New FTC Final Rule Bans Most Noncompete Agreements

Using a noncompete agreement or a noncompete clause in an employment contract has been a standard business practice for years. The Federal Trade Commission (FTC) estimates that about 30 million American workers—almost one out of every five—are subject to agreements restricting their rights upon termination of employment. But now the FTC has issued a final rule banning most noncompetes nationwide.

The new 570-page final rule takes into account comments to the initial rule proposed by the FTC in 2023. It's scheduled to go into effect 120 days after being published in the Federal Register, which ends up in September 2024. But we may not have heard the final word on this issue. (See "Business Groups Take the FTC to Court," below.)

Why Employers Require Noncompetes

Typically, an employer requires employees to sign noncompete agreements as a condition of employment or upon termination of employment. Noncompetes are designed to protect the business interests of the employer, guard against disclosure of trade secrets or prevent competitors from poaching customers or clients.

A noncompete will generally limit employment activities in the same field for a specified period. For instance, an executive who signs a noncompete may be prohibited from joining another company in the same industry or profession or starting up a similar new company in the same geographic area for at least three years.

However, if agreements are overly restrictive, they may not be enforceable. Essentially, the restrictions must be reasonable under the circumstances. In the past, the enforceability of noncompetes has often been challenged in the courts. And some states (such as California) ban noncompetes for employees altogether.

Nevertheless, most workers are inclined to accept noncompete agreements at their face value. The agreements may impose conditions that effectively force them to stay longer at a job than they would like or leave for a lower-paying job or one that's not as personally rewarding. Or they may feel compelled to locate to a different part of the country. In some cases, they may even leave the workforce.

FTC Steps In

In April 2024, the FTC addressed this issue head-on by imposing a nationwide ban on noncompete agreements for most employees and independent contractors. When the FTC initially proposed the rule in January 2023, it received 26,000 public comment letters. While 25,000 comments supported the proposed crackdown on noncompete agreements, a sizable segment of the business community has strongly objected to the change.

Ultimately, the FTC decided to go ahead with the ban, with certain modifications. The agency determined that noncompetes unfairly deter competition. The final rule defines a noncompete as a "term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker" from either taking a different job or operating a business after the end of employment.

Under the final rule, the vast majority of existing noncompetes will no longer be enforceable after the effective date. However, existing agreements signed by "senior" executives—who represent less than 7.5% of the workforce—may still be enforced. And employers can't enforce new noncompetes with employees, regardless of whether the worker is a senior executive.

For these purposes, senior executives are defined as workers who earn more than $151,164 annually and are in a policymaking position. A "policymaking position" means that the person has final authority to make policy decisions that control significant aspects of a business entity or common enterprise, but not someone whose role is limited to advising or influencing such decisions.

Exceptions to the Rule

There are a few limited exceptions to the ban as follows:

• The final rule doesn't apply to 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 final rule doesn't apply in connection with 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.
• The final rule doesn't apply where 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 they have a good-faith basis to believe that the final rule is inapplicable.

Employers must provide notice to employees with existing agreements that they won't be enforcing those agreements. However, to streamline matters, the final rule eliminates a provision in the proposed rule that would have required employers to legally modify existing noncompetes by formally rescinding them. The final rule also includes some model language that employers can use to notify workers about the change.

Business Groups Take the FTC to Court

The day after the FTC approved its final rule banning noncompete agreements, the U.S. Chamber of Commerce and several business groups filed a lawsuit in the U.S. District Court for the Eastern District of Texas. The plaintiffs are asking the federal court to block the rule, claiming that the FTC doesn't have the legal authority to establish a ban that breaks with centuries of precedents. Furthermore, they argue, the scope of the change is too broad.

"The sheer economic and political significance of a nationwide noncompete ban demonstrates that this is a question for Congress to decide, rather than an agency," wrote the Chamber of Commerce. It asserts that noncompete agreements are essential to protecting internal company secrets and proprietary information. The plaintiffs also maintain that many noncompetes don't pose any threat to unfair competition in the marketplace.

Another more aggressive lawsuit has been filed by Ryan LLC, a provider of tax services and software, in U.S. District Court for the Northern District of Texas. The plaintiff is asking the federal court to vacate the rule, which it claims is unconstitutional. More legal challenges are expected to follow.

The final rule received bipartisan support in Congress. Contact your legal and financial advisors for the latest developments.

Potential Upsides for Workers

The FTC foresees numerous positive results for the workforce from its new final rule. It's estimated that the rule will:

• Lead to the creation of roughly 8,500 new businesses every year,
• Increase average earnings for workers by $524 per year,
• Lower health care costs by up to $194 billion over the next decade, and
• Increase the number of new patent applications by 17,000 to 29,000 annually due to more innovation.

Once the final rule takes effect, suspected violations of the ban can be reported to the FTC's Bureau of Competition by emailing noncompete@ftc.gov.

Options for Employers

Despite the ban against noncompetes, employers will still have some options for protecting their business interests. This includes trade secret laws and nondisclosure agreements (NDAs) that cover proprietary information. It's estimated that more than 95% of the workers with noncompetes have already signed an NDA. These NDAs remain in effect regardless of the ban on noncompetes.

Next Steps

Both employers and employees should take note of the new rules relating to noncompete agreements and take necessary actions to comply with the changes—unless business groups succeed in their current legal efforts to modify or overturn the rule. For more information, contact your legal and financial advisors.

©  2024