This is the third part of a multi-part blog post series discussing the implications and fallout from the Final Rule recently adopted by the Federal Trade Commission (FTC), banning the enforcement of almost all noncompete agreements with workers. In Part 1 of this series, we discussed the general parameters of the rule and several threshold questions that it raises. In Part 2, we discussed the types of arrangements that are prohibited by the Final Rule and the alternatives to noncompete clauses that likely remain available to companies following the effective date of the Final Rule.
In this post, we discuss two areas where the Final Rule will have a significant effect: the noncompetition covenants entered into by sellers of a business, and the application of the Internal Revenue Section 280G golden parachute rules to noncompete agreements impacted by the Final Rule. The Final Rule is currently expected to be effective on September 4, 2024, unless earlier enjoined, delayed, or invalidated by a court or other governmental body.
The ‘Sale of Business’ Exception to the Noncompete Ban
The Final Rule does not prohibit enforcement of noncompete clauses that are “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.”
Meaning of ‘Business Entity’
The Final Rule defines a “business entity” for purposes of the sale-of-business exception as “a partnership, corporation, association, limited liability company, or other legal entity, or a division or subsidiary thereof.” The FTC confirms in the preamble to the Final Rule that “other legal entity” includes trusts and general partnerships. Notably, this definition includes the sale of subsidiaries or divisions, as the FTC concluded that the goal of protecting the value of a business acquired by a buyer also applies equally to the sale of such separate business lines.
Meaning of ‘Sale’
The FTC’s 2023 proposed rule limited the sale-of-business exception to sales by “substantial” owners, members, or partners holding at least a 25% ownership interest in a business entity. This minimum ownership threshold was omitted from the Final Rule. In crafting the final exception, the FTC determined in response to comments that no specific floor of “substantial” ownership served the policy aim of facilitating the effective transfer of goodwill between the seller and the buyer while avoiding permitting noncompetes that are “more likely to be exploitative and coercive due to an imbalance of bargaining power between the seller and the buyer.”
‘Bona Fide’ Sales
However, the preamble to the Final Rule suggests that the FTC’s requirement that sales be “bona fide” is intended to include some analysis of the bargaining dynamic in a specific transaction: “In general, the Commission considers a bona fide sale to be one that is made between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale.”
Specifically excluded from “bona fide” sales are:
- “springing” noncompetes and noncompetes arising out of repurchase rights or mandatory stock redemption programs that do not give the worker knowledge of or ability to negotiate the terms or conditions of the sale at the time of contracting,
- sham transactions between wholly owned subsidiaries (i.e., not “independent parties”), and
- transactions whose sole purpose is to evade the Final Rule.
‘Ownership Interest’
The Final Rule refers to the noncompete being entered into in connection with the sale of an “ownership interest” (unless the transaction is a sale of all or substantially all of a business entity’s operating assets). As the definition of “business entity” includes the full variety of entity forms, such interests would necessarily take a variety of forms, including stock of a corporation, membership interests in a limited liability company, or partnership interests in a general or limited partnership.
The term “ownership interest” is not defined in the Final Rule, however, and there is therefore uncertainty regarding how the FTC would apply it to particular forms of equity or equity-based compensation whose value depends on the equity value of the business enterprise and are generally regarded as “securities” for purposes of the federal securities laws, including stock options, restricted stock units, stock appreciation rights and other “phantom” or synthetic interests. The term “ownership interest” likely would not include transaction bonus arrangements, but where companies carve out large percentages of sale proceeds for management (e.g., 5%–15%) which may be subject to deal terms, including escrows or earnouts, ambiguity exists.
Noncompetes and Code Section 280G’s Golden Parachute Rules
Under Section 280G of the Internal Revenue Code, a corporation will be denied an income tax deduction on any “excess parachute payments” made to certain “officers” and other disqualified individuals in connection with a change of control, and the individuals receiving such excess parachute payments will be subject to a nondeductible 20% excise tax penalty, in addition to regular federal and state income tax.
One of the primary exemptions under Section 280G permits the company to establish by clear and convincing evidence that a payment is “reasonable compensation” for services to be provided after the change in control, which includes refraining from providing services due to an enforceable noncompete covenant. To the extent that covenants based on noncompete clauses are unenforceable under the Final Rule, a significant tool used to reduce parachute tax penalties will cease to be available. The impact will be felt by all corporations engaged in change-in-control transactions, but particularly by public companies ineligible for Section 280G’s private company shareholder approval process to exempt compensation that would otherwise be subject to Section 280G.
The Final Rule does not exempt completed transactions that have relied on noncompete covenants in various capacities, including in Section 280G calculations. Companies that have engaged in recently closed transactions may therefore need to recalculate Section 280G analyses to remove reliance on potentially unenforceable noncompete covenants to reduce the value of parachute payments. If updated Section 280G calculations reflect an increase in the value of parachute payments, parachute excise taxes and loss of deduction penalties may apply retroactively. In addition, contractual gross-up provisions may be triggered, requiring new or increased payments to executives.
Noncompete clauses that were used in completed business transactions to calculate reasonable compensation for purposes of Section 280G, and the facts surrounding the negotiation of the agreements that include noncompete clauses, should be carefully reviewed to determine whether the noncompete clauses could satisfy the requirements of the sale-of-business exception.
In addition, as discussed in Part 1 of this series, the Final Rule contains a limited exception from the noncompete ban for existing noncompetes with “senior executives” who are in “policy-making positions” with respect to the entire business enterprise and earn more than $151,164 annually remain enforceable. Section 280G relies on a definition of “officer” (generally, an “administrative executive who is in regular and continued service”) that is broader than the definition of “senior executive” under the Final Rule (which relies on finding “policy-making authority”). As a result, noncompetes used in recently closed transactions to calculate reasonable compensation for “officers” may no longer be enforceable if the individuals do not meet the “senior executive” test.
Next Steps
Despite the uncertainty surrounding the Final Rule, including whether it will become effective, companies may take this as an opportunity to evaluate the arrangements that they currently have in place with workers and consider potential alternatives to noncompete clauses that may be appropriate. For additional action items, please see Part 1 and Part 2 of this series, as well as Morgan Lewis’s recent LawFlash and FAQs. If you have questions about the information in this post, or otherwise related to the FTC’s Final Rule, please contact the authors or your usual Morgan Lewis contacts.