FTC Non-Compete Ban: What you need to know

Reed Smith partners Mark Goldstein, Cindy Minniti, and Michelle Mantine come together to break down the Federal Trade Commission's final rule on non-compete agreements and how it may affect U.S. businesses.

Transcript:

Intro: Hello, and welcome to Dealmaker Insights, a podcast brought to you by Reed Smith's corporate and finance lawyers from around the globe. In this podcast series, we explore the various legal and financial issues impacting your deals. Should you have any questions on any of the content, please contact our speakers. 

Mark: Welcome back, everyone, to Dealmaker Insights. My name is Mark Goldstein. I'm a partner in Reed Smith and Labor and Employment Group, and I'm joined by my colleagues, Cindy Minniti and Michelle Mantine, both partners as well at the firm. Today's topic is non-compete agreements. Been all over the news lately. Non-compete agreements have long been used by businesses to bar key employees from leaving their business and going and setting up shop across the street the next day. There are a whole host of reasons why businesses may want to impose a non-compete agreement on an employee. However, over the past several years, state legislators have worked increasingly scrutinized the use of non-compete agreements that passed a whole host of legislation. And finally, the U.S. Federal Trade Commission in April 2024 issued a final rule that if it takes effect, would prohibit virtually all pre-existing and future non-compete agreements across the U.S. So I'd like to turn it over to my colleagues today, Cindy and Michelle, and together we'll break down what the Federal Trade Commission's final rule says and how it may impact U.S. businesses. So, Cindy, let me start with you. Can you tell us a little bit about the background to the rule? 

Cindy: Sure. Thanks, Mark. Like you said, there have been a lot of state legislation recently over the last couple of years, really trying to limit the use of non-compete agreements. And President Biden in July of 2021 directed the Federal Trade Commission to come up with some federal legislation really limiting the use of non-compete agreements. In an effort to really be wide sweeping in January of 2023, the FTC put out a proposed rule, which got a lot of attention from businesses and a lot of people commented on the proposed rule during the comment period. There were about 26,000 comments to the proposed legislation. And then ultimately, the proposed rule is now out as of May of this year, it was published in the Federal Register. And like you said, if it does go into It will go into effect in September. But it really is an absolute ban to non-compete agreements. There are very, very limited exceptions, but this is really an absolute ban on current and future non-compete agreements for virtually everyone. There's a small exclusion for senior executives and some other minor exclusions, but really this is an effort to really stop people from really enforcing non-competes on their workforce, really open up people and to be able to go to competitors. It's also interesting that it's not just for employees. The proposed rule is for anyone that's really doing work. So So employees, contractors, anybody that's got any kind of a relationship. So independent contractors, interns, it's really very broad sweeping. 

Mark: That's a great point, Cindy. And the definitions within the final rule are really key and are extremely broad. The definition of worker, as you said, the definition of non-compete clause is quite broad. Michelle, let me ask you, because I know that this is a question a lot of our clients have asked. We understand that future non-compete agreements after the rule takes effect, if it takes effect in September as the currently scheduled effective date, those would not be above board. But what about pre-existing non-compete agreements? I know Cindy alluded to it, but how does the final rule adjust pre-existing non-competes? 

Michelle: No, it's a great question, Mark. And as Cindy said, it's pretty broad sweeping. Yes, the final rule absolutely applies to pre-existing non-compete agreements. There is sort of or are limited exceptions. The exception that I would note here in particular is for pre-existing non-compete agreements entered into with senior executives. And that term, like so many of the other definitions that accompany this rule, is defined very carefully and specifically in terms of what it means to be a senior executive. And if you fall outside of that category, the ban does apply. With respect to those other pre-existing non-compete agreements, those not with senior executives, I mean, the ban is saying, as Cindy pointed out, that the agreements will not be enforced. First, they are illegal, and that would be after the final rule's effective date, which currently absent any changes from it based on litigation is September 4th. The FTC is also saying as part of this guidance that the employer must provide clear and conspicuous notice to the worker of these sort of factors to make it very clear to the worker that if they have this pre-existing non-compete agreement, it's going away very soon. So the exceptions are extremely narrow. And again, something that if you're looking on relying on an exception for the senior employees, the senior executive employees, or in another context, you really need to look closely at the definitions to make sure you're in a safe spot. 

Cindy: Michelle, that's a great point about the definitions. Another question we get a lot is when you talk about non-compete, what about competitive activity during employment? And I think it's important to note that this is a broad sweeping regulation for post-employment restrictions. So we still are able to have employers banning current employees from having any sort of competitive activity during their employment, that this is really post-employment competitive activity that we're talking about. And I think it's just important to note. 

Michelle: Great point, Cindy. Let me ask, are there any exceptions? I know, obviously, we have the carve out for pre-existing agreements with senior executives, which from a high-level perspective, the rule essentially defines as someone making at least $151,000 a year and in a policymaking position. Besides that, are there any, Cindy, let me ask you, are there any exceptions to the rule? Some state legislatures, like in California and Minnesota, who have adopted all-out bans on restrictive covenants, do still include a carve-out, for instance, in the sale of business context. 

Cindy: Yeah. So I think that's probably one of the most talked about things right here is it's a bona fide sale of business is an exception. And there was a lot of discussion about what is a bona fide sale of business and are there percentages or a threshold that should be considered. Considered, and that was a lot of the comments and a lot of the consideration, but this final rule does have a carve-out for bona fide sale of the business so that you could have a restriction there because there are other interests at stake. And there are two other sort of litigation exceptions as well. So if there was litigation or if there was some interest in enforcing the non-compete before the rule goes into effect, or if there's a good faith belief that the rule is inapplicable. So, you know, I guess if you're arguing, is someone really a senior executive, or if you believe that they are a senior executive, something like that. But so those are the two sort of litigation exceptions. But I think really, the sale of the business is probably the one that we're going to see the most. Mark, did you have any thoughts on the sale of business and all of the discussion and back and forth, you know, before the final rule was proposed? 

Mark: Yeah. So I think that the sale of business exception probably is the biggest change between the proposed rule and the final rule. Generally speaking, the proposed rule that came out in January 23 is conceptually the same as the final rule that came out in April, May of 2024. Some of the language was tweaked, but the underlying concepts are the same. But the sale of business exception changed substantially. And the reason for that is because in the proposed rule, the FTC said that this carve out for the sale of business would only apply if the person that you're trying to bound by a non-compete is purchasing or owns 25% or more of an ownership interest in the entity at issue. So if somebody had a 12.5% ownership interest, the sale of business exception would not apply and they could not be bound by a non-compete. So in the final rule, the FTC dropped that 25% requirement, really conceding that there was no specific underpinning or justification for that metric. However, the FTC has said that despite this, they do anticipate rigorously looking at transaction to make sure that folks aren't entering into what they call sham deals. So essentially make sure there's a genuine bona fide sale at issue, not some sort of attempt to evade the FTC's non-compete ban. 

Cindy: I’m going to jump in on that. I think that's really important because we were hearing a lot of questions when we saw the proposed rule about what really is a sale and what if there are some corporate maneuvers that can happen, would we still have the enforceability of these restrictions? And I think that the comments and the commentary took a long, hard look at that and tried to make this as broad as possible. 

Mark: Yeah, that's exactly right. And the FTC even calls out things like repurchase rights or mandatory stock redemption programs and makes clear that those are not bona fide sales transactions, so they would not be subject to the exception. Obviously, particularly in the private equity space, businesses will be looking to capitalize and see if there are transactions that can be deemed bona fide that perhaps are broader than the scope initially contemplated by the FTC based on the language in the final rule. And that's obviously something you'd want to consult with counsel about to see if you're able to exercise and invoke the sale of business exception. Michelle, let me ask you, because I know that I've gotten this question a whole lot. But if you put a non-compete into a document other than an employment agreement or restrictive covenant agreement, some other sort of agreement could be an equity incentive, equity agreement, does that matter at all to the FTC? 

Michelle: It does not. And I have gotten that question a lot as well, Mark. People are trying to think of ways in which perhaps the non-compete has legs. And I don't say that in a nefarious way. I think people are thinking about ways in which to protect their trade secrets, their technology, things that they have concerns about sort of walking out the door. What will happen to it if that employee leaves? Are they adequately protected? And the FTC has said that, you know, this non-compete ban covers all terms of employment that meet the definition of a non-compete clause, regardless of whether that terms in something characterized as an employment agreement, an incentive equity award agreement, or some sort of separate restrictive covenant agreement, separation agreement, employee handbook, whatever document it is, you have to, again, go back to those definitions and say, is this a non-compete clause? And then is there any narrowly tailored or limited exemption that might apply here, right? So they really are saying they want these gone. Interestingly, the FTC had sort of a follow-up to the final rule release in April that they did on May 14th of 2024, sort of talking about how do you comply with the new rule. Interestingly, they didn't provide, at least from my perspective, they didn't provide a whole lot of concrete, specific guidance. But they certainly hammered home this point that if it's a non-compete, it doesn't matter what kind of document it sits in. We're saying this rule is saying get rid of them. And they even said, if you're an organization that's perhaps not under the purview of being regulated by the FTC, that the FTC would encourage you to get rid of non-competes because of the damages that, in its view, non-competes have had on the working environment. So definitely broad sweeping, to say the least. 

Mark: And I want to ask you something, Michelle, and it relates to something Cindy said earlier. Cindy mentioned this covers post-employment non-compete agreements. So non-competes during employment are still permissible. I want to ask you about what we call garden leave agreements. And these are very common in the UK and in the US are fairly common in the financial sector. And essentially, a garden leave agreement is an agreement where for a certain period of time, often somewhere between 90 and 180 days, when individuals still remain employed by a business, they'll still be getting paid their salary, but they won't perform any active duties. They often won't come into the office. But again, they'll still technically remain an active employee. Does the FTC weighed in on garden leave agreements? 

Michelle: They have, and the final rule does not apply to these agreements. I mean, as you pointed out, sort of the structure of them, they're also common in different sectors like financial services, for example. I think that the idea that garden leave agreements are sort of outside the scope is consistent with what Cindy mentioned before about this being a post-employment rule. The final rule commentary actually specifies that an agreement whereby the worker is still employed and receiving the same total annual compensation and benefits on a pro rata basis would not be a non-compete clause under the definition because such an agreement is not a post-employment restriction. So they're looking at it in that circumstance as the worker continues to be employed, even though the worker's job duties, their access to colleagues or the workplace has been significantly changed or perhaps it's gone away entirely. You know, so it's a really interesting sort of take on things and makes you think that perhaps we'll be seeing more employers use these garden leave agreements as it seems like one of the only, if not the only, option for a business that has concerns about, you know, sort of how workers may compete post-employment with them. Can this garden leave provision provide them with any protection or benefit? 

Cindy: Michelle, I think that's a great point on garden leave and looking at garden leave and is that an opportunity for employers to protect interests that they want to protect while employees are They're still getting compensation, so they're not being penalized in some way. And I do think that we might see garden leave becoming a little bit more commonplace moving forward. The one thing that I would encourage everyone to do is just really take a look at garden leave and make sure that it's not having unintended consequences. Make sure that your benefit plans are protecting people that we think it's going to protect and make sure that there's no other agreements or anything else that we need to look at. So we want to make sure we're not solving for one issue, but creating others. So look at that closely. Great point. Mark, I think we were just going to turn and I think it would be interesting if you want to talk about non-exempt status and what does that do with this rule? 

Mark: Yeah. So a lot of chatter has been around what types of organizations are exempt from the purview of the FTC's rule, because Section 5 of the FTC Act does not apply to every single entity in the US. For one thing, certain banks are exempted from Section 5 of the FTC Act. Another type of business that has traditionally been thought of as being exempt are nonprofits. And the FTC acknowledges, therefore, in the commentary on the final rule, that on its face, a true nonprofit is not subject to the final rule and therefore is not banned from having non-compete agreements with its employees. Though, you know, I think it's probably fair to say that non-compete agreements are less common in the nonprofit sector than they are in the for-profit sector. But the FTC then goes on and cautions entities that are claiming tax exempt status as nonprofits and says, you know, just merely claiming tax exempt status does not mean that you are truly outside of the purview of the FTC Act. The agency says, you know, what we look to is really that there be an adequate nexus between an organization's activities and its public purposes, and also that its net proceeds be properly devoted to recognize public as opposed to private interests. So the FTC uses a two-part test to determine whether or not an entity truly meets the test for being a nonprofit, regardless of what's claimed on a tax form. So an entity theoretically could be claiming tax-exempt status, but for purposes of final rule, the FTC might not consider that to be a nonprofit. And thereby the entity would be subject to the final rule. So if you're a business that is claiming tactical gun status as a nonprofit and still want to be able to use non-competes going forward, it would certainly make sense to review with counsel, you know, whether or not, you know, you definitely squarely fit within, you know, the law's definition of a nonprofit. 

Michelle: Mark, just two points on that. At the May 14th discussion by the FTC on how to comply with the non-compete ban, they actually mentioned this scenario in particular. And the FTC encouraged entities that are truly nonprofits to also get rid of their non-competes. It was quite an interesting take, in my view, that they were sort of acknowledging, yes, some of you might be outside of the span and outside of our purview of Section 5, but that we're strongly encouraging you to get rid of these provisions that we think are just not good. The other point on that, I just want to flag for everyone, if you haven't read it, if you're thinking about relying on nonprofit status or anything else to say to keep yourselves out of the purview of Section 5, take a minute to read the FTC's statement from November of 2022 on sort of the scope as the current administrators, the current agencies who see the scope of Section 5 of the FTC Act. They are interpreting it more broadly than ever. Specifically, they've said in that statement and in other public forum that the FTC Act really is designed to go after conduct that doesn't otherwise violate the antitrust law. So it might not be a violation of the antitrust laws, but they still think it sort of looks and smells like it could be a violation. It is extremely broad right now in the territory that sort of is being caught within Section 5. So you want to be really careful about sort of what you're doing and whether or not you could get caught up in a Section 5 investigation. 

Mark: That makes sense. Thanks, Michelle. Before we turn to what the future holds, Cindy, I just want to confirm with you, outside of non-compete agreements, that's just one type of restriction or contractual clause that businesses may use to make sure that employees don't improperly compete with them. They may use things like employee or customer non-falsific clauses, confidentiality clauses. Are those referenced by the final rule? 

Cindy: So that's a great point. So yes, employers can still use non-disclosure agreements. We can still have non-solicitation agreements. We can still have confidentiality clauses, again, subject to other restrictions and other guidance that's already out there and in place. But that's all permissible. Here, we're really talking about non-compete, so stopping somebody from competing with the employer. So, as long as you're complying with applicable state law and other federal laws, these other agreements are permissible. 

Michelle: Probably a good time to take a look at those NDAs that you're using and those confidentiality agreements to make sure that they have the protections that you really need here. Because I think in the past, right, we've relied or some businesses may have relied on the non-compete and they're going to have to rely more heavily on the NDA and that confidentiality agreement. 

Cindy: So that's a great point, because not only do we want to make sure that the other agreements are in place and that they're drafted appropriately, but in practice, employers should be really making sure that they're doing what they need to do to really protect things that they're saying are protectable. So, you know, if you've got confidentiality agreements in place, you want to really make sure that you are treating that information as confidential and that if there's a challenge, that you can really show why you don't want that information getting out. So really looking not only at your documents, but your practices. 

Michelle: That's a great point. 

Mark: So I want to ask you both in closing, what you think employers should do in the near term and potentially in the long term. And just to give everyone a status update, the U.S. Chamber of Commerce has filed a lawsuit that has been consolidated effectively with another lawsuit in Texas federal court challenging the final rule on a host of grounds, including that the FTC doesn't have the authority to issue a rule like this. The Chamber of Commerce has made a motion to essentially ask the court to nullify or validate the rule. There's been no ruling on that yet, but since we have until at least September 4th before the final rule will take effect, there's plenty of time for the court to rule and for there potentially to be appeals. I think it's fair to say a lot of people from the business community think that there's at least a reasonable likelihood that the final rule will not take effect, at least as planned, understand either in whole or in part, and that some of the arguments put forth against the rule do hold water. So let me ask each of you, Michelle, I'll start with you. What would you say for the business community in the US right now, who's kind of bit of a limbo period, how they should proceed? 

Michelle: Mark, it's a great question because we're really in sort of this limbo period, right? I think the biggest thing I would recommend right now is not to panic, to use this time, as we were just discussing, to take a look at, sort of take inventory of your agreements, your NDAs, your confidentiality agreements, how many workers you have that have a non-compete, how many of those might fall into the senior executive category, sort of looking at, okay, what's our exposure if this rule goes into effect, if this ban goes into effect? And then you need to sort of take, I think, a measured approach and sort of evaluating, okay, if it goes into effect, when we get rid of these, how do we protect ourselves from what we otherwise saw that nothing could protect us? Protecting our business interests post-employment and thinking of practical ways to do that with other agreements. I wouldn't suggest doing anything rash at this point, Mark, because of the good points you made with this pending litigation. I would expect the court to move rather quickly here and within the next couple of months, knowing that this proposed ban goes into effect on September 4th. And I do think there are some excellent, excellent legal arguments as to how the rule is just outside of the FTC's domain here and is really stepping on what is otherwise within our state law purview. you. That being said, again, with the state laws, those have also been developing quite often and they're changing. So keeping an eye on those, if you do have non-competes, making sure that the ones you have, that you are okay from a state law perspective as well. I think it's a really good time to look at that as well. So that's just a few tidbits. I'm sure Cindy can add to that. 

Cindy: No, Michelle, that was a great answer. I think that's right. I think you should be taking stock right now of what agreements you have in place and what do you actually need, looking at what you want to protect and is there another better way to do that? And even making sure that the agreements, you know, whether this goes forward or is changed in some way or, you know, we really have to be mindful that there are state laws out there and there are other restrictions. So really want to make sure that we're looking at that. So I think take the summer, let's enjoy ourselves and look at all of our non-compete agreements and policies and practices and make sure that we're We're really protecting what we need to and so that you're ready if this does go into effect, but you're ready nonetheless for the state laws or other changes that may come along the way if it's not this one. 

Mark: Awesome. Thank you, Cindy. Thank you, Michelle. And thank you, everybody, to listening to the Dealmaker Insights podcast brought to you by Reed Smith. And we thank you very much. 

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