The End of Non-Competes as We Know Them?
New FTC Regulations limit enforceability of covenants not to compete
Table of Contents:
Intro and Background
Covenants not to compete, also known as non-competes, have long been the bane of employees in a variety of industries. While state-specific laws sometimes limited the scope and duration of non-competes, there often was not a uniformity of application among classes of employees, industries, and types of service arrangements. In an increasingly distributed workplace environment post-COVID, this often created confusion and conflicts of laws between states.
Feelings were mixed on non-competes, but many businesses relied upon such restrictions to protect the value and competitive position of their enterprise. The damage that can be done by an employee fleeing to greener pastures is very real. But, non-competes can be over-enforced to limit the prospects of at-will employment – especially for rank-and-file employees. The inability of employees to litigate the enforceability of non-competes can have a chilling effect on the mobility of such employees.
These concerns were addressed on April 23, 2024, when proposed Regulations by the Federal Trade Commission were finalized and issued. This new “Rule,” authorized by 15 U.S.C. Section 45, had the general effect of treating many non-competes in employment contexts to be unfair methods of competition between businesses. The Regulations can be found at 15 CFR Sections 910.1 – 910.6.
The General Rule
The ban on non-competes takes effect 120 days after the publication of this final rule on April 23, 2024. So, August 21, 2024 should be the effective date of the new Regulations.
Generally, all non-competes (regardless of when created) with respect to “workers” will be unenforceable after the effective date unless entered into as part of a bona fide sale of a business. Outside of this context, the only existing non-competes that will remain enforceable after the effective date will be those entered into by senior executives before the effective date.
Under the new Rule, non-competes are treated as unfair methods of competition in three specific scenarios:
1. When entered into or attempted to be entered into;
2. When enforced or attempted to be enforced; and
3. When it is represented that a worker is subject to a non-compete.
For purposes of this ban, “workers” are defined to include paid and unpaid workers without regard to federal or state employment status. This broad definition includes employees, independent contractors, volunteers, interns, externs, apprentices, and even sole proprietors providing a service. However, while this definition includes a worker for a franchisee or franchisor, it does not include an actual franchisee with respect to a relationship with a franchisor.
What is a Non-Compete?
The new Rule contains an express definition for a “non-compete clause.” Effectively, this renders unenforceable any clause – whether part of a stand-alone agreement or a broader agreement – that either penalizes or functions to prevent a worker from seeking employment after their current employment ends or from starting a business after their current employment ends. For this reason, it is helpful to consider any covered non-compete as a post-employment non-compete under the new Rule.
Note, however, that this technical definition does not prevent a current employer or service recipient from preventing a worker’s competition while currently employed. This will be of interest to those who moonlight, start side hustles, or work multiple jobs. Generally, this Rule does not alter one’s existing state-law duty of loyalty to a current employer. Preparations to compete while still employed can still be penalized or prevented by one’s current employer, subject to state-law restrictions.
Note also that this Rule does not prevent other protections such as confidentiality, non-disclosure, and non-solicitation agreements. These vital protections remain enforceable, and perhaps will become a central focus of business protection going forward. Just because one can leave to go work for a competitor, or start a competing business, does not mean they can poach employees or use confidential information. But, it is much harder to prove violations of these types of restrictions than it is to prove competition.
Exceptions
As alluded to above, there are three safe harbor exceptions to the Rule, under which non-competes are not deemed to be unfair methods of competition. The first is for a senior executive, so long as the non-compete existed prior to the Rule becoming final. The second is for a bona fide business sale. The third is where a cause of action relating to a non-compete accrued prior to the effective date.
Senior Executives
Senior executives are defined to include only a worker in a policy-making position, which generally includes a president, CEO, or similar officer of a business entity. The policy-making authority of an employee of a subsidiary over a common enterprise appears to follow a facts-and-circumstances test.
Beyond policy-making authority, there is a compensation threshold which does not appear to be subject to inflation adjustments. Any worker making less than $151,164 on an annualized basis for the preceding year (either the trailing 52-weeks, a calendar year, or a fiscal year) is not a senior executive. This compensation includes all salary, commissions, and nondiscretionary bonuses/other compensation, but does not include discretionary bonuses, and benefits such as contributions to health insurance, life insurance and retirement plans.
Note that classification as a senior executive only has relevance to the enforceability of a non-compete entered into prior to the effective date. After the effective date, new non-competes – even for senior execs – are not enforceable.
Business Sale
Non-competes entered into as part of a bona fide business sale remain valid, whether entered into before or after the effective date. Business sales include a sale of a business entity itself, a sale of a person’s ownership in a business entity (like under a buy-sell agreement), and a sale of substantially all of a business entity’s operating assets.
Note that there are no express carve-outs for non-competes entered into in exchange for valuable consideration outside of a sale of a business, or in conjunction with an award of equity. Instead, one must fit into the narrow rubric of a repurchase of that equity, or a broader sale of the entire business, to meet the exception.
Existing Causes of Action
For any causes of action that accrue prior to the effective date, non-competes remain enforceable with respect to that specific cause of action.
Note that the Rule does not require the cause of action to be discovered before the effective date. So, if one were to later discover a violation of the non-compete that occurred before the non-compete was invalidated by the new Rule, the date of discovery likely would not matter under a plain reading of the Rule.
Good-Faith Exception
If an employer or business has reason to believe that the new Rule is not applicable (due to one of the exceptions, or perhaps due to a relationship with a person not believed to be a worker), an attempt to enforce the non-compete (even if invalid) or a representation that the non-compete exists will not violate the new Rule.
Notice Requirements
For non-competes that are indeed rendered unenforceable, there is no requirement that these documents be torn up or expressly terminated. Instead, for every person who imposed a non-compete, they must provide to the worker subject to that non-compete a notice that the non-compete is henceforth unenforceable.
Note that the deadline for providing this notice is the effective date.
The Rule provides a sample form and model language for the notice, which I have cut-and-pasted below:
Penalties
The new Rule does not state or alter any express penalties. Instead, it appears to fall within the general jurisdiction of the FTC or U.S. Attorney General under 15 U.S.C. Sections 45(b) and 57b to commence an administrative action, or a civil action in a U.S. District Court, against any person who is found to have violated the general prohibition on unfair competition.
As an outcome, 15 U.S.C. Sections 45(l)-(m) authorize civil penalties of up to $10,000 for (1) each violation of a civil order not to engage in unfair competition, or (2) each knowing violation of the Rule itself.
Practical Application and Take-Aways
For estate planning and tax attorneys and advisors, non-competes relating to a client’s workers can often represent a personal or business asset – especially non-competes entered in exchange for valuable consideration. This value may be changed by the Rule. Further, non-competes are often part of buy-sell agreements and other entity governing documents.
One must be cautious, first and foremost, about the notice requirement for existing non-competes which may be deemed invalid. There is a limited window of 120 days which will end on August 21, 2024 to provide the required notice under the new Rule.
As part of this, it may be a good time to dust off and review any existing nondisclosure, confidentiality, and non-solicitation agreements to ensure these agreements or clauses work as intended. Beefing up these protections may be important to fill the gap left by unenforceable non-competes.
While there is no temporal limitation on discovery, exploration of whether a cause of action may be accruing or have accrued prior to the August deadline may be important as well. On this note, those meeting the definition of “workers” are not yet in the clear. Regardless of effective date, you cannot avail yourself of the new Rule through moonlighting or experimental businesses started while in one’s current employment. Geographic scope of existing non-competes will become increasingly important.
In the vein of geographic and temporal scope, note that enforceable non-competes will continue to be bound by the same state-law and contract law limitations that traditionally have applied. As noted above, with a distributed/remote workforce, these concerns are increasingly important to determine “place” of competition.
Finally, much like the Corporate Transparency Act, I anticipate that there could be some pushback and lawsuits commenced over this new Rule. For the time being, it is not wise to counsel anybody to ignore a federal rule. But, we could end up with grey areas if this Rule is subsequently altered judicially.