A closer look at the FTC’s proposed ban on noncompetes

What effect would the rule have on U.S. businesses?
Employee Noncompete

Just a few days into 2023, the Federal Trade Commission, the federal agency charged with enforcing anti-competitive, deceptive and unfair business practices throughout the U.S., released a proposed rule that would ban the use of post-employment, noncompete clauses in most employment contracts, nationwide. The same proposed rule would ban clauses the FTC deems to be their functional equivalent.

The proposed rule explicitly states that certain broad nondisclosure agreements may violate its proposed rule. The FTC’s proposed rule allows it to deem other contracts, such as non-solicitation agreements, unfair and deceptive, as well. Many other contract terms may be impacted.

The FTC does not address the impact of its rule on term contracts. Those are contracts that require employment for a specific period of time.

The question regarding whether term contracts unfairly restrict the free movement of labor may now be grist for consideration.

Beyond creating a new category of illegal contract terms, the proposed rule goes further.

It mandates that any employer who has included a noncompete clause in any contract with a worker take the further step of rescinding the offending clause. An employer must do so through specific, individualized communications with any employee or worker to whom the clause has been proposed.

A set of model communications the FTC deems effective is included in the proposed rule. The model communications require an employer to reaffirm that a previously proposed noncompete clause is invalid; that it is, even, unlawful; that the employee may accept another job with any company or person at any time; and that the employee may compete with the employer, including by running a competing business.

The proposed rule provides a safe harbor during which an employer seeking to rescind its use of noncompete clause may avoid enforcement action by complying with the FTC’s proposed notice procedures. However, the continued use and enforcement of noncompete clauses in violation of the rule would constitute an unfair and deceptive business practice, subjecting an employer to an FTC enforcement action under the proposed rule. Penalties available to the FTC in its enforcement actions include substantial fines, the imposition of injunctions and other forms of relief.

The FTC’s proposed rule, as published, is supported by information and analysis set forth in a 216-page positionpaper the FTC authored.

The FTC’s paper argues that post-employment noncompete clauses suppress competition and so suppress employee wages as well as innovation; they have a discriminatory impact on women and minorities; and they are, generally, bad for the economy in jurisdictions where they are enforced. The FTC’s paper claims that these clauses have specific, negative impacts in industries such as healthcare, by creating concentration in services, which, in turn, impact the price of healthcare services.

The FTC’s paper acknowledges that some states, such as California, ban noncompete clauses already, while others, such as New Hampshire, subject such clauses to stricter scrutiny.

Despite the multiplicity of state choices in this domain, which is often a feature of our federal system of government, the FTC’s analysis concludes that a nationwide, categorical ban is in order. It does so upon examining enforcement dynamic realities from an employee’s perspective, as well as alternatives that would permit the use of noncompetes in certain limited circumstances, even when subject to a rebuttable presumption of invalidity.

The FTC analysis does not discuss the impact of disruptions to business caused by labor shortfalls, which have been enormous in recent years. The FTC’s analysis also does not consider the role of employment contracts in business valuation.

Such an argument would proceed as follows: A business does not arise out of thin air. Enterprising risk-takers must develop an idea. They must believe the idea can lead to a sustainable business model. Ideas are not self-executing. Entrepreneurs must convince others to invest in the idea. Those others must believe there will be some return in doing so. Perhaps that return will take the form of a dividend. Perhaps it will be the payment of interest and principal on a loan. Perhaps it will come at an acquisition moment or when additional capital comes in from another source.

Regardless, at each step, a business must convince the source of capital, the lifeblood of the business, that the business has value. All parties to this process will seek to define the business in determining its value. To define a business, parties will seek to know what a business owns, what it has given away, and what it has sold or promised. This requires an examination and assessment of the business’s contracts.

If a business cannot say, with greater levels of certainty, that it possesses what it claims has value as a definitional matter in its contracts, its ability to attract capital will diminish substantially.

For many businesses, the use of contracts to protect their intellectual property as it flows to employees and independent contractors is vital to the process of defining the business, and so, of protecting the value of the businesses.

These devices therefore are also vital to ensuring that there is capital sufficient to offer employment to employees in the first place.

The FTC’s proposed rule provides an opportunity for the public and, specifically, for impacted industries, to bring forward this argument as part of the public discussion over the position the FTC has put forward through its proposed rule. Indeed, for the Noncompete Clause Rule to become a rule, the FTC must follow specific rulemaking procedures, including notice and public comment mandates built into federal rulemaking. The FTC is accepting comments through March 6.

Even if it were to become a rule, the Noncompete Clause Rule will be subject to court challenges. These challenges will include arguments, now increasingly accepted by federal courts reviewing executive branch lawmaking, that FTC’s rulemaking authority does not encompass the power to promulgate the rule through any properly delegated authority.

Within specific enforcement actions, entities subject to any FTC enforcement action seeking sanctions in this subject area may raise the same, or similar defenses, while also making merits based arguments regarding the specific business needs supporting the use of noncompete clauses.

Regardless of the fate of the FTC’s proposed rule, those entities that continue to deploy noncompete clauses, or their functional equivalents, would be well advised to document the purpose such clauses serve in their contracts in order to create a stronger record of legitimate business need should their practices become subject to FTC scrutiny.

Michael S. Lewis is senior litigation partner at the law firm of Rath, Young & Pignatelli.

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