Yesterday afternoon, as expected, the Federal Trade Commission (FTC) announced its Final Rule banning noncompetes throughout the United States during an open hearing available to the public. The FTC’s Final Rule is more measured than the proposed rule announced on January 5, 2023 in several key respects–most notably, (1) nonsolicitation agreements are not prohibited, with some caveats explained below and (2) nondisclosure agreements (NDAs) seem to be on somewhat better footing, as the FTC has abandoned its proposed de facto noncompete test, also with some caveats below. Not unexpectedly, the vote broke down along party lines, 3-2, with the Democratic commissioners voting in favor and the Republican commissioners voting against it. The Final Rule is not yet effective, and the U.S. Chamber of Commerce has already filed a lawsuit challenging it today. Many commentators (including yours truly) believe the Final Rule will not survive that litigation. And while it is an inherently political rule, it does provide some lifelines for employers eager to protect their trade secrets and customer relationships. Here are my preliminary thoughts on what employers and employees need to know.
Quick History: As followers of this blog already know, after his election, President Biden issued an Executive Order that was short on detail and simply encouraged the FTC to take unspecified action against unfair noncompetes and other agreements limiting employee mobility. On its face, the Executive Order focused on “unfair” agreements which have generally been understood to mean noncompetes imposed on lower-wage workers.
On January 5, 2023, the FTC announced a proposed rule that would ban noncompetes and de facto noncompetes. That proposed rule received unprecedented public feedback, including approximately 26,000 comments from employers, employees, attorneys, academics and trade groups.
The Expected: The Final Rule provides that it is an unfair method of competition—and therefore a violation of Section 5 of the FTC Act—for employers to enter into noncompetes with workers after the effective date. That effective date is defined as 120 days after the Final Rule’s publication in the Federal Register. Existing noncompetes with workers, other than senior executives, will not be enforceable after the effective date of the Final Rule. The Final Rule defines the term “senior executive” to refer to workers earning more than $151,164 annually who are in a “policy-making position.”
Noncompetes are defined under the Final Rule as follows:
“A term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from:
(i) seeking or accepting work in the United States . . . where such work would begin after the conclusion of the employment . . . ;
(ii) operating a business in the United States after the conclusion of the employment . . . .”
As explained below, the biggest definitional problem will be what agreements “function” as a noncompete.
The Final Rule requires employers to provide a notice to employees that their noncompetes are no longer enforceable. The FTC has been gracious enough to provide a sample notice for employers wishing to do so in the Final Rule.
The Final Rule’s ban will apply nationwide, overriding state laws regarding noncompete agreements and will be retroactive, except as to existing noncompetes with senior executives.
The Unexpected: I am still reviewing the 570 pages of analysis and commentary released with the Final Rule yesterday afternoon. But based on my preliminary review, the Final Rule does not go as far as the proposed rule announced last year.
The Final Rule expressly allows nonsolicitation provisions to be used as a tool to protect customer relationships. This should provide adequate protection to employers concerned that their sales representatives may try to take advantage of the access they have been provided to those customers. For the uninitiated, a nonsolicitation provision allows an employee to compete against their former employer provided they do not solicit or do business with customers that they serviced at their previous employer for a limited period of time, generally 1 to 2 years.
There is explicit language in the commentary to the Final Rule recognizing the continued viability of nonsolicitation agreements: “The Commission also notes that, to the extent commenters seeking an exception are referencing different restrictive covenants, including some garden variety nonsolicitation agreements, which do not prohibit or function to prevent a worker from switching jobs or starting a new business as described in Part III.D, the final rule does not apply to them. Thus, the Commission focuses on commenters’ purported need for an exclusion based on non-competes alone.” (Final Rule, p. 80).
In fact, the FTC approves the use of reasonable NDAs and nonsolicitation agreements, stating “the Commission finds that less restrictive alternatives, including appropriately tailored NDAs and nonsolicitation agreements, are sufficient to address disclosure of confidential information and concerns related to client business.” (Final Rule, p. 370).
And the FTC may–I repeat may–have softened a bit over its exaggerated concern over the alleged misuse of NDAs. Last year’s proposed rule was replete with statements about how NDAs could be used as de facto noncompetes, despite the utter paucity of empirical and legal support. As readers will recall from my blog post last year, I was nervous that the FTC might target these agreements, which are essential to the protection of trade secrets.
But owners of trade secrets are not completely out of the woods yet. The FTC has replaced the de facto noncompete test (which I criticized for its lack of clarity) with a “functional” test. Unfortunately, there is little guidance on what a functional noncompete test is, other than the circular argument that it would function to prevent an employee from working for another company or opening their own business.
The Future: The U.S. Chamber of Commerce has already filed a lawsuit today and it has signaled in its press release that it will vigorously challenge the FTC’s authority to issue the Final Rule. The Chamber will undoubtedly seek an injunction at some point postponing enforcement of the Final Rule. I will detail my thoughts later in a future blog post but it is difficult to imagine that the Final Rule will survive this challenge, in light of the U.S. Supreme Court’s antipathy toward administrative activism and the absence of past enforcement in this area by the FTC. Frankly, the FTC’s claim that it has regulated this area in the past is contrived, given the fact that it did not do so until only days before its proposed rule last year.
So What Does It All Mean? For the past year, lawyers have been advising their clients that they should narrow their noncompetes or begin considering alternatives. While narrowing noncompetes is a good start, the FTC has given its imprimatur to the coupling of narrow nonsolicitation agreements with appropriate NDAs. The FTC has also provided employers with a “good faith” exemption to defend themselves, which could come into play if either the nonsolicitation agreement or NDA is later found to be a “functional” noncompete.
For employers determined to keep their noncompetes, they should closely monitor the Chamber’s lawsuit as well as other litigation that will likely be filed challenging the Final Rule. But if no injunction is granted (or if it is denied), they will proceed at their own risk as the 120 days after publication approaches.
However, for other employers not interested in that risk but who nevertheless need to protect their trade secrets and customer relationships, the safest course would be to do what the FTC says is acceptable–namely, use (1) nonsolicitation agreements that are tailored to the actual customers that an employee serviced for a reasonable period of time; and (2) NDAs that avoid overly broad terms such as definitions that include all information shared with an employee and by including carve-outs for public information, information that the employee brought with them or information known within the industry. Given the language accompanying the FTC rule, those employers would also have the benefit of the good faith exemption if those agreements are challenged as functional noncompetes.
For employees, they now have greater bargaining power to negotiate narrower agreements with their employers. More on this later as well.
I will supplement this post later once I get through the entire 570 pages.