On January 5, 2023, the Federal Trade Commission (FTC) announced its long-anticipated proposed rule, which if adopted, would essentially ban all noncompete agreements between employers and their workers that restrict such workers from obtaining new employment following the end of their working relationship with the employer (with a narrow exception for noncompete agreements entered into in connection with the sale of a business). The rule follows President Biden’s Executive Order on Promoting Competition in the American Economy, issued on July 9, 2021, in which he directed several federal agencies to consider different measures to promote competition, including limitations on noncompete agreements that curtail worker mobility. According to the FTC’s press release, the proposed rule would boost competition for workers and foster innovation and entrepreneurship, leading to an estimated increase in American workers’ earnings of between $250 billion and $296 billion per year.
The Proposed Rule
As currently drafted, the FTC’s proposed rule prohibits employers throughout the United States from doing the following after cessation of services by the worker: (1) entering into a noncompete clause with a worker; (2) maintaining a noncompete clause with a worker; or (3) representing to a worker that they are subject to a noncompete clause when there is no good-faith basis to believe that the noncompete is enforceable. The proposed rule does not prevent employers from prohibiting competition while the worker provides services to the employer.
A “worker” is defined as any person who works for an employer, whether paid or unpaid, including independent contractors, volunteers and interns, regardless of seniority or position. The term “non-compete clause” means “a contractual term between an employer and 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.” Accordingly, the proposed rule applies to traditional noncompete agreements as well as any other contractual provision that would impede a worker’s ability to obtain employment, which the FTC refers to as “de facto” noncompete agreements. For example, the FTC notes that a nondisclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment would be considered a de facto noncompete and banned. In addition, a de facto noncompete agreement could also include broadly worded client or customer nonsolicitation agreements, “no-business” agreements prohibiting the worker from doing business with the employer’s former clients or customers, and “forfeiture for competition” agreements under which a worker gives up some benefit or must pay liquidated damages if they engage in competition. Whether those types of agreements would be prohibited by the new rule will be fact dependent and determined on a case-by-case basis.
In addition to banning noncompete agreements on a going-forward basis, the rule requires that employers rescind any existing noncompete agreements with current and former workers by the compliance date (i.e., 180 days after publication of the final rule) and provide such workers with individualized, written notice that the noncompete is no longer in effect within 45 days of recission (with regard to former workers, however, the employer is only required to send recission notices to those workers whose contact information the employer has readily available). The retroactive effect of the proposed rule is particularly alarming given that employers would need to rescind existing noncompete agreements binding individuals to whom they have already provided valuable consideration, in the form of cash and/or equity, in exchange for their agreements not to compete. Such a result clearly strips employers of a benefit for which they negotiated; it remains unclear whether employers could reasonably claw back consideration already provided to such individuals.
In addition to rendering most noncompete agreements unenforceable, the proposed rule provides the FTC with authority to issue cease-and-desist orders to employers, to obtain injunctive relief and to pursue civil penalties from employers for violating any cease-and-desist order. The amount of civil penalties per violation remains unknown.
Notably, the FTC’s proposed rule includes a narrow exception for noncompete agreements entered into by workers in connection with the sale of a business, which are commonplace in the context of mergers, acquisitions and asset sales. Under the rule, (1) a person who is selling a business entity (or otherwise disposing of all of the person’s ownership interest in the business entity) or (2) a person who is selling all or substantially all of a business entity’s operating assets could be subject to a noncompete, but only if such individual holds at least a 25% ownership interest in such business entity.
The concept of limiting noncompetes in the sale-of-business context to only those individuals who own a portion of the business being sold is a well-recognized concept under many state laws (e.g., California), but the idea of establishing a specific ownership percentage is entirely new. The FTC explained that it chose 25% because it believes it “strikes the appropriate balance between a threshold that may be too high (and would exclude many scenarios in which a non-compete clause may be necessary to protect the value of the business acquired by the buyer) and a threshold that may be too low (and would allow the exception to apply more broadly than is needed to protect such an interest).” The FTC has expressly invited public comment on this issue, stating that “in a final rule, the Commission could set this standard at a different percentage level—for example, 50% or 10%.”
Moreover, the proposed rule does not define what constitutes an “ownership interest” and is silent on whether stock options, restricted stock units or other equity incentives should be factored into the calculation threshold. The FTC does make clear that the proposed rule would not apply to noncompete agreements with institutional sellers, such as corporations or private equity funds, entered into in connection with a transaction. Subject to existing federal and state law, these noncompete agreements would remain available. It is expected that the FTC will provide more detailed guidance on the sale-of-business exception prior to the adoption of a final rule.
The proposed rule is subject to a 60-day public comment period, which ends on March 10, 2023. Once the FTC reviews all comments, it is expected to publish a final rule, and employers will have 180 days thereafter to ensure compliance. However, given the breadth of the proposed rule and the abrupt change in the law, we expect the FTC’s final rule to be subject to numerous legal challenges. Indeed, the U.S. Chamber of Commerce has already voiced its opposition to the proposed rule, and FTC Commissioner Christine Wilson published a dissenting opinion explaining that the proposed rule is “vulnerable to meritorious challenges” that will result in “protracted litigation in which the Commission is unlikely to prevail,” including claims that the FTC is exceeding its authority under the non-delegation doctrine (i.e., Congress has not explicitly delegated to the FTC rulemaking authority on this issue) and claims based on the major questions doctrine, a Supreme Court principle holding that courts should not defer to agency rule-making that concerns questions of “vast economic or political significance” in the absence of clear congressional authorization.
For now, employers that utilize agreements with noncompete clauses should begin to review their existing agreements with employees, independent contractors and other service providers for any contractual terms that may be subject to the proposed rule. This includes taking a closer look at nondisclosure and nonsolicitation provisions that might restrict a worker from securing future employment, as well as taking inventory of former service providers whose agreements may be implicated by the rule. Further, employers should consider an impending federal prohibition on noncompete agreements in connection with entering into any post-employment noncompete agreement in the future. We will continue to monitor all developments with respect to the FTC’s rule and will report accordingly.