Federal Court Lifts Ban on Noncompete Agreements

The nationwide ban against noncompete agreements for most employees and independent contractors has been overturned by the U.S. District Court for the Northern District of Texas. The ban, which was scheduled to take effect on September 4, 2024, was mandated under a new final rule issued by the Federal Trade Commission (FTC) in April 2024. The federal ruling effectively allows companies to enter into new noncompete agreements and enforce existing ones as permitted under prior law. However, we may not have heard the final word on this "final rule."

What Is a Noncompete Agreement?

Noncompete agreements have been a common business practice for decades. A noncompete agreement is a document, or a clause in a document or contract, that employers may require employees to sign as a condition of employment or when their employment is terminated. Likewise, independent contractors may be asked to sign noncompete agreements before commencing contract work.

In addition, noncompete agreements may come into play when a business or business interest is sold. Some buyers require sellers to sign noncompetes to prevent them from taking customers or launching competing business ventures after the deal is complete.

A noncompete generally limits business activities in the same field or for a specified period (or both). For instance, if a CEO of a manufacturing firm departs the company, he or she may be prohibited from serving in an executive capacity for another manufacturing firm for three years. The agreement may also include geographic limitations.

The main intent of these agreements is to protect the business interests of employers or buyers, guard against disclosure of trade secrets, and prevent competitors from stealing customers or clients. To be legally enforceable, an agreement must be "reasonable" under the facts and circumstances. Not surprisingly, noncompetes are often contested in court. And some states (such as California) ban noncompetes for employees altogether.

Why Did the FTC Restrict Noncompetes?

Workers have long complained that the use of noncompete agreements provides an unfair advantage to businesses. Noncompetes may impose conditions that effectively force workers to stay longer at jobs than they would like or leave for lower-paying jobs or other positions that aren't as personally rewarding. Or they may feel compelled to relocate to another part of the country. In some cases, they may even leave the workforce.

In 2023, the FTC responded to these concerns by issuing a proposed rule banning companies from using noncompete agreements. Although most public comments favored a nationwide ban, a prominent segment of the business community strongly objected to this proposal. Ultimately, the FTC decided to go ahead with the ban, with certain modifications.

Under the final FTC rule, existing noncompetes generally would no longer be enforceable after the effective date, except for agreements signed by "senior executives." A senior executive is defined for this purpose as someone earning more than $151,164 annually who's in a "policy-making" position. This is an individual, such as the company's president or CEO, who has final authority to make policy decisions that control significant aspects of a business entity or common enterprise. However, it doesn't refer to someone whose role is limited to advising or influencing such decisions.

Additionally, the rule would have required employers to give employees (except senior executives) with existing agreements adequate notice that they wouldn't enforce any applicable agreements after the effective date. The final rule spells out the details on notification.

There are noteworthy exceptions to the final rule, including:

• Nonprofit organizations and industries that aren't covered by the Federal Trade Commission Act, such as banks and other financial institutions, common transportation carriers, air carriers, and any individual or business subject to the Packers and Stockyards Act,
• The 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, and
• A cause of action related to a noncompete accrued prior to the effective date.

The final rule also provides that it's not an unfair method of competition for a person to enforce or attempt to enforce a noncompete when he or she has a good-faith basis to believe that the final rule is inapplicable.

According to the FTC, the new final rule would have resulted in wage increases annually totaling $300 billion and created nearly 8,500 new businesses per year. It would have allowed workers to freely pursue work opportunities without the fear of being taken to court by their employers.

Why Did the Federal Court Reject the Final Rule?

On August 21, 2024—shortly before the effective date of the final rule—the U.S. District Court for the Northern District of Texas ruled in Ryan, LLC v. Federal Trade Commission that the FTC exceeded its authority in implementing the noncompete rule.

Important: This decision has implications that extend beyond the plaintiff in this case. The court held that the FTC can't enforce the ban on a nationwide basis.

A key factor in the Ryan decision was the U.S. Supreme Court's recent decision in the case of Loper Bright Enterprises v. Raimondo. This ruling overturned the Chevron doctrine. Under that doctrine, if Congress hasn't directly addressed the question at the center of a dispute, a court was required to uphold the agency's interpretation of the statute as long as it was reasonable.

Now, under Loper, it's up to courts to decide "whether the law means what the agency says." Federal laws are often somewhat ambiguous, so this decision may have implications for all federal agencies, not just the FTC.

The U.S. District Court for the Northern District of Texas had temporarily blocked the final rule as it applied to the plaintiff in this case, a tax services and software provider headquartered in Dallas. The firm was joined in the suit by the U.S. Chamber of Commerce—the biggest business lobby in the country—and several other business groups. The tax services firm argued that the ban on noncompetes would harm its business by exposing confidential information and enabling its competitors to poach its best employees.

After deliberating the matter, the federal court determined the FTC had overstepped its bounds by prohibiting virtually all noncompetes instead of targeting the worst offenders. The court rendered a final decision that can be appealed to the U.S. Court of Appeals for the Fifth Circuit.

Will the FTC Appeal this Ruling?

The U.S. Chamber of Commerce has applauded the Ryan decision, calling the case a "significant win" and stating that the ban would have harmed businesses and the overall economy. For its part, FTC leadership acknowledged its disappointment in the outcome of the case and asserted that it is "seriously considering" an appeal. Alternatively, FTC spokesperson Victoria Graham says the agency may contest noncompetes on case-by-case basis. So companies that enter into excessively restrictive agreements may still be vulnerable to attack.

There isn't a consensus among federal courts on this issue. A week before the Ryan decision, the U.S. District Court for the Middle District of Florida ruled that the ban was probably illegal and refused to enforce it against a real estate developer. Conversely, in July, the U.S. District Court for the Eastern District of Pennsylvania held that the FTC's final rule was reasonable and that noncompetes are rarely warranted.

For More Information

For now, the FTC is prohibited from enforcing its final rule banning noncompetes for most employees and independent contractors, but businesses are in limbo as they wait for a possible appeal. If the government pursues this avenue, it faces an uphill battle in the wake of the Loper decision. Contact your financial and legal advisors for the latest developments on this hot-button issue.

©  2024