FTC Issues Final Rule Banning Non-Competes

04/25/2024|8 minute read

Key Takeaways

• On April 23, 2024, the Federal Trade Commission (FTC or the Commission) presented its Final Non-Compete Clause Rule (the Final Rule). If it isn't blocked by a nationwide injunction - which is a distinct possibility - the Final Rule will go into effect 120 days after it is published in the Federal Register.
• The Final Rule constitutes a near-total ban on the use of non-competes in the employment context. It will apply to ban nearly all non-competes entered into after the effective date and prohibit enforcement of all but a select group of currently valid Senior Executive non-competes.
• The Final Rule does not restrict the use of non-competes in the context of the sale of a business, which is a notable departure from the FTC's proposed rule, first published on Jan. 5, 2023 (the Proposed Rule).

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The Federal Trade Commission (FTC or the Commission) presented its Final Non-Compete Clause Rule (the Final Rule) on April 23, 2024. The Final Rule follows more than 15 months, and 26,000 public comments, after the FTC first introduced its Proposed Rule to ban non-competes nationwide, published on Jan. 5, 2023 (the Proposed Rule). The Final Rule was adopted during a public hearing and approved along a party line vote, 3 (Democrat)-2 (Republican). The Final Rule is slated to go into effect 120 days after it is published in the Federal Register, which will occur shortly.

If the Final Rule goes into effect - which is a big IF, because it has already been challenged in at least two federal district courts, and injunctions are often granted in litigations challenging newly enacted rules that entail substantial changes in practices before the courts decide the issue - nearly every employer in the country would be left without the ability to enforce currently valid, or enter into new, non-compete agreements with their employees, regardless of the employee's access to trade secrets and confidential information, or level of compensation.

The Final Rule:

Pursuant to the Final Rule, employers would be precluded from:

• Enforcing a non-compete against any "worker," except for Senior Executives who signed their agreement before the Final Rule's effective date.
• Entering into a new non-compete with any "worker," including Senior Executives.

The Final Rule defines a "worker" broadly to mean "a natural person . . . without regard to the worker's title or the worker's status under any other State or Federal laws, including, but not limited to, whether the worker is an employee, independent contractor, extern, intern, volunteer, apprentice, or a sole proprietor who provides a service to a person." Thus, employers cannot classify a worker out of the Final Rule's application.

Who Is Covered by the Senior Executive Exception?

The requirements necessary to qualify under the Senior Executive exception - for whom preexisting non-competes will remain valid after the Final Rule's effective date - are not as plain as they may initially seem. To qualify as a Senior Executive, an employee must pass a two-part test. They must (1) earn more than $151,164/year in total compensation and (2) hold a "policy-making position" with their former employer. While the wage threshold is fairly straightforward, the FTC's definition of a policy-making position is not clear, nor does it seem it will be easily agreed upon between parties. If the Final Rule goes into effect, we expect that this provision will lead to significant legal battles in any enforcement action.

The Commission defines a policy-making position as:

• "[A] business entity's president, chief executive officer or the equivalent, any other officer of a business entity who has policy-making authority, or any other natural person who has policy-making authority for the business entity similar to an officer with policy-making authority. An officer of a subsidiary or affiliate of a business entity that is part of a common enterprise who has policy-making authority for the common enterprise may be deemed to have a policy-making position for purposes of this paragraph. A natural person who does not have policy-making authority over a common enterprise may not be deemed to have a policy-making position even if the person has policy-making authority over a subsidiary or affiliate of a business entity that is part of the common enterprise."

The definition of policy-making position relies on the FTC's definition of policy-making authority. That term is defined as:

• "[F]inal authority to make policy decisions that control significant aspects of a business entity or common enterprise and does not include authority limited to advising or exerting influence over such policy decisions or having final authority to make policy decisions for only a subsidiary of or affiliate of a common enterprise."

Although the FTC believes these two definitions, functioning together with the wage threshold, will mean that more than 99% of employees will not qualify as a Senior Executive, that belief is far from certain. By way of extreme example, there seems to be an equally fair reading of the Final Rule to advocate for both sides of the argument that a business leader who is in charge of a multimillion- or multibillion-dollar business line, which is one of many business lines held by a parent corporation, does - or does not - qualify as a Senior Executive.

Non-Compete Definition: Does It Include Non-Solicitation, Garden Leave, Forfeiture-for-Competition or Liquidated Damages?

Beyond the question of the Senior Executive carveout, the Final Rule leaves employers, and their employees, with a great deal of uncertainty about the application of the Final Rule to employment provisions other than non-competes. This is because the FTC does not simply define a "non-compete" as a prohibition on working for a competitor, but rather as a covenant that "prohibits a worker from, penalizes a worker for, or functions to prevent a worker from" either:

• "[S]eeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment that includes the term or condition; or
• [O]perating a business in the United States after the conclusion of the employment that includes the term or condition."

Thus, although the FTC states that it did not intend to "categorically prohibit other types of restrictive employment agreements, for example, NDAs [non-disclosure agreements], TRAPs [training-repayment agreements], and non-solicitation agreements," if the provision is drafted broadly enough that it meets the "prohibits," "penalizes" or "functions" criteria, then it may violate the Final Rule.

• "These types of agreements do not by their terms prohibit a worker from or penalize a worker for seeking or accepting other work or starting a business after they leave their job, and in many instances may not have that functional effect, either. However . . . if an employer adopts a term or condition that is so broad or onerous that it has the same functional effect as a term or condition prohibiting or penalizing a worker from seeking or accepting other work or starting a business after their employment ends, such a term is a non-compete clause under the final rule."

The Commission's position on whether garden leave qualifies as a non-compete, and is therefore prohibited, is a bit clearer, but not absolutely certain. If the employer utilizes a true "garden leave," whereby the employee remains on payroll but is simply cut off from the company's systems and asked not to work, the Commission says that would not violate the Final Rule and does not constitute a non-compete.

• "With respect to garden leave agreements . . . the Commission notes that an agreement whereby the worker is still employed and receiving the same total annual compensation and benefits on a pro rata basis would not be a non-compete clause under the definition, because such an agreement is not a post-employment restriction. Instead, the worker continues to be employed, even though the worker's job duties or access to colleagues or the workplace may be significantly or entirely curtailed. Furthermore, where a worker does not meet a condition to earn a particular aspect of their expected compensation, like a prerequisite for a bonus, the Commission would still consider the arrangement 'garden leave' that is not a non-compete clause under this final rule even if the employer did not pay the bonus or other expected compensation."

Finally, the FTC takes a dim view of forfeiture-for-competition provisions and liquidated damages, specifically stating that these provisions operate to "penalize[]" an employee for starting new employment; thus they are banned by the Final Rule.

• "Another example of a term that 'penalizes' a worker . . . is a forfeiture-for-competition clause, which, similar to [an] agreement with liquidated damages . . . imposes adverse financial consequences on a former employee as a result of the termination of an employment relationship, expressly conditioned on the employee seeking or accepting other work or starting a business after their employment ends. . .

Ultimately, if the Final Rule goes into effect, employers may - and indeed should - still utilize non-solicitation, garden leave and confidentiality provisions. The FTC might not "categorically" allow all of these provisions, and still reserves its right to challenge them if they are akin to non-competes, but, when drafted appropriately, these provisions will place employers in a strong position to protect their business interests.

Sale of a Business Restrictions Return to Business as Usual.

The Final Rule is clear that the ban does "not apply to a noncompete clause that is entered into by a person pursuant to a bona fide sale of a business entity, of the person's ownership interest in a business entity, or of all or substantially all of a business entity's operating assets." This differs meaningfully from the Proposed Rule, which required the seller to have at least 25 percent ownership in order to justify a non-compete in connection with the sale of a business. Seller non-competes must still be reasonable as to duration and scope in accordance with applicable state law.

The Final Rule Is Limited to For-Profit Entities - Particularly Impactful in Healthcare.

The FTC's scope of authority is generally understood to extend only to for-profit entities; specifically, an entity "organized to carry on business for its own profit or that of its members." This limited authority, and the application of the Final Rule, is particularly acute for workers and employers in the healthcare space. The FTC relies on data "indicating that as many as 58% of all U.S. hospital systems claim tax-exempt status as nonprofits, 24% are for-profit hospitals, and 19% are State and local government hospitals." Thus the FTC's authority stands to have a significantly disproportionate impact across the healthcare industry. The Final Rule acknowledges this and "recognizes that not all entities in the healthcare industry fall under its jurisdiction," but the Commission still argues that "entities claiming tax exempt status are not categorically beyond the Commission's jurisdiction . . . ." If the Final Rule goes into effect, the application of the FTC's governing authority within the healthcare space will surely be litigated.

Preexisting Claims Remain.

The Final Rule states that it does "not apply where a cause of action related to a non-compete clause accrued prior to the effective date [of the Final Rule]." This means that all preexisting actions, and seemingly those where (at a minimum) the breach occurred before the effective date, are still valid and enforceable.

Franchisees Are Excluded; Their Employees Are Not.

The only exception to the Commission's definition of a "worker," to whom the Final Rule applies, is a "franchisee in the context of a franchisee-franchisor relationship." However, this does not include a "person who works for a franchisee or franchisor." The distinction here is the difference between the line cook at a fast-food restaurant and the induvial who owns the restaurant as part of a franchise agreement.

Notice Is Required.

If the Final Rule goes into effect, employers will be required to notify all current and former employees (excluding Senior Executives) who are subject to a non-compete that their non-compete is not enforceable. The Final Rule provides optional model language that an employer may use and requires service on the employee by hand, mail, email or text message.

Prudent Next Steps.

There are currently two lawsuits that have been filed against the FTC challenging its authority to promulgate the Final Rule. Although neither plaintiff has yet sought a nationwide injunction, such an application seems likely in advance of the Final Rule's effective date. Whether the injunction will go into effect in the near term or whether the courts will issue expedited briefing schedules before issuing an injunction is not yet known. However, a nationwide injunction will certainly be sought, and its implementation is a distinct possibility, which means the impact of the Final Rule likely won't be felt by employers for many months, if not longer.

Accordingly, employers may continue to operate their restrictive covenant programs in a "business as usual" fashion, bearing in mind that non-competes and other covenants are still governed by state law and must meet the appropriate legal scrutiny.

Employers with a large workforce that utilize non-competes are best counseled to take stock of the agreements that they have in place and identify the employees (and former employees) who are subject to non-competes. If the Final Rule goes into effect, these are the employees who will require notice that their non-compete will not be enforced.

Regardless of whether or not the Final Rule ultimately takes effect, this rulemaking process, and the attention that the FTC has brought to this contractual provision, reflects a continuing shift in employer-employee relationship dynamics and highlights the dissatisfaction of some workers with the use of employment non-competes. The need for companies to revise their employee mobility policies and practices, particularly through increased efforts to improve employee retention and through the use of less-restrictive covenants (non-solicitation agreements, garden leave arrangements, confidentiality and nondisclosure agreements), together with carefully planned and implemented trade secrets policies and practices, has never been more necessary in light of the changing legal landscape in this area.

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