Another Battle in the War on Non-compete Clauses

On April 23, the Federal Trade Commission (FTC) voted 3-2 along partisan lines to approve its final Non-Compete Clause Rule, which purports to ban most non-compete agreements (the “rule”).

The rule is scheduled to go into effect on Sept. 4 of this year.

Before parsing the details of the rule, two caveats are essential.

First, the rule is going to be struck down. It will in all likelihood never even go into effect. The first lawsuit challenging the rule, from Texas tax services firm Ryan LLC, was filed on the day it was issued; the U.S. Chamber of Commerce filed its lawsuit against the rule the following day.

The FTC issued the rule under its FTC Act Section 5 “unfair trade practices” enforcement authority. Whether the FTC can issue any rules at all regulating business practices will be the first question the courts will have to decide in these lawsuits. Although the FTC has issued a dozen or so rules defining some business practices as “unfair trade practices” under Section 5 in the 110 years since the agency’s enactment, almost all of those rules dealt with false statements and other deficient disclosure practices, and only one was subjected to judicial review.

None of those rules attempted to illegalize a business practice like the use of non-compete agreements. There is already an extensive body of state common law regulating the permissible use of such agreements and almost two dozen state statutes that expressly govern when such agreements can—and cannot—be applied.

The FTC’s aggressive initiative also comes as the Supreme Court is actively curtailing federal agencies’ discretion to expansively interpret statutory grants of regulatory authority. This rule almost surely will be deemed violative of the high court’s recent West Virginia v. EPA “major questions doctrine,” under which an agency cannot issue a new rule with widespread “economic and political significance” absent an express congressional directive. The FTC itself notes in its rule commentary that as many as a quarter of all U.S. workers currently are subject to non-compete agreements; that fact alone is likely to trigger a rejection of the FTC’s effort to illegalize such agreements absent an express directive.

Second, it is also critical to note that there is no private right of action under Section 5 of the FTC Act. This means that only the FTC itself can enforce the rule if it ever goes into effect, which it won’t.

Now on to the details.

The Basic Rule > The rule generally would bar any “business entity” from subjecting an employee to a “non-compete clause,” which is defined in the text as:

A term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from:

1.  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

2.  operating a business in the United States after the conclusion of the employment that includes the term or condition.

The rule would prohibit employers from entering into or attempting to enter into a non-compete clause with an employee; enforcing or attempting to enforce such a requirement; or representing that a worker is subject to such a requirement.

If the rule ever takes effect, workers currently subject to banned non-compete clauses must be given a prescribed notice that such clauses will no longer be enforceable, but no formal rescission of such clauses is required.

Garden Leave > The rule applies to only post-employment restrictions; the FTC expressly notes that non-compete restrictions that apply during a paid garden leave period are therefore not subject to the rule.

Non-Solicitation Agreements > The commission commentary notes—as it did in the proposed rule—that “non-solicitation agreements” that bar a former employee from soliciting former clients for business “are generally not non-compete clauses under the final rule because, while they restrict who a worker may contact after they leave their job, they do not by their terms or necessarily in their effect prevent a worker from seeking or accepting other work or starting a business.”

The commission does note that under certain circumstances a non-solicitation agreement could violate the rule by effectively preventing workers from seeking or accepting other work or starting a business after their employment ends. Whether a non-solicitation agreement meets this threshold is a fact-specific inquiry that must be done on a case-by-case basis.

Exception No. 1—Business Sales > The rule expressly states that it “shall not apply to a non-compete clause that is entered into by a person pursuant to a bona fide sale of a business entity, of the person’s ownership interest in a business entity, or of all or substantially all of a business entity’s operating assets.”

The rule commentary clarifies that this exception would apply to buy-sell arrangements as long as the shareholder was not required to purchase his shares as a condition of employment and there is nothing else that effectively makes the arrangement a sham transaction designed to evade rule prohibitions.

One of The Council’s primary critiques of the proposed rule was its very limited and unworkable sales agreement exception. The rule adopts The Council’s recommendations and completely exempts owner business-sale related non-compete agreements.

Exception No. 2—“Senior Executives” > Non-compete clauses already in place with “Senior Executives” are exempt from the rule’s non-compete prohibition, but new agreements with “Senior Executives” would be subject to those prohibitions going forward. “Senior Executives” are defined as individuals who made more than $151,164 on an annualized basis during the last year and who are a business entity’s president or chief executive officer (or the equivalent) or any other individual with “policy making authority” for the entire business. The definition of “policy making authority” is, admittedly, limited and appears to apply to only C-suite-level officers or their equivalents.

Going Forward, a Silver Lining?

The debate over the permissible use of non-compete clauses will not end when the FTC’s rule is inevitably thrown out by the courts. Members of Congress on both sides of the aisle are discomfited by the perceived widespread abuse of non-compete agreements against hourly and other low-income workers, and congressional legislation already is pending to ban them. Seventeen states currently ban the use of non-competes for lower-wage workers, and another four prohibit them completely (although each includes an owner’s sales exception). More are actively considering imposing their own bans.

Through that lens, the FTC rule may be viewed as a ceiling—even this FTC did not think it appropriate to apply its ban to non-compete clauses negotiated as part of a bona fide sale of an owner’s interest in a business; to non-solicitation arrangements; or to qualifying “Senior Executives.” We can debate the details but have no doubt that we will heavily tout those fundamental rule exclusions in the legislative battles to come.