FTC proposes ban on noncompetes

On January 5, 2023, the Federal Trade Commission (FTC) announced a sweeping new proposed rule banning non-compete agreements between nearly all employers and workers with its release of a Notice of Proposed Rulemaking (NPRM). If enacted in its current form, the FTC rule would constitute a drastic change in the US labor market across all sectors.  However, it remains to be seen how the NPRM will be affected by public comments and whether it will survive anticipated litigation challenging the FTC’s antitrust rulemaking authority.

Restrictions under the proposed rule

Based on its stated concerns that, among other things, the use of non-compete clauses by employers negatively affect competition and harm workers by restricting a worker’s ability to change jobs, the FTC’s proposed rule provides that non-compete clauses are an “unfair method of competition” under the FTC Act and bans employers from entering, attempting to enter or maintaining non-compete clauses with their workers. Workers under the proposed rule include not only employees, but also other workers, regardless of whether paid or unpaid, including independent contractors, externs, interns, volunteers, apprentices and even sole proprietors who provide a service to a client or customer. The rule also prohibits employers from representing to workers that they are subject to a non-compete clause where the employer has no good-faith basis to believe the worker is subject to an enforceable non-compete restriction.

In addition, the rule would require employers to rescind existing non-compete clauses with workers prior to the compliance date and actively provide compliant notice to workers that the contracts are no longer in effect. Such notice must be within 45 days of rescinding the non-compete clause, in an individualized communication provided on paper or in a digital format (like email or text message). This notice requirement extends not only to current workers, but also to those who formerly worked for the employer, provided it has their contact information readily available.

However, the proposed rule has a limited exception for non-compete clauses between franchisees and franchisors (though not those for individuals who work for franchisees or franchisors). There is also a narrow exception for non-compete clauses relating to the sale of a business, which applies where the person selling a business entity or its operating assets is a substantial owner, member or partner in the business entity. To qualify for this exception, the person must hold at least a 25-percent ownership interest in a business entity.

Non-competes banned by the proposed rule

Under the proposed rule, a non-compete clause is defined as a “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.” A functional test is incorporated into the proposed rule to help employers determine whether a restriction qualifies as a non-compete clause.

Under this functional test provision, the proposed rule states that non-compete clauses include contractual terms that are “de facto” non-compete clauses because they have the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the end of their employment relationship. Examples of potential “de facto” non-compete clauses include the following:

• A non-disclosure agreement between an employer and a worker that is so broad that it effectively precludes the worker from working in the same field after the end of their employment relationship
• A contractual term between an employer and a worker that requires the worker to pay the employer or a third-party entity for training costs if the worker’s employment ends within a specified time period, where the required payment is not reasonably related to the costs the employer incurred for training the worker

This functional test will be key in determining whether other forms of restrictive covenants, like customer non-solicitation restrictions or non-disclosure provisions, will also be impacted by this ban.  According to the FTC, “the definition of a non-compete clause would generally not include” non-disclosure agreements and client or customer non-solicitation agreements because such agreements “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.”

Preemption of inconsistent state laws

Traditionally, non-competition agreements between employers and their workers are governed by state laws, which vary greatly. Some states, like California, have essentially done away with non-competition agreements with employees, while others have limited their use with low-income workers. Many other states use a reasonableness test (looking at factors like duration, geographic limitations, scope of restricted activities and consideration) to determine enforceability of non-competition clauses.

If the FTC’s proposed rule goes into effect, it would preempt all inconsistent state laws and, therefore, essentially take away authority from the states to regulate non-compete clauses.  This would reflect a sweeping change from the current legal landscape.

Comment period and potential challenges

The FTC invites the public to submit comments on the proposed rule during a 60-day period until March 10, 2023. Following the close of this comment period, the FTC will review the comments and may make changes in a final rule, based on the comments and further analysis of this issue. This process may take several months after the close of the comment period. If a final rule becomes effective, compliance will likely be required as of 180 days after the final rule’s publication.

It is almost certain that the FTC’s rule will be vigorously opposed through the comment period by business groups, among others, and subject to legal challenges in court once published. Similarly, states that are accommodating toward non-compete agreements may challenge the FTC’s proposal. Indeed, the dissenting FTC commissioner, Christine S. Wilson, described the proposed rule as “a radical departure from hundreds of years of legal precedent” and predicted that it was unlikely to survive a legal challenge noting multiple potential challenges to the rule, such as, among other things, the lack of clear authority for the FTC to undertake such competition rulemaking and the major questions doctrine, which involves situations where an agency seeks to regulate matters of vast significance without clear congressional authorization.

Next steps

While no action to comply with this proposed rule is required at this time, employers should track the status of this proposed rule closely.  Additionally, employers should carefully account for the FTC’s (and the Department of Justice Antitrust Division’s) generally hostile posture toward agreements that might restrict labor market competition.  Recent enforcement has shown that, even apart from the FTC’s proposed rule, the antitrust agencies are closely scrutinizing labor market restraints.  In 2023, that scrutiny is likely to intensify. We will continue to monitor this issue and report on new developments.

If you have any questions regarding the FTC’s new proposed rule, please contact the authors or your DLA Piper relationship attorney.