The Federal Trade Commission’s (FTC’s) January 5, 2023, notice of proposed rulemaking would ban businesses from entering into and maintaining noncompete clauses with workers. In this LawFlash, we answer several frequently asked questions related to the proposed rule’s applicability and anticipated impact, and discuss what businesses can do to prepare.
Employers and the business community can submit comments on the proposed rule, whether individually, jointly through industry or trade associations, or as part of a consortium of interested businesses.
Each of the commissioners published separate statements on the notice of proposed rulemaking (NPRM) with their respective support for or criticisms of the proposed rule. These statements strongly encourage comments from interested stakeholders on, among other topics, the potential impact of the proposed rule, whether there are alternatives or modifications that should be considered, and whether the agency has appropriately considered the costs/benefits and academic literature that addresses noncompete clauses.
Commissioner Christine S. Wilson cautioned that “this is likely the only opportunity for public input before the Commission issues a final rule,” and emphasized that “it is important for commenters to address the proposed alternatives to the near-complete ban on noncompete provisions.”
If and when the proposed rule or a version of it becomes final, it is likely to face several legal challenges in the courts. Commissioner Wilson’s dissenting statement on the proposed rule outlines some of the primary arguments against the legality of the proposed rule:
Yes. If the proposed rule is finalized in its current form, it will require employers and businesses to rescind their existing noncompete clauses and provide notice to their workers, broadly defined, of the rescission.
Given the broad definition of “worker,” which includes employees, independent contractors, externs, interns, volunteers, apprentices, and sole proprietors, the proposed rule will potentially have wide applicability. As previously indicated, we expect that there will be some legal challenge to the final rule, and it is possible that a court will block enforcement of the final rule pending a resolution of those challenges.
It is unclear. The NPRM does not currently address equity forfeiture or clawback provisions. The NPRM states that it will apply to provisions that operate as “de facto” noncompete clauses. Determining whether a provision amounts to a de facto noncompete clause will be a fact-sensitive assessment that turns on the effect on the worker. Therefore, if a clawback provision operates as a de facto noncompete provision, it may fall within the proposed rule’s coverage.
If, however, the clawback or forfeiture provision allows for an employee’s choice to compete and forfeit/trigger clawback or to not compete and retain the subject equity, it may not be prohibited by the final rule. The NPRM suggests that the amount of any forfeiture or clawback could play a role in determining if there is a de facto noncompete clause.
Specifically, the NPRM references a case in which a court found that a liquidated damages provision in a partnership agreement was considered a de facto noncompete “given the prohibitive magnitudes” of damages a partner would be required to pay for engaging in competitive activity. This reference to a case involving a partnership agreement further underscores how the proposed rule could have a broad impact on not only traditional employment agreements, but also partnership and other business contracts.
The proposed rule also states that a de facto noncompete clause can include an agreement that a worker repay training costs to the employer in the event the worker resigns within a specified period, if the repayment amount is not reasonably related to actual costs incurred for training the worker. Public comments seeking clarification of this issue could clear up the ambiguity in any final rule.
Yes. Although the NPRM currently provides an exception for noncompete clauses that are entered into by a person selling a business or substantially all of a business’s assets, that exception only covers a “substantial” owner, member, or partner, which is defined as an owner, member, or partner holding at least a 25% ownership interest in the business.
The proposed rule’s requirement that employers notify workers that their noncompete agreements are rescinded might also apply in the context of a sale of business, requiring buyers to notify individual sellers who held less than 25% ownership of the sold business that their existing sale-of-business noncompete agreements are rescinded.
It is unclear. The NPRM’s definition of “workers” does not expressly address partners or members. “Workers,” however, is broadly defined to include “any natural person . . . who works for an employer.” The definition of “employer” incorporates the definition for that term in 15 U.S.C. § 57b–1(a)(6), which includes partnerships and “other legal entit[ies].”
Any partner or member who “works for” a partnership or other legal entity (i.e., a member who holds both a membership interest and an employment role) may arguably be covered by the proposed rule, whereas partners or members who do not perform any work would not be covered.
This question demonstrates how the proposed rule’s broad definition of “workers” increases the potential impact of the rule beyond traditional employer/employee noncompete agreements. Public comments may address this issue.
It is unclear. Although the NPRM states that it does not prohibit “concurrent-employment restraints,” it does not expressly address termination notice requirements or create an exception for noncompete clauses that will pay terminating employees to remain employed and refrain from working for a competitor for a certain period of time (commonly referred to as “garden leave” clauses).
Although the NPRM states that it does not generally prohibit customer nonsolicitation or confidentiality agreements, whether such agreements qualify as prohibited “noncompete clauses” depends on the language of the agreement. The NPRM states that a de facto noncompete provision can be any agreement that has the effect of prohibiting a worker from seeking or accepting employment with a person or operating a business after separating from an employer.
As an example, the NPRM notes that a nondisclosure agreement written “so broadly that it effectively precludes the workers from working in the same field” would be considered a de facto noncompete agreement. The NPRM does not provide an example of how a customer nonsolicitation clause could be considered a noncompete agreement. If, for example, such a provision were written to effectively prohibit any commercial interaction with any customer in a particular industry or field, the FTC may take the view that that provision operates as a de facto noncompete.
In considering whether a confidentiality agreement operates as a de facto noncompete, we anticipate that courts will likely consider whether the agreement has temporal and geographic limitations, and scrutinize the scope of the confidentiality clause and its exceptions to determine if, for example, the employer is precluding the former employee from using any of the following:
Courts may also analyze how employers seek to enforce confidentiality clauses by, for example, demanding the return of all information and materials received, encountered, or learned during the employment, in determining whether the confidentiality clause operates as a de facto noncompete.
Sections 280G and 4999 of the Internal Revenue Code impose tax penalties in circumstances where the value of compensation that is contingent on a change in control equals or exceeds three times the average annual compensation of certain employees and other service providers. The value of noncompete agreements is often used to reduce the value of parachute payments for purposes of Section 280G calculations because payments for noncompete agreements can be considered reasonable compensation for refraining from performing services.
To the extent that noncompete agreements are unenforceable, this significant tool used to reduce parachute tax penalties will cease to be available.
Public comments on both the proposed noncompete ban and various alternatives, expressly including limitations for senior executives, need to be submitted by April 19, 2023.
If adopted by the FTC, the final rule would go into effect 180 days after the final version is published in the Federal Register. At that point, we expect the final rule will be subject to legal challenges, which may delay its effective date.
Employers and businesses should consider taking the commissioners up on their invitation to submit comments to the proposed rule, either individually or through an association. For instance, if there are alternatives to the proposed rule that may work better for certain industries, employers and businesses should consider proposing them.
Despite the uncertainty surrounding the proposed rule, parties to existing or potential transactions should prepare for its implementation by reviewing existing noncompete agreements and considering the effect that any final rule would have on such agreements. Businesses should also prepare by analyzing the breadth of their confidentiality clauses and tightening up trade secret protection plans by properly identifying, classifying, and protecting trade secrets with reasonable measures.
Our lawyers regularly assist clients with audits of their restrictive covenants and trade secret protection plans. We are also available to assist with drafting comments on the proposed rule.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following: