule in the Federal Register. The rule would become effective 60 days later, but employers would not be required to come into compliance until 180 days after publication of the final rule.

13. How likely is it that the Proposed Rule will be challenged in court?

Very likely. Given the publicly announced commitment by legal and business groups, including the US Chamber of Commerce, to challenge the FTC’s authority to ban (or even limit) non-compete clauses, we anticipate litigation surrounding adoption of the rule that could further delay — or even prevent — actual implementation of a final non-compete rule. It is worth noting that less controversial proposed rules often ultimately take months if not years to become effective, if they become effective at all.

14. Has FTC taken any other steps to attack the use of non-compete clauses between employers and workers?

As noted above, this notice follows on the heels of the FTC’s recent consent orders alleging violations of Section 5 of the FTC Act through the imposition of non-compete restrictions on workers. Even prior to the Proposed Rule becoming final, we anticipate the FTC will continue investigating non-compete agreements and seeking injunctive relief where the non-compete agreements are wide-ranging and apply to lower-wage employees.

Next Steps for Employers and Investors

Employers that utilize non-compete agreements should consider the possible implementation of a broad federal prohibition on post-employment non-compete agreements in deciding how extensively to use non-compete agreements in the future. The Proposed Rule is consistent with a trend at the state level in recent years to restrict the use of non-compete agreements. Even while the Proposed Rule is under consideration and subject to revision, it may influence some courts in their assessments of whether to enforce non-compete agreements. Goodwin’s employment lawyers are ready to provide assistance to employers considering whether and in what circumstances to use non-compete agreements while the rulemaking process unfolds.