On April 23, the Federal Trade Commission (FTC), by a 3-2 vote, approved a Final Rule banning almost all worker noncompetes. The Final Rule will go into effect 120 days following its publication in the Federal Register. In this LawFlash, we answer several frequently asked questions related to the Final Rule’s applicability and anticipated impact, as well as what businesses can do to prepare.
As the time to provide comments to the FTC has passed, the only way to challenge or support the Final Rule is through litigation against the FTC. Within hours of the FTC’s vote to adopt the Final Rule, the first challenge was filed, in the US District Court for the Northern District of Texas, by tax services firm Ryan LLC. (Ryan LLC v. Federal Trade Commission, 3:24-cv-986 (N.D. Tex., Apr. 23, 2024). The U.S. Chamber of Commerce filed its legal challenge against the FTC’s Final Rule on April 24, 2024 and moved for a preliminary injunction to stay the enforcement of the Final Rule on April 25. (Chamber of Commerce of the United States of America v. Federal Trade Commission, 6:24-cv-00148 (E.D. Tex., Apr. 24, 2024). A third lawsuit was filed against the FTC on April 25 by ATS Tree Services LLC in the US District Court for the Eastern District of Pennsylvania. (ATS Tree Services LLC v. Federal Trade Commission, 2:24-cv-01743 (E.D. Pa. Apr. 25, 2024)).
Yes, the Final Rule provides that nearly all existing worker noncompetes are not enforceable. The Final Rule provides that it is an unfair method of competition for persons to, among other things, enter into noncompete clauses with workers on or after the Final Rule’s effective date. However, there are three important carveouts:
Yes, the FTC’s commentary on the Final Rule clarifies that “forfeiture-for-competition” clauses, where the agreement imposes adverse financial consequences on a former worker as a result of competition with the employer following termination of the employment relationship, is unlawful under the Rule. The FTC’s clarification hinges on its expansive definition of “noncompete clause.” The Final Rule defines “noncompete clause” as a term or condition of employment that either “prohibits” a worker from, “penalizes” a worker for, or “functions to prevent” a worker from “(i) seeking 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 (ii) operating a business in the United States after the conclusion of the employment that includes the term or condition.” Thus, the definition in the Final Rule is clarified to go beyond express noncompetes to cover a broader range of provisions.
Yes. The prohibition against noncompete clauses does not apply to a noncompete clause that is entered into 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. While the proposed rule only provided an exception for noncompetes tied to the sale of a business for owners who held a 25% ownership interest in the business being sold, the Final Rule removed that ownership threshold in response to comments made during the rulemaking process.
The Final Rule’s definition of “workers” does not specifically address whether partners or members with an ownership stake in a business are included in the definition, other than to state that “sole proprietors” can be considered workers. However, the FTC’s comments to the Final Rule indicate that such partners, members, or other holders of ownership stakes may be covered by the sale-of-business exception, assuming their noncompete agreements are tied to the sale of their ownership stake in the business. Whether or not a partner or business owner who retains their ownership stake in the business can be subject to a noncompete after they stop working for the business is unclear and likely to be a highly litigated issue should the Final Rule become effective.
The Final Rule does not categorically ban other types of restrictive covenants such as nonsolicitation or confidentiality agreements. However, the FTC clarifies that the rule can apply to these covenants when they restrain such a large scope of activity that they function to prevent a worker from seeking or accepting other work or starting a new business after their employment ends. For example, confidentiality agreements and nondisclosure agreements (NDAs) may be noncompetes under the “functions to prevent” prong of the definition where they span such a large scope of information that they function to prevent workers from seeking or accepting other work or starting a business after they leave their job. Examples of such an agreement may include a confidentiality agreement or NDA that bars a worker from disclosing, in a future job, any information that is ”usable in” or “relates to” the industry in which they work, or which bars a worker from disclosing any information or knowledge the worker may obtain during their employment whatsoever, including publicly available information.
The FTC received comments using the term “garden leave” for a wide variety of agreements, so it declined to opine on how the definition of “noncompete clause” applies to every potential iteration of a “garden leave” agreement. The FTC also declined to include an exception for noncompetes made in exchange for receiving compensation. Consequently, a post-employment noncompete clause, for a worker that does not fit within any of the Final Rule’s exceptions, is likely prohibited by the Final Rule even if the worker would receive payments throughout the noncompete period.
The FTC did note, however, that a situation in which a worker is still employed and receiving the same total annual compensation and benefits on a pro rata basis, while having their job responsibilities and access to the workplace restricted, would not qualify as a prohibited noncompete clause because such an agreement is not a post-employment restriction. Such commentary on garden leave suggests that noncompetes with termination notice requirements or garden leave payments, in which a worker remains employed but is restricted from continuing their normal job duties, is permitted. That being said, it could also be argued that an extended termination notice requirement or garden leave period lasting several months or more is prohibiting or preventing a worker from accepting work and is, therefore, a prohibited noncompete clause as defined by the Final Rule. We expect this to be a highly litigated issue if the Final Rule becomes effective.
Sections 280G and 4999 of the Internal Revenue Code impose tax penalties in circumstances where the value of compensation that is contingent on a change in control equals or exceeds three times the average annual compensation of certain employees and other service providers. The value of noncompete agreements is often used to reduce the value of parachute payments for purposes of Section 280G calculations because payments for noncompete agreements can be considered reasonable compensation for refraining from performing services.
To the extent that noncompetes are unenforceable, this significant tool used to reduce parachute tax penalties will cease to be available.
This is particularly salient because of the two narrow exceptions under the Final Rule. First, Sections 280G and 4999 of the Internal Revenue Code rely on a definition of “officer” that is based on a facts and circumstances test that is broader than the definition of “senior executive” under the Final Rule. As a result, a noncompete that was used to calculate reasonable compensation for an “officer” may no longer be enforceable if the individual does not meet the “senior executive” test. Second, because the Final Rule does not prohibit enforcement of noncompete clauses that are entered into pursuant to a bona fide sale of a business entity, noncompete clauses that were used to calculate reasonable compensation, and the facts surrounding the entering into the agreement that includes the noncompete clause, should be carefully reviewed and considered to determine whether the noncompete clause satisfies the requirements of this exception.
Yes. In addition to the specific exceptions provided in the Final Rule, such as the sale of business or franchisee exceptions, there are categories of business exempt from the FTC’s jurisdiction, and therefore, exempt from the FTC’s Final Rule. Specifically, in Section 5 of the FTC Act (15 U.S.C. § 45(a)(2)), there is an exemption for banks, savings and loan associations, credit unions, air carriers, common carriers, firms governed by the Packers & Stockyards Act, and most nonprofits—except trade associations with for-profit members. However, FTC Commissioner Slaughter noted potential application of the ban to certain nonprofits that benefit their for-profit members, adding a layer of complexity.
The FTC Act allows the FTC to obtain equitable remedies using:
The FTC is also entitled to seek monetary remedies in some situations, including:
The FTC can impose a civil penalty amount of up to $51,744 for violations of orders issued under the FTC Act. Moreover, each day of continuance of such failure or neglect shall be deemed a separate offense.
Beyond penalties issued by the FTC, many states have “mini-FTC Acts” that provide rights for private litigants and theoretically allow treble damages. Although the viability of a private claim under a mini-FTC Act is speculative, it is an enforcement avenue employers should be aware of.
It is difficult to predict how the legal challenges to the Final Rule will impact the ultimate enforceability of the rule and when those challenges will result in more clarity. However, the rule faces strong challenges on both statutory and constitutional grounds, notably from the Chamber of Commerce. Critics of the rule focus on three core arguments.
First, the FTC lacks the statutory authority to legislate substantive rules entirely. In critics’ view, canons of statutory interpretation and the limited way in which the agency historically exercised its alleged rulemaking authority indicates the FTC does not have the authority to promulgate substantive rules such as the noncompete rule.
Second, even if the FTC does have rulemaking authority, the “major questions” doctrine prohibits the promulgation of the noncompete rule. The “major questions” doctrine requires “clear congressional authorization” when an agency claims power to regulate in an area of tremendous “economic and political significance.” Some argue that noncompetes fall under this category. Moreover, FTC Commissioners Holyoak and Ferguson highlighted in the open commission meeting the long history of state-level regulation of employee restrictive covenants, implying a lack of clear federal mandate.
Third, even if Congress did grant the FTC this authority, that conferral is an unconstitutional delegation of legislative power. Because “unfair methods of competition” is not an “intelligible principle” sufficient for rulemaking delegation, Congress did not have the authority to grant FTC rulemaking responsibility on the topic. These arguments underscore the potential overreach of administrative power in enacting the rule.
Employers and businesses should consider the following to prepare for the Final Rule:
Our lawyers regularly assist clients with audits of their restrictive covenants and trade secret protection plans. We are also available to assist with preparing any employee communications necessary as a result of the Final Rule.
If you have any questions or would like more information on the issues discussed in this LawFlash, please contact any of the following: