The FTC Proposes a Federal Ban on Non-Compete Provisions

Many companies require that executives and highly-skilled workers agree to a contract provision prohibiting them from competing with the company during employment and for a period thereafter, such as by working for or with a competitor or launching a competitive venture. Although not uncommon, courts have disfavored these provisions, and many states have passed statutory circumscriptions on their use in response to overreach by some employers. In response to an executive order issued by the Biden Administration, the Federal Trade Commission (or “FTC”) proposed a rule in January 2023 that would invalidate existing non-compete provisions and prohibit employers from using them in future agreements with “workers,” a term encompassing more than an hourly or salaried employee (the “FTC Proposed Rule”)  Below, this article briefly addresses (a) an overview of non-compete provisions and their current use and enforceability, and (b) the specific terms of the FTC Proposed Rule.

Overview of Non-compete Provisions

Employers use non-compete agreements to safeguard confidential and proprietary information, discourage turnover and limit wasted training and onboarding expenditures, prevent former employees from poaching customers, and, frankly, to limit future competition. Such non-compete provisions ordinarily describe the non-compete period, the types of activities deemed “competitive” (and thus prohibited), and, in some cases, the non-compete agreement’s geographic limits. Courts have traditionally disfavored such provisions, and in recent years states have begun passing statutory restrictions on their use and scope. 

Approximately 17% of U.S. workers are subject to a non-compete provision. Traditionally, such provisions were required only by highly-skilled employees or those with special knowledge of a business’s confidential information, operations, methods, products or services, or other key areas. The fact that the invasive restriction could be balanced against the employer’s interest in protecting its business in the context of a highly-skilled or capable worker (rather than simply eschewing competition and applying such terms as a blanket matter) was a key factor that justified such terms’ enforceability. However, last year, 30% of those subject to non-compete provisions made less than $13/hour, a level of overreaching by some employers that drew the scrutiny and ire of federal and state legislators and policymakers. 

Non-compete provisions as contractual terms have a deep history in English common law which, in part, informed the centuries-long ebb and flow of views on the permitted scope of such provisions. That history consistently, though to varying degrees, counsels in favor of reasonable and balanced terms as they must be weighed against the public policy in favor of free employment mobility and relatively unfettered or uncontrived competition in the market, including in attracting and retaining highly-skilled employees. 

The Rule’s Specific Terms and Proscriptions

The Prohibition on Non-compete Provisions Applies to “Workers,” a Broadly-Defined Term

The FTC non-compete rule defines “worker,” the operative term in the rule’s prohibition, to mean: “a natural person who works, whether paid or unpaid, for an employer,” including, without limitation, “an employee, individual classified as an independent contractor, extern, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer.

The Proposed Rule Would Prohibit De Facto and Implied Non-competition Terms

Regulators generally are loath to allow one to do indirectly what one could not do directly, using a workaround to circumvent what would otherwise result from the direct application of a law or rule.  The FTC non-compete rule treats a provision as a non-compete provision if it “has the effect of prohibiting 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. The rule text provides two non-exclusive examples of potential de facto non-compete provisions, depending on the circumstances:

A non-disclosure agreement drafted so broadly as to effectively preclude the worker from working in the same field after the conclusion of his or her employment with the employer, or

A provision requiring a worker to pay the employer or a third-party entity for training costs if his or her employment ends within a specified time period, but the required payment is not reasonably related to the costs the employer incurred in training the worker (i.e., the amount is punitive).

An employer also violates the FTC Proposed Rule if it implies or represents that a worker is covered by an enforceable non-compete provision without a good faith basis for that conclusion.

The Exception to the Proposed Rule is Narrow

The exceptions to the FTC non-compete rule are narrow and would not apply in the ordinary course of the relationship between a worker and their employer. The prohibition of the FTC Proposed Rule would not apply when an employee and a worker enter into a non-compete provision in the course of selling a business entity or substantially all of the assets of such a business entity, so long as the worker is a “substantial owner,” “substantial member,” or “substantial partner” of the entity at the time the parties entered into the provision. For this purpose, an owner, member, or partner is sufficiently “substantial” if he or she “holds at least a 25 percent ownership interest in a business entity.

An Employer Must Rescind Existing Non-compete Provisions and Notify Workers

If the FTC Proposed Rule is adopted as it stands, an employer must provide individual notice to affected employees notifying them that the non-compete provision is no longer effective.  Individual notice in this context means a correspondence directed to such a person, as the relevant agreement(s) require notice to be given, rather than by simply posting a notice on an internal company intranet system or physically posting notices in the office, for example.  The FTC Proposed Rule provides the text of a short communication that an employer can provide to affected workers, with such notice deemed sufficient (a “safe harbor”) for purposes of effective notice.

Preemption of State Law Less Restrictive Than the FTC Proposed Rule

As noted above, numerous states have adopted a ban or restrictions on the use of non-compete provisions. In 2022, five states and the District of Columbia enacted laws designed to restrict the use of non-compete provisions, while many more states have proposed or have passed legislation that has yet to become effective.  The FTC non-compete rule would control in the event any state law conflicts with it or provided a less stringent restriction on a given point.[9]

Providing Comments to the FTC

The FTC proposed its rule in January 2023, and has extended the deadline for public comments from March 20 to April 19. Comments on the FTC Non-Compete Clause Rule can be submitted here. The FTC Proposed Rule is likely to face significant legal challenges, so its potential effective date (and whether it will survive such legal challenges) is unclear.