A proposal by the FTC to ban noncompete agreements in employment has been widely criticized by business groups, with the U.S. Chamber of Commerce threatening a lawsuit if it goes into effect. But, as Seyfarth Shaw’s Robert Milligan discusses, the potential noncompete ban is just the latest in the agency’s self-described crackdown over what it views as unfair labor practices, so companies need to take a clear-eyed look at their contracts.
In early January, the FTC published a proposed rule that would ban all noncompete agreements between employers and workers — broadly defined to include employees, independent contractors, interns and others. If adopted, the rule would bar both prospective and existing noncompete agreements. Around the same time, the FTC took legal action against three companies and two individuals, forcing them to drop noncompete restrictions.
Taken together, the FTC’s actions make at least one thing clear: Companies should use this as an opportunity to evaluate their use of restrictive covenant and trade secret protections agreements/policies (e.g. noncompetes, nonsolicitations and nondisclosures) and ensure that they comply with existing legal requirements and that they are reasonable.
The proposed rule is currently subject to public comment until March 20, after which the FTC may move to make it final. Dozens of business organizations, including the U.S. Chamber of Commerce, have requested a 60-day extension on that deadline and have indicated they may challenge the proposed rule in court. That includes organizations in manufacturing, commerce, retail, insurance, franchise, healthcare, technology, financial services, construction and staffing.
In addition to the Chamber’s threat, the rule would likely be subject to significant legal challenges, particularly with the Supreme Court’s skepticism of federal agencies’ use of expanded authority without the clear direction of Congress. Litigation to enjoin the rule could be filed after the final version of the rule is issued but before it takes effect, during the 180-day notice period.
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What’s covered by the ban?
This proposed ban is based on a preliminary finding that noncompetes constitute unfair competition and therefore violate Section 5 of the Federal Trade Commission Act, aligning with the agency’s recent statement on reinvigorating Section 5.
The specific scope of restrictive covenants that may be banned under the proposed rule is unclear because noncompete agreements are defined to include any agreements that have “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.” Nondisclosure, nonsolicitation and other covenants designed to protect employers from unfair competition may also be prohibited by the FTC’s proposed rule if they satisfy the FTC’s functional test.
In the proposed rule, the FTC provided two examples of contractual terms that may be de facto noncompete clauses. One example is a nondisclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from employment in the same field after the conclusion of their tenure with the company. The second example is 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 terminates within a specified time period, where the required payment is not reasonably related to the costs the employer incurred for training the worker.
Employers can comply with the rule by rescinding prior noncompete clauses no later than the compliance date, which would be 180 days after the date of publication of the final rule, according to the proposed rule.
Are there exceptions?
As written, the proposed rule is broad and does not include exclusions for management, executives or those provided access to trade secrets. While nondisclosures and nonsolicitations may be exempted in part from the proposed rule, the FTC’s functional test does not provide clarity to determine what contractual language would be viewed as a de facto noncompete.
One other notable exception is that the rule would not ban restrictive covenants entered into in connection with the sale of a business for those who have a substantial interest. “Substantial” is established by those holding at least a 25% ownership interest in the business entity. Owners under the 25% threshold would receive the benefit of the noncompete ban.
Inside the FTC’s crackdown
This proposed rule comes after years of allegations that some employers were abusing noncompete agreements by deploying them in ways that go well beyond preventing unfair competition or protecting trade secrets. Many states have responded to such abuses by restricting the use of agreements with employees making less than certain compensation thresholds (e.g. Washington, Oregon, Illinois, Colorado, D.C. and Massachusetts).
Particularly given the extremely broad scope and the express language of the proposed rule, the FTC would supplant state laws that permit noncompetes. State statutes, regulations, orders or interpretations that afford greater protection to workers still would be allowed. Accordingly, if the FTC is successful in implementing its proposed rule, it would have the effect of displacing state laws that expressly permit noncompetes, including noncompete reform legislation that was passed in recent years. The Illinois Chamber of Commerce, for example, criticized the proposed rule, claiming it ignores Illinois recent changes to its noncompete laws the organization believes strike the appropriate balance between employer and employee rights in that state.
Traditionally, noncompete agreements have been effective tools for employers to protect themselves against unfair competition and misappropriation of trade secrets. A well-drafted and narrowly tailored noncompete agreement restricts such unfair competition and misuse of trade secrets, while still permitting reasonable employee mobility. Such covenants are helpful tools in promoting innovation, fostering employee training and development, protecting trade secrets and preventing unfair competition.
The FTC’s proposed total ban of noncompete agreements (and arguably other covenants, including potentially even nondisclosure agreements, as noted above) under the premise of promoting employee mobility, idea proliferation and wage growth ignores that employees are stakeholders in their employers. Employees, shareholders, customers, vendors and suppliers all benefit from fair competition, and restrictive covenants — including noncompete agreements — protect fair competition and trade secret protection.
A day before the FTC issued its proposed rulemaking, the agency announced it had reached a settlement with three employers in the security and manufacturing sectors the FTC said had illegally imposed noncompete restrictions. The consent orders prohibit the companies and, where applicable, their individual owners, from enforcing or threatening to enforce noncompetes against any relevant employees. Additionally, the orders ban them from communicating to any relevant employee or other employer that the employee is subject to a noncompete; require them to void and nullify the challenged noncompetes without penalizing the affected employees; require them to provide copies of the order to current and past employees who were subject to the challenged noncompetes; require them to provide a copy of the complaint and order to current and future directors, officers and employees of the companies who are responsible for hiring and recruiting; and require them, for the next 10 years, to provide a clear and conspicuous notice to any new relevant employees that they may freely seek or accept a job with any company or person, run their own business or compete with them at any time following their employment.
What should employers do?
The agency’s news release announcing the settlements also encouraged individuals to report overly restrictive employment contracts, signaling the potential for future actions related to noncompete agreements even in the absence of a total ban.
Thus, the FTC is not waiting for a final rule before flexing its muscle under Section 5, and employers should examine their existing restrictive covenants to determine whether they are overly broad and may invite FTC scrutiny.
Employers should take a close look at their restrictive covenants to ensure they are reasonable and compliant with the ever-evolving requirements of the law. We recently saw Colorado, D.C., Illinois and Oregon enact new laws governing restrictive covenants, and New Jersey, Connecticut and New York introduced their own respective bills on employee mobility. California and Washington have new laws prohibiting employers from using employee agreements that prohibit the disclosure of certain conduct the employee believes is unlawful, such as illegal harassment or discrimination.
Companies may consider whether their interests may be adequately protected with tailored customer nonsolicitation or nondisclosure agreements, rather than noncompetes, and whether limitations should be placed on what type of employee is asked to sign certain agreements. Restrictions should be reasonable in terms of duration, geography and scope of activities prohibited and supported by a legitimate business interest where such agreements are allowed under law.
Companies should also use appropriate policies, procedures and training regarding the handling and use of trade secrets, including identifying such secrets and appropriate limitations on access, such as ensuring the return of confidential materials and information upon employee departure along with reasonable onboarding procedures.
In light of the FTC’s self-described crackdown, it is imperative that companies conduct a critical assessment of their restrictive covenant agreements and trade secret protections to avoid harm to their business and further government scrutiny.