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The Procurement Lawyer Spring 2023

New FTC Rule Proposes Banning Noncompete Clauses

George Edward Stewart III and Michael Jay Schrier

Summary

  • Discusses new Federal Trade Commission proposed rule that would create a near-complete ban on non-compete agreements
  • Provides overview of the current state of non-compete agreements in the United States
  • Explores legal and social justifications the FTC sets forth for its proposed rule and alternatives proposed by the FTC
  • Discusses whether the proposed rule is necessary for government contractors and suggests that government contractors should be exempt from the rule
New FTC Rule Proposes Banning Noncompete Clauses
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On January 19, 2023, the Federal Trade Commission (FTC) issued a proposed rule that envisions a near-total ban on non-compete agreements nationwide. Applying a very broad application of sections 5 and 6(g) of the Federal Trade Commission Act (codified at 15 U.S.C. § 45) to eliminate “unfair method[s] of competition,” the FTC’s proposed rule not only prohibits the use of noncompetes across all industries and trades, but the rule also seeks to retroactively invalidate preexisting non-competes that may already be in place.

The FTC’s proposed rule represents a major development in employment law that will have dramatic impacts on contractors and noncontractors alike should it become enacted as written. If the rule is adopted, employers will no longer have the option to use restrictive covenants and other types of noncompete provisions in future employment contracts or rely on previous provisions entered into with employees. Regardless of whether this is viewed as a blow to employers and their ability to protect trade secrets—especially those in the federal contracting space where competition is fierce and a company’s institutional knowledge oftentimes is the deciding factor in a procurement—or as a major victory for employees of all types, giving them the power to freely move jobs or negotiate higher wages, this proposed rule stands to significantly change how noncompetes are used nationwide going forward.

The first part of this article provides a brief overview of the current state of noncompetes in the United States. The second part of this article explores the various legal and social justifications the FTC sets forth for its proposed rule to ban noncompetes. The third part of this article details the contours of the proposed rule. The fourth part of this article discusses the various alternatives proposed by the FTC and explains why any one of those alternatives may end up replacing the proposed rule. And the final part of this article briefly discusses whether the new proposed rule is even necessary for government contractors, suggesting that government contractors be exempt from whatever new rule the FTC ultimately adopts.

The Current State of Noncompetes

As a general matter, there is no one universal law governing non-competes in the United States. Each state has developed its own statutory framework and common law addressing how these employment restrictions should be interpreted and applied, if at all. As such, while certain principles exist across some jurisdictions, there is no one-size-fits-all approach to noncompetes, and their enforcement varies greatly across the country. This section will describe a few of these overarching principles and will provide a general categorization of the various jurisdictions that may (or may not) enforce noncompete provisions in employment contracts.

Noncompetes come in a variety of forms across the United States. One of the most common versions is “restrictive covenants,” which are also known as “covenants not to compete” or “noncompete clauses.” These provisions act to restrict the employee’s ability to find competing future work after they discontinue their employment. Under this clause, the parties typically agree that the employees will not undertake a similar type of work within a specified time period in a particular geographic location. For example, an employer and employee may agree that the employee will not pursue future employment in substantially the same capacity or role at a competing business in a 60-mile radius for the immediate 12-month period following termination of the employment.

Not all restrictive covenants are enforceable, however. Courts routinely find that there needs to be a legitimate business interest to protect, and that the clause is not just being used as a means “to protect employers from run-of-the-mill business competition.” The clause therefore must be reasonable to be enforceable, and this is usually done by limiting the “time, territorial effect, and activities prohibited.” As one court described, restrictive covenants are enforceable when they are (1) in writing, (2) made as part of an employment agreement, (3) based on valuable consideration, (4) reasonable as to both time and territory, and (5) designed to protect a legitimate business interest of the employer. In practice, this means that even in employment contracts where the parties willingly agree to a restrictive covenant, noncompete clauses may be ruled void if they are not specifically tailored to protect the employer’s business interests and instead needlessly restrict the employee’s ability to find future employment.

A close cousin to noncompetes are non-solicitation covenants that prohibit employees from soliciting business from the employer’s customers. Like restrictive covenants, these are more likely to be upheld when the restriction is limited in duration and applies to only certain customers serviced by the employee during their tenure of employment. Courts will often follow a similar analysis and consider the time and geographic limitations on the non-solicitation provision as well as whether it serves a legitimate purpose for the employer.

Often found in contracts with restrictive covenants and non-solicitation clauses are confidentiality agreements, which serve a different purpose. Confidentiality agreements, also referred to as non-disclosure agreements, prohibit employees from disclosing confidential information about their former company to potential competitors unless express authorization is given. Confidentiality agreements are used oftentimes in conjunction with noncompetes and non-solicitation agreements to bar employees from using the information they obtained during their employment for their personal advantage, such as opening a new business intended to compete with their former employer.

While reasonable nonsolicitation and confidentiality agreements are usually not expressly prohibited under state statute or common law, the same is not true for noncompetes. Notably, California, South Dakota, and Oklahoma have near-complete bans on the use of non-competition agreements. Other states, like Virginia, Maryland, and Colorado, place restrictions on the use of noncompetes that usually preclude their use in specific circumstances, such as for low-wage employees or certain types of occupations. Many states, however, like those in the Southeast, adhere to the common law outlined above for noncompetes, usually upholding such clauses as long as they have reasonable geographic and time limitations that serve to protect the employer’s business interests.

The Authority and Justification Behind the FTC’s New Proposed Rule

One of the preludes to the policy shifts barring noncompetes was Executive Order 14036, signed by President Biden on July 9, 2021. The “Executive Order on Promoting Competition in the American Economy” set forth policy objectives to promote competition in a number of industries and sectors:

This order affirms that it is the policy of my Administration to enforce the antitrust laws to combat the excessive concentration of industry, the abuses of market power, and the harmful effects of monopoly and monopsony—especially as these issues arise in labor markets, agricultural markets, Internet platform industries, healthcare markets (including insurance, hospital, and prescription drug markets), repair markets, and United States markets directly affected by foreign cartel activity.

Specifically, the Executive Order took aim at the use of noncompetes for workers. The Executive Order noted that these agreements made “it harder for workers to bargain for higher wages and better work conditions” and were used to restrict workers from changing jobs. To remedy this problem, section 5, paragraph (g) of the Executive Order instructed the FTC to take action:

To address agreements that may unduly limit workers’ ability to change jobs, the Chair of the FTC is encouraged to consider working with the rest of the Commission to exercise the FTC’s statutory rulemaking authority under the Federal Trade Commission Act to curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.

In other words, President Biden directed the FTC to use its authority to prevent unfair competition as a means of addressing the use of employer noncompetes.

The FTC’s authority derives from the Federal Trade Commission Act (the Act). Section (a)(1) of the codified statute states that “[u]nfair methods of competition in or affecting commerce, and unfair or deceptive acts or practices in or affecting commerce, are hereby declared unlawful.” The statute therefore provides the FTC the authority to prevent the following under section (a)(2):

The Commission is hereby empowered and directed to prevent persons, partnerships, or corporations, except banks, savings and loan institutions described in section 57a(f)(3) of this title, Federal credit unions described in section 57a(f)(4) of this title, common carriers subject to the Acts to regulate commerce, air carriers and foreign air carriers subject to part A of subtitle VII of Title 49, and persons, partnerships, or corporations insofar as they are subject to the Packers and Stockyards Act, 1921, as amended, except as provided in section 406(b) of said Act, from using unfair methods of competition in or affecting commerce and unfair or deceptive acts or practices in or affecting commerce.

The Act, however, has not traditionally been used to regulate noncompete agreements between employers and employees. The statute’s broad language could arguably be construed to cover noncompetes, but it remains to be seen whether a court would agree that all noncompetes fall under the FTC’s authority without other unfair competitive practices in the mix.

While seemingly broad, the Act is not without its limits. There are at least two key restraints on the FTC’s authority to police unfair competition under the Act. First, the Act does not apply to all persons, partnerships, or corporations. Rather, the Act carves out an exemption for banks, federal credit unions, air carriers, common carriers, meatpackers and poultry dealers. Similarly, the plain text of the statute states that it only applies to “persons, partnerships, or corporations.” It is unclear whether this language would cover certain business entities falling outside those identified in the statue, such as some nonprofit groups. These limitations therefore cloud whether the FTC is acting within its authority when it attempts to promulgate rules that would conceivably impact employers and employees—especially in the exempt industries.

Despite these potential limitations on the FTC’s authority, the proposed rule does not carve out any specific exceptions. Instead, the proposed rule appears to broadly apply across all industries nationwide irrespective of any particular employment conditions. Part of the proposed rule’s justification for the sweeping regulation is that “important research has shed light on how the use of noncompete clauses affects competitions.” Citing the difference in state laws as “natural experiments” and a number of academic studies, the FTC posits that the research shows that use of non-competes has negatively impacted competition in labor markets (with an estimated one out of five American workers bound by a noncompete clause) and has resulted in reduced wages for all workers, including even those not bound by noncompete clauses. Furthermore, the FTC notes in the proposed rule that the evidence appears to be inconclusive whether noncompetes actually result in job creation, but that there is evidence noncompetes foreclose competitors from accessing talent, inhibit new business formation, decrease innovation, and possibly increase consumer prices. The FTC therefore concludes that because much of the legal framework governing noncompetes was formed decades ago without the benefit of this research the current status quo allows “serious anticompetitive harm to labor, product, and service markets to go unchecked.”

The FTC explicitly uses the proposed rule to determine that noncompetes are an unfair method of competition, further justifying the FTC’s rule against noncompetes. The FTC cites a series of cases in the proposed rule establishing that facially unfair conduct as well as conduct that impacts competition falls under the FTC’s purview. As such, the FTC concludes that the use of noncompete clauses is an “unfair” method of competition under its statutory authority because they negatively affect competitive conditions and are “exploitive and coercive.”

The Scope of the FTC’s New Rule

To address these unfair competitive practices, the FTC’s proposed rule sets out several new and significant restrictions. Section 910.2(a) would squarely prohibit noncompetes across the board:

(a) Unfair methods of competition. It is an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker; maintain with a worker a non-compete clause; or represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe that the worker is subject to an enforceable non-compete clause.

The rule makes clear that employers may not enter into or attempt to enter into a noncompete with an employee, maintain a noncompete with existing employees, or represent to an employee that they are subject to a noncompete.

The definitions employed by the rule are also very broad and cause the rule to apply in many different contexts. The rule’s definition of “non-compete” in proposed section 910.1(b) specifies that it would apply to both explicit contractual terms as well as “de facto” noncompete clauses that would have the effect of prohibiting workers from seeking or accepting employment with a competing firm. Examples of these “de facto” clauses are provided, such as broad clauses that effectively preclude workers from working in the same field after the conclusion of the workers’ employment and clauses that require workers to pay the employer (or a third party) for training costs if the workers’ employment terminates within a specified timeframe where the cost is “not reasonably related to the costs the employer incurred for training . . . .” While this provision does not outright ban non-disclosure and non-solicitation agreements, the broad restriction against “de facto” clauses presumably would apply to these types of agreements. It also creates undo uncertainty and future litigation risk related to any non-disclosure or non-solicitation agreements.

Additionally, the rule’s proposed definition of “worker” in Section 910.1(f) includes both paid and unpaid workers, 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.” This definition makes no distinction whatsoever between high- and low-wage employees, meaning that the ban would be in full force and effect for every type of profession. The only exceptions provided for under the proposed rule are for a franchisee in the context of a franchisee-franchisor relationship and for the sale of a business—but only where the party restricted by the non-compete clause is an owner, member, or partner holding at least 25 percent ownership interest in the business entity. The proposed rule notes, however, that both of these exceptions would remain subject to federal antitrust law as well as other applicable law.

The proposed rule also is intended to apply retroactively. Proposed section 910.2(b) explicitly states that “an employer that entered into a non-compete with a worker prior to the compliance date must rescind the non-compete clause no later than the compliance date.” The proposed rule goes so far as to provide a template notice, and it provides that this notice requirement applies to current and former employees (at least those where the employer has their contact information) and must be sent in an “individualized communication” within 45 days of the rescission date.

As of the date of this publication, the FTC is in the process of culling through the comments it received during the comment period, which closed on March 20, 2023, before the FTC publishes its final rule. Although it is difficult to predict when a final rule will eventually issue, the FTC likely received more comments than usual based on the sweeping and high-profile nature of this rule and the overwhelmingly large numbers of industries and interests impacted by the proposed rule. The FTC, therefore, probably will not issue a final rule for several more months, especially if it decides to adopt any different alternative policies discussed below. Employers will be expected to be in compliance within several months after the final rule is issued, however.

The FTC’s Four Alternative Approaches

Interestingly, the FTC may have led with the most extreme version of the rule here with the intention of reining in the final rule. By publishing the most controversial option as the proposed rule—a complete ban on all noncompetes—the FTC strongly encouraged stakeholders across the industries to submit comments. The FTC then could craft the final rule with the benefit of these additional comments and without an additional comment period.

Whether or not this was the true intent of the FTC, the proposed rule does suggest that the FTC is considering other alternative approaches in lieu of a complete ban. The FTC states that these alternatives arise from two key questions: (1) whether the rule should impose a ban on noncompete clauses or a rebuttable presumption of unlawfulness and (2) whether the rule should apply uniformly to all workers or whether there should be exemptions or different standards for different categories of workers. The various alternatives that may materialize in the final rule, therefore, are permutations of the answers to either question.

The first question involves the “Categorical Ban vs. Rebuttable Presumption.” The FTC describes this approach as adopting a rebuttable presumption instead of a categorial ban, making it presumptively unlawful for an employer to use a noncompete clause. But if the employer can meet a yet-to-be-defined burden, such as maybe “clear and convincing evidence” or “preponderance of the evidence,” to show that the noncompete is reasonably necessary and narrowly tailored, then the noncompete might be permissible. The FTC notes in the proposed rule the rationale for this approach would be that a general prohibition against noncompetes should be the default rule, but also acknowledges that there may be specific sets of facts where a noncompete is justified. Additionally, the FTC suggests that this approach is similar in many respects to the current common law practices already in place because most states require there to be a legitimate business interest to justify the non-compete (along with reasonable limitations in the clause itself).

The second question involves the “Uniform Rule vs. Differentiation.” The FTC explains that this question involves the concept of whether all employees or only certain employees would receive the benefits of the ban on noncompetes. Rather than applying a rule uniformly to all workers, the FTC explains that it could apply different rules to different categories of workers based on a worker’s job function, occupation, earnings, another factor, or some combination of factors. The FTC notes that many recent state laws differentiate among different categories of workers—often reserving the ban on noncompetes for low-wage workers.

Based on the above considerations, the FTC presents four discrete alternatives. Alternative #1, entitled “Categorical Ban Below Threshold, Rebuttable Presumption Above,” states that the FTC would categorically ban the use of noncompete clauses for some workers and apply a rebuttable presumption of unlawfulness to noncompete clauses for other workers. An example of this would be a rule that outright bans noncompetes except for those workers who are exempt under the Fair Labor Standards Act (FLSA) or earn more than $100,000 a year.

Alternative #2, entitled “Categorical Ban Below Threshold, No Requirements Above,” would make it easier for employers to use noncompetes once a specific threshold is met. Under this option, the rule would categorically ban the use of noncompete clauses for some workers and not apply any requirements to the other workers. The practical effect would be the other workers above the threshold would simply be exempt from coverage under the rule. An example of this rule might be the prohibition of non-competes only for employees earning $100,000 or less per year or who are non-exempt under the FLSA. The FTC cites state laws in Washington, Massachusetts, and Rhode Island as possible real-world examples of this approach in practice.

Alternative #3, entitled “Rebuttable Presumption for All Workers,” does not create any threshold requirements. Instead, the rule would apply a rebuttable presumption of unlawfulness to noncompete clauses for all workers. This alternative is similar to the current version of the FTC’s proposed rule except that it allows employers to demonstrate the need for a noncompete by meeting a certain burden of proof and demonstrating that the non-compete is reasonably necessary.

Alternative #4, entitled “Rebuttable Presumption Below Threshold, No Requirements Above,” represents the least drastic change from the current law in most states. The rule would apply a rebuttable presumption of unlawfulness to noncompete clauses for some workers and not apply any requirements to the other workers. This would mean that even low-wage workers or those exempt from the FLSA could conceivably be bound by a noncompete if an employer can meet its burden. And like Alternative #2 (or the current state of the law in most states), employees making a certain amount or more or who are exempt from FLSA would have no protection against noncompetes.

The FTC’s request for comments on these four alternatives shows that the FTC may seriously consider (if it is not doing so already) one of these approaches instead of a complete ban on noncompetes across the board. Although the FTC made it clear in its proposed rule that it does not propose any of these approaches due to its preliminary concerns, the FTC could always have a change of heart after reviewing the points raised in the comments received.

Should the New Rule Apply to Federal Contractors?

Although the FTC provides a detailed analysis in support of its ban on noncompetes, the FTC concludes in the proposed rule that a “one-size-fits-all” approach is the best course of action. The FTC, however, provides no examination of whether the rule is necessary or beneficial for federal contractors or their employees. Indeed, for government contractors, the proposed rule in its current form likely will not yield the same benefits or protections as for other industries and may conflict with already pre-existing regulations.

The federal contracting space is already heavily regulated, and many of the justifications the FTC points to in support of the ban on noncompetes do not carry the same weight for government contractors. For example, FAR 52.222-55, Minimum Wages Under Executive Order 13658, sets the minimum wage for workers of service and construction federal contractors. Similarly, the Service Contract Labor Standards (formerly known as the Service Contract Act), implemented in FAR 52.222-41, and the Construction Wage Rate Requirements statute (formerly known as the Davis Bacon Act), implemented in FAR 52.222-4 through 52.222-11, set prevailing wages for service and construction contractors, respectively. All of these wages are adjusted routinely and implemented into existing contracts via amendments. The FTC’s argument that noncompetes suppress wage growth, therefore, does not take into consideration the wage protection already afforded to federal contractor employees.

Some FAR clauses even have the practical effect of banning noncompetes on a de facto basis. FAR 52.222-34, for Project Labor Agreements (PLAs), essentially requires union contracts for large federal construction projects. These PLAs have Davis Bacon Act prevailing wages as the floor for any bargained wages. This severely undercuts any argument that federal contractor employees suffer wage suppression as might others in unregulated markets.

Other FAR clauses already make federal contractor employers carefully consider whether noncompetes are truly necessary or beneficial. FAR 52.222-40 requires contractors to notify their employees of their rights under the National Labor Relations Act via physical postings throughout contractor offices. Such postings encourage workers to assert their rights to unionize, among other things, and federal contractors may already be wary of attempting to foist onerous noncompetes on their employees as a result. Other regulatory policies aimed at creating an equal opportunity workplace, such as Executive Order 11246, the Vietnam Era Veterans’ Readjustment Assistance Act, and the Rehabilitation Act of 1973, prohibit discrimination in various forms and are included via FAR provisions in most federal contracts.

Even higher-wage employees receive some indirect job security unique to the federal contracting workspace. Executive Order 14055, “Nondisplacement of Qualified Workers Under Service Contracts,” sets forth a policy for service contracts that successor contractors should hire the predecessor’s employees “in the interests in economy and efficiency” and to “avoid[ ] displacement of these employees.” FAR 52.237-3, Continuity of Services, states that services performed under the contract are “vital to the Government and must be continued without interruption.” As such, contractors are required to take measures to cooperate with successor contractors during phase-in, phase-out, and the FAR even provides a mechanism for predecessor contractor employees to switch over to the successor contractor. And FAR 52.222-46, Evaluation of Compensation for Professional Employees, identifies the negative consequences that may occur should an agency recompete a contract that ultimately leads to lower compensation for professional employees. Accordingly, the clause instructs agencies to consider professional compensation as part of proposal evaluations and enables an agency to justify rejection of a proposal on this basis.

Lastly, the economics of the federal contracting workspace are different than those in other industries. Federal contracts often require a highly skilled workforce with years of experience and education in very specific areas. Workers who meet these qualifications are many times not widely available. This means federal contractors must offer highly competitive compensation packages to recruit and retain employees so that the contractors may continue to remain eligible for federal contract opportunities. Unlike many of the industries as to which the FTC’s new rule was designed to protect against wage suppression, it is frequently the case that there is no “race to the bottom” in terms of wages for federal contractors. Rather, there is a highly competitive jobs market where contractors with the most resources can hire the best and brightest.

Arguably, noncompetes may better serve the federal government’s interests by protecting small businesses from the “brain drain” that would naturally result if there were no restrictions in place. The procurement system in the United States has gone to great lengths to protect small business interests because such businesses are the backbone of the federal contracts and the American economy as a whole. Many times, employees get their start with small businesses, obtaining key experience and skills on the job at great cost to the small business. Noncompetes offer a limited means by which small businesses can protect their investment and prevent their employees from moving to the larger, more established firm across the street that can offer a more competitive salary due to its size. Noncompetes also help protect a small business’s proprietary and innovative practices that may set it apart from larger players in the contracting space. Keeping noncompetes as a tool for small businesses to use helps these companies—which are the focus of the Small Business Administration’s systems of goals and preferences for small businesses (and the related FAR provisions implementing these policies)—withstand pressures, at least in the local market, while allowing its workers to seek new jobs outside the geographic scope or time limitations. The current system seems to create a good balance between small business needs and workers’ independence in the federal contracting space. Completely barring all noncompetes, even among federal contractors, thus will likely cause more harm than good by erasing the thin barrier protecting small business concerns from all-out bidding wars for employees with larger corporate rivals. Accordingly, there is a good argument that the FTC’s proposed rule as written is not a good fit for the government contracting sector.

Conclusion

The FTC’s near-complete ban on noncompetes is a significant development for employers around the country in both the federal and nonfederal workspaces. While noncompetes have been used for decades to protect trade secrets and confidential information, they also have been criticized for limiting worker mobility, depressing wages, and even stifling innovation. The proposed ban by the FTC seeks to strike a balance between protecting companies’ interests and promoting a more competitive labor market. If the proposed rule is adopted, it would mark a significant shift in the legal landscape surrounding noncompete agreements and could have far-reaching implications for businesses and workers alike.

It remains to be seen whether the rule as proposed will be adopted outright in the timeframe suggested. The FTC itself has suggested that it may consider an alternative approach that walks back the categorical ban on all noncompetes. And other legal challenges may impact the rule’s trajectory. In United States v. Patel, for example, the U.S. District Court for the District of Connecticut acquitted a handful of hiring managers for allegedly “restrict[ing] the hiring and recruiting of engineers and other skilled-labor employees between and among [their companies]” by entering into an agreement not to poach employees under certain circumstances. The court found the no-poach agreement was not a market allocation agreement because it had far too many exceptions and did not actually operate as a “cessation of meaningful competition in the allocated market.” Although this case did not deal directly with the proposed rule, this loss may cause the FTC to think twice about the proposed rule’s viability in courts before issuing it as is. Alternatively, the holding could have the reverse effect and invigorate the FTC to pass the proposed rule in its current form to offer a means to better protect employees.

Time will tell whether the Patel decision or another lawsuit, such as an Administrative Procedure Act challenge, will ultimately impact the FTC’s final rule or its implementation timeline. And congressional action or a change in the White House in the upcoming 2024 election could drastically alter the scope of the rule or lead to its repeal altogether. Because the future of this regulation remains uncertain, employers of all types should continue to stay informed on the changing legal landscape involving noncompetes.

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