The Federal Trade Commission (FTC) has proposed a new rule that would prohibit employers from imposing and enforcing non-compete clauses on their employees nationwide. California already has a ban on non-compete clauses on workers in California. The proposed FTC rule would expand the ban nationwide and narrow the exemption for selling business owners in California to those owners holding 25% or more of the business. The proposal stems from President Biden's Executive Order 14036 signed in July 2021, aimed at promoting a more competitive marketplace for workers in the economy.
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According to the FTC, about 18% of all employees in the United States “are bound by a non-compete clause and are thus restricted from pursuing better employment opportunities” in their field of expertise. Proponents of the rule argue that non-compete agreements suppress wages, prevent employees from freely changing jobs, hinder innovation, and impede entrepreneurs from starting new businesses.
If approved, the FTC anticipates the new regulation will increase career opportunities for those 30 million Americans and increase earnings as much as $296 billion per year. If that is true, then the converse is also true, and employers can expect payroll expenses and employee turnover to increase, particularly for those industries and employers where non-compete provisions are regularly used.
Is Your Business Ready for the Potential Impact of the New FTC Rule?
Here's what you need to know to safeguard your interests:
Scope and Applicability
Employers would be prohibited both from entering into new non-compete provisions and from maintaining their existing non-compete clauses with all workers. This applies to all individuals who work for an employer — from senior-level executives with access to a company’s most sensitive and valuable information, to independent contractors, consultants, interns, and even volunteers — whether paid or unpaid.
The Impact on Business Owners
- Mergers and Acquisitions: Non-compete agreements are often imposed on owners of a business as part of a sale to protect the value of the acquired company's goodwill, customer relationships, and trade secrets for the benefit of the buyer. California enforces reasonable non-competes on business sellers. The proposed rule would impact California sellers by only allowing a non-compete on business owners holding at least 25% of the ownership of the business. Many buyers place a tremendous value on the enforceability of non-competes in a business acquisition. Raising the threshold to 25% nationwide may lead to an increased use of earnouts and other similar deal structures to prevent competition by owners holding less than 25%. Furthermore, the proposed rule would invalidate non-compete clauses entered into in connection with completed transactions, which may create a surprise opportunity for smaller selling owners and a surprise risk for buyers with respect to those small selling owners.
- Franchise Agreements: Franchisors frequently use non-compete agreements to protect their brand and business model. The proposed rule could make it more difficult for franchisors to enforce non-compete agreements against franchisees, which could undermine the value of the franchise system and reduce franchisors' ability to control the quality and consistency of their products and services.
- Incentive-based Compensation Plans: Employers often make executives' involvement in equity plans and other performance-driven compensation, including short and long-term bonus plans, profits interest agreements, and retention contracts, contingent upon their agreement to comply with non-compete obligations.
- LLC and Partnership Agreements: The proposed rule's reach encompasses partnerships and agreements among individuals, which implies that regular non-compete provisions in partnership and LLC agreements might also be affected. Please refer to the limited exception mentioned below.
- Technology Transfer Agreements: Technology transfer agreements often contain non-compete clauses to protect the intellectual property being transferred. The proposed rule could make it more difficult for technology transfer agreements to include non-compete clauses, which could reduce the willingness of companies to share valuable intellectual property with others.
Narrow Exceptions for the Sale of a Business
The new rule would not affect non-compete clauses that are part of a business sale or the sale of a business entity's operating assets, as long as the person restricted by the clause is a substantial owner or member of the business at the time the clause is entered into. This applies to individuals who have a minimum ownership stake of 25% in a company. This threshold exceeds even California's exception to its general ban on non-compete clauses, which does not require such a substantial ownership stake. As a result, the FTC rule may preempt California's typically stringent non-compete laws in certain situations.
Scope and Jurisdiction
The newly proposed Federal ban would supersede any State statute, regulation, order, or rule. It is important to note that the FTC's jurisdiction under Section 5 of the FTC Act is not unlimited. Banks, federal credit unions, air carriers, common carriers, meatpackers, and poultry dealers are exempt from its coverage. Section 5 may also only be enforced by the FTC against "persons, partnerships, or corporations." Certain conduct engaged in by non-profit entities may be beyond the FTC's reach.
Compliance and Enforcement
If approved, the new rule would go into effect 180 days after the date of publication of the final regulation. Employers must rescind any non-compete agreements with workers within this time frame and provide written notice to the worker or former employee within 45 days of rescinding the non-compete clause. Any employer that fails to comply with the new rule may face legal penalties.
Alternative Restrictive Covenants
Various legal options that may reduce the impact of the proposed FTC rule on non-compete agreements include non-disclosure, non-solicitation, and garden leave policies, as well as forfeiture or clawback agreements, no-business/non-interference agreements, and some liquidated damages provisions. However, it's important to remember that these alternatives are not foolproof, and broad or unclear contract terms may still be considered "de facto" non-compete clauses.
We encourage you to reach out to our team at Adams Corporate Law to explore these options and ensure your agreements are properly drafted and enforceable in California.
Legal Options for Protecting Trade Secrets
In the supplemental information to the proposed rule, the FTC acknowledged that protecting trade secrets is often used to justify non-compete clauses but suggests that trade secret law provides alternatives to such clauses. They cite the doctrine of inevitable disclosure, the Uniform Trade Secrets Act (UTSA) and the Defend Trade Secrets Act of 2016 (DTSA), which allow for civil action against trade secret misappropriation.
However, relying on civil litigation for trade secret protection has limitations, as it only provides after-the-fact consequences and can be a lengthy, expensive process, making it difficult for companies to fully recover their losses.
Anticipated Legal Challenges to the Proposed Non-Compete Rule
The proposed non-compete rule is subject to change, and the process could extend into 2024. Once published, the rule will likely face legal challenges as it will greatly impact an area traditionally governed by state laws—leading to potential allegations of regulatory overreach.
Businesses and trade associations affected by the rule are likely to challenge it under the Administrative Procedure Act, citing a potential lack of authority, Congressional authorization, and delegation of legislative power. This could lead to years of legal battles before any variation of it can be implemented.
Future-Proof Your Business
While no immediate action is required, it’s best to stay ahead of the proposed rule and safeguard your interests now. Adams Corporate Law can help you assess the potential impact on your business or transactions in California, and develop a plan to change or update your restrictive covenant clauses should the new rule be adopted. Moreover, our team can assist in crafting a response to the Commission, as the comment period has been extended to April 19, 2023.
Contact Adams Corporate Law at (714) 699-9602 today.