By Clifford R. Atlas with Jackson Lewis P.C., Erik J. Winton with Jackson Lewis P.C., Daniel J. Doron with Jackson Lewis P.C., and Daniel F. Thornton with Jackson Lewis P.C.
The Federal Trade Commission (FTC) proposed a new rule that, if made final, would (at least on its face) effectively prohibit non-compete agreements other than in very limited circumstances.
What Is in the Proposed Rule?
The proposed rule, which would supersede all contrary state laws, is remarkable for its sweeping definition of “non-compete clauses” that fall within the ban.
The ban would extend to “de facto” non-compete clauses — that is, other contractual provisions that have the “effect” of prohibiting workers from seeking or accepting employment or operating a business after the conclusion of the worker’s current employment. In this regard, the ban may implicate broadly drafted non-disclosure-of-confidential-information restrictions and repayment-of-training-costs provisions. The ban also could implicate customer non-solicitation restrictions, depending on the surrounding facts.
If adopted, the proposed rule will require all employers that use any agreement with a non-compete clause (or with a clause that could be deemed to be a non-compete clause under the expansive definition in the proposed rule) to take action to rescind the non-compete clause. Remarkably, any provision negotiated in exchange for the non-compete (for example, a severance provision) would remain intact. This recission action will require individualized communications from the employer to all current employees, as well as former employees.
Further, while the proposed rule contains a sale-of-business exception, even that is exceptionally narrow, being limited to individuals with at least a 25 percent ownership stake in the business.
Non-Compete Clauses Prohibited
The proposed rule declares it to be an “unfair method of competition” for an employer to:
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Enter into or attempt to enter into a non-compete clause with a worker;
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Maintain with a worker a non-compete clause; or
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Represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe the worker is subject to an enforceable non-compete clause.
The restriction applies to employees, independent contractors, interns, and volunteers alike. It also applies to independent contractors who are engaged through their own business entity if the individual is a sole proprietor of the entity through which they are engaged.
“Functional Test” for Prohibited Non-Compete Clause
The proposed rule defines a prohibited non-compete clause as “a contractual term between an employer and a worker that prevents 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.”
It states, however, that a vaguely described “functional test” will apply to determine whether a contractual provision is a prohibited non-compete clause. It also expressly brings within the purview of the ban any contractual term that operates as a “de facto non-compete clause” in its effect.
The proposed rule gives two examples of such “de facto non-compete clauses”:
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A non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer.
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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 period, where the required payment is not reasonably related to the costs the employer incurred for training the worker.
The proposed rule does not address whether a customer non-solicit provision would be deemed a prohibited non-compete clause. The FTC’s supplementary materials, however, state that “the definition of non-compete clause would generally not include other types of restrictive covenants—such as non-disclosure agreements (‘NDAs’) and client or customer non-solicitation agreements—because these covenants generally do not prevent a worker from seeking or accepting employment with a person operating a business after the conclusion of the worker’s employment with the employer.” However, under the definition of “non-compete clause,” the proposed rule provides: “such covenants would be considered non-compete clauses where they are so unusually broad in scope that they function as such.” (Emphasis added.)
The supplementary materials also mention “no-business agreements” (prohibiting a worker from doing business with former clients or customers of the employer), “no-recruit agreements” (prohibiting the worker from hiring or recruiting the employer’s workers), and “liquidated damages provisions” (requiring the worker to pay the employer a sum of money if the worker engages in certain conduct) as other types of agreements that “can sometimes” be broad enough in scope to fall within the proposed rule’s definition of non-compete clause.
When exactly such “sometimes” might occur is not defined. That, presumably, would be determined on a case-by-case basis.
If the proposed rule is adopted in its present form, it appears certain that disputes will arise over whether NDAs, customer non-solicitation provisions, the other types of provisions mentioned above, or other possible restrictions an employer might use will pass muster under the FTC’s nebulous “functional test.” Employers using broad non-disclosure provisions, or broad customer non-solicitation provisions, may face significant uncertainly as to whether the FTC or a court would second-guess the validity of those post-employment obligations.
The FTC’s second example of a “de facto non-compete clause,” concerning the repayment of training costs, creates further uncertainty over the variety of contractual provisions and executive compensation that employers use to retain employees (many of which employers regard as carrots, rather than sticks). Examples include retention bonuses, equity grants, and other forms of incentive compensation that would be forfeited if an employee separates from the employer within a specified period of time.
Rescission and Notice of Rescission
The proposed rule requires:
an employer that entered into a non-compete clause with a worker prior to the [date that is 180 days after publication of the final rule] must rescind the non-compete clause no later than the [date that is 180 days after publication of the final rule].
Somewhat confusingly, the proposed rule requires a notice of the rescission be sent to current and former employees within 45 days after the date of recission. In practice, this a
ppears to mean the deadline to send such rescission notices would be the 225th day following publication of the final rule. With respect to former workers, the employer must send notices only to those former workers whose contact information the employer has readily available.
The rescission notice must be sent “in an individualized communication … on paper or in a digital format such as … an email or text message.” The content of the notice must “communicate[] to the worker that the worker’s non-compete clause is no longer in effect and may not be enforced against the worker.” A model form of notice is included in the proposed rule, but employers are not required to use that model.
While the proposed rule does not prescribe the form a rescission should take, it does provide that an employer who complies with the notice requirement also will be deemed to have complied with the rescission requirement.
Importantly, possibly depending on the specific language of the applicable agreement or plan, the rescission would have no bearing on bargained-for benefits negotiated in consideration for the non-compete clause, whether those benefits are in the form of base compensation, incentive compensation, deferred compensation, or even consideration in connection with the sale of a business (except to the limited extent of the sale-of-business exception described below).
Are Any Employers Excluded From Coverage Under the Proposed Rule?
Section 5 of the Federal Trade Commission Act (which the FTC cites as the source of its power to promulgate the proposed rule) does not apply to the following industries:
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Banks;
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Savings and loan institutions;
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Federal credit unions;
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Common carriers;
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Air carriers and foreign air carriers; and
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Persons and businesses subject to the Packers and Stockyards Act, 1921 (subject to certain exceptions).
This is something acknowledged by the FTC in their supplementary materials, even if it is not explicitly stated in the proposed rule itself.
There Is No Need to Panic
Employers that use restrictive covenants understandably are nervous about the FTC’s proposed rule. It is still early in the process, however, and the provisions of a final rule are in flux. Even then, if the final rule is issued, there will be significant and substantial legal challenges to it.
What is important now is the same as what has always been important under the many years of well-developed caselaw pertaining to restrictive covenants. Restrictive covenants should be drafted narrowly to protect a legitimate business interest of the employer, such as trade secrets, confidential information, or customer goodwill. The restrictions themselves should be no broader than necessary to protect those legitimate interests, and they must be reasonable in terms of duration, geography, and scope of activities prohibited. Agreements should be drafted in a way to increase the likelihood that any provisions found to be unlawful can be severed from the agreement, leaving other restrictions intact. Finally, restrictive covenants generally should not be used with lower-level workers absent legitimate reasons to do so.
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