Explaining the FTC’s Proposed Rule to Ban Noncompetes Nationwide
The Federal Trade Commission (“FTC”) last Thursday announced a Proposed Rule which would ban noncompetes nationwide. Noncompetes are a widespread and often exploitative practice with which employers limit employees’ ability to ‘compete’ with their former employer during or after employment. Studies have shown that noncompetes suppress wages, hamper innovation, and block entrepreneurs from starting new businesses. “The freedom to change jobs is core to economic liberty and to a competitive, thriving economy,” said FTC Chair Lina M. Khan. She continued: “Noncompetes block workers from freely switching jobs, depriving them of higher wages and better working conditions, and depriving businesses of a talent pool that they need to build and expand. By ending this practice, the FTC’s Proposed Rule would promote greater dynamism, innovation, and healthy competition.”
Given the harm that noncompetes cause by restricting employees’ ability to seek better employment, the FTC’s expansive executive action is excellent news for employees across the United States. But the sweeping language of the Proposed Rule is deceptively simple. This post explains the major provisions of the Proposed Rule, discusses the potential implications and potential legal challenges of the Rule, briefly explains the historical legal and executive developments that preceded the FTC’s announcement of this Proposed Rule, and outlines the next steps before the Rule can go into effect.
The FTC’s Proposed Rule
On Thursday, January 5, 2023, the FTC proposed a new rule that would ban employers from imposing noncompetes on their workers. The FTC estimates that the new rule could increase wages by nearly $300 billion per year and expand career opportunities for about 30 million Americans.
Creating a Broad National Rule
If implemented as is, the FTC rule would represent a nationwide sea change in employment relationships, potentially affecting nearly every employer and employee. The FTC’s Proposed Rule broadly defines a noncompete clause as a “contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.” The only exception is that the ban does not apply to a person selling or otherwise disposing of their ownership interest in a business entity under limited circumstances, making this national noncompete ban arguably broader than any existing state noncompete ban.
Until now, noncompete law has been generally governed on a state-by-state basis, with each state setting out its own rules. The FTC’s Proposed Rule would not only create a unified rule for the entire country but would go well beyond the vast majority of current state employee protections. Many states have restricted noncompete agreements in various ways but include some sort of exception permitting some categories of noncompetes to survive. For example, the Massachusetts Noncompetition Agreement Act caps the noncompete restricted period to 12 months and requires either a garden leave clause (which pays the worker for the term of the restricted period at least half of the worker’s highest salary from the last two years) or some other mutually-agreed upon consideration that benefits the worker. And Illinois noncompete agreements are permitted only if they are supported by valid consideration, which may be two-years of employment from the time the employee signs the noncompete, or other consideration which can include professional or financial benefits. To be sure, state legislation has been trending towards increased restrictions on noncompetes, with more and more states passing new employee-friendly statutes in recent years (for example the recently implemented D.C. statute, discussed in greater detail below). But the FTC’s Proposed Rule is a complete ban on noncompetes: there is no carveout provision permitting certain types of noncompete agreements.
The Scope of the Proposed Rule
The Proposed Rule defines “employer” broadly, encompassing “a person…that hires or contracts with a worker to work for the person,” and “worker” as “a natural person who works, whether paid or unpaid, for an employer.” Workers explicitly include, “without limitation,” independent contractors, externs, interns, volunteers, and apprentices.
This language is arguably broader than any currently existing state noncompete ban or partial ban: there are no carveouts exempting government or other types of employers from coverage, and the explicit inclusion of certain types of workers renders this national noncompete ban broader than the recent D.C. Noncompete Ban that went into effect in October 2022. D.C.’s noncompete ban exempts certain types of workers from protection, including volunteers, babysitters, lay members elected or appointed to office within any religious organization and engaged in religious functions, broadcast employees, “highly compensated employees,” and “highly-compensated” medical specialists. Similarly, the Illinois Freedom to Work Act, the recently enacted Virginia law regulating noncompetes, Virginia Code § 40.1-28.7:8, and the Maryland Non-Compete and Conflict of Interest Clause Act prohibit noncompetes only for employees earning less than a specified salary threshold.
The FTC’s Proposed Rule provides no profession- or industry-specific exemptions and does not distinguish between workers based on their compensation. It provides a flat-out ban of all noncompete clauses, regardless of the worker’s profession or compensation level.
In line with California’s broad ban of noncompetes and non-solicitation agreements, which voids “every contract” (including those agreed to before the date of the law), the Proposed Rule requires employers to rescind existing noncompete clauses no later than the compliance date, which is 180 days after the date of publication of the Final Rule. It goes further to require employers to notify workers and former workers (if the former worker’s contact information is “readily available”) when the employer rescinds existing noncompete clauses via an “individualized communication” on paper or in digital format. The Proposed Rule provides model language for this notice of rescission. And finally, as a rule that would apply nationwide, it would supersede any state statute, regulation, or order to the extent inconsistent with the Proposed Rule.
Authority for the FTC’s Proposed Rule
Workers should not prematurely celebrate the FTC’s Proposed Rule: first because it does not take effect until 180 days after the date of publication of the Final Rule, and in the meantime it is certain to face legal challenges as employer groups and organizations are likely to wage an all-out campaign to prevent the rule’s implementation. One of their first arguments is certain to be that the agency lacks the power to regulate noncompete agreements. The Federal Trade Commission Act (“FTCA”) gives the FTC the power to prevent unfair methods of competition and investigate unfair or deceptive acts that affect commerce. Piggybacking on this principle, in the Proposed Rule the FTC defines “unfair methods of competition” to include when “an employer [enters] into a non-compete clause with a worker; maintain[s] with a worker a non-compete clause; or represent[s] to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe that the worker is subject to an enforceable non-compete clause.” Through this definition, the FTC intended to forestall challenges to its authority by linking its general enforcement power to its regulatory effort in this new arena.
In announcing a recent policy change in the FTC’s approach to enforcement litigation, on November 10, 2022, the FTC Chair discussed the agency’s new approach to enforcement and provided clear indications of other changes to come. See November 10, 2022 Statement, FTC Chair Lina M. Khan. The Chair explained that Section 5 of the FTCA empowered the FTC to bring enforcement actions to “prevent” businesses “from using unfair methods of competition.” She laid out why she disagreed with the FTC’s prior recent practice of avoiding bringing standalone Section 5 cases and argued that the FTC has a statutory mandate to fight unfair methods of competition on various fronts. She explained that the FTC’s new policy provided a framework and identified the factors the agency would use to determine whether a business practice constitutes an “unfair method” of competition. In the new rule, the FTC has simply exercised that same authority provided in Section 5 to identify noncompete agreements as a particular form of unfair competition.
The FTC’s change in its approach to Section 5 “unfair methods of competition” cases and its promulgation of this new noncompete rule are grounded in President Biden’s July 2021 issuance of the Executive Order on Promoting Competition in the American Economy, which called upon the FTC to issue a rule banning or limiting noncompete agreements. Plainly, Chair Khan has devoted considerable thought to anticipating and addressing future challenges to the FTC’s new rule and sought to ground her arguments in the text of the FTCA itself and the core principles giving rise to the FTCA in the first place. Time will tell whether her arguments prevail against the inevitable challenges to come.
To begin with, the FTC must demonstrate that noncompete agreements are indeed “unfair methods of competition.” The Proposed Rule leads from that assumption; its internal definition of “unfair methods of competition” states that noncompetes are such. The Proposed Rule itself, across nearly 200 pages, as well as the Statements by FTC leadership in support of it, cite dozens of studies demonstrating the ways in which noncompetes constitute unfair methods of competition.
Commissioner Christine S. Wilson’s Statement dissenting from the Proposed Rule disputes the validity of these studies, and in future litigation the validity of these, and presumably other, studies is likely to be central to the question of whether the FTC does have the authority to regulate noncompetes.
As for the practical impact of the Proposed Rule itself: several states have comparably broad noncompete bans (such as California and Oklahoma) and have not suffered from the parade of horribles [MT1] predicted by employers, e.g., the refusal of employers to do business in those states or the widespread theft of confidential information and clients. Similarly, law firms are not allowed to impose noncompetes on attorneys, and the legal industry has managed to survive and thrive. If anything, a nationwide ban as envisioned by the FTC would have the effect of leveling the playing field, letting employers and employees alike make the best business decisions for themselves regardless of the unique idiosyncrasies of a particular jurisdiction’s noncompete law.
Further, the announcement of a Proposed Rule is only the beginning of the process: the FTC will assess submitted Comments and is likely to make at least some changes before issuing its Final Rule. Unfortunately for employees, however, when government entities welcome public comment before finalizing a new rule or law, they sometimes walk back broad language. For example: the Council of the District of Columbia originally passed the Ban on Non-Compete Agreements Amendment Act of 2020, but, under intense pressure from D.C. employers to amend the Act to include additional exemptions from the list of eligible employees, the Council delayed the Act’s applicability date repeatedly and ultimately passed the Non-Compete Clarification Amendment Act of 2022, which severely scaled down protections for employees and constructed employer-friendly exemptions. While large portions of the Proposed Rule, as-written, may survive legal challenges to the substantive provisions, the public comment period, likely dominated by powerful employer-interests, may sway the FTC to walk back some of its expansive language before legal challenges even begin.
A final consideration is the stability of even a Final Rule across changing White House administrations. Other agency’s rules have swung back and forth depending on the administration in charge. See, e.g., the Department of Education’s Title IX guidance: the Obama administration’s 2011 and 2014 guidance was completely rolled back by the Trump administration’s rule issued in 2020 significantly impairing student survivor access to Title IX protections, and the Biden administration’s Department of Education issued a proposed rule in June of 2022 which has not yet been finalized. A Final Rule banning noncompetes may be susceptible to partial or complete revocation during the next Republican administration. This uncertainty presents challenges to both employers and employees if the FTC’s regulations swing back and forth every four to eight years. Further, the FTC faces challenges from an unfriendly Republican House of Representatives and a conservative Supreme Court set against the expansion of agency authority to interpret and enforce its governing statute.
Defining “Noncompete Clause” and the Proposed Rule’s Functional Test
In an attempt to provide some clarification for application of the complete ban on noncompetes, the Proposed Rule provides for a “functional test for whether a contractual term is a non-compete clause.” It specifies that a contractual term may be a “de facto non-compete clause because it has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer,” and provides a few examples of de facto noncompete clauses, including:
- A nondisclosure agreement “written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment…”; and
- A contractual term requiring the worker “to pay the employer or a thirdparty entity for training costs if the worker’s employment terminates within a specified time period, where the required payment is not reasonably related to the costs the employer incurred for training the worker.”
Beyond that, the Proposed Rule does not provide guidance for how and when the functional test should be applied. The FTC’s Notice of Proposed Rulemaking, only states that “whether a contractual term is a non-compete clause…would depend on a functional test. In other words, whether a contractual term is a non-compete clause would depend not on what the term is called, but how the term functions.”
Without further clarification on how the functional test works, employers and workers both may face confusion about whether contractual terms such as non-solicitation agreements will fall under the noncompete ban. Many non-solicitation agreements limit former employees from working with any former or potential clients of the former employer. This often has the same impact as a noncompete, especially in certain fields such as sales, and is particularly unfair to former employees who brought their clients to the former employer in the first place. As written, the Proposed Rule’s functional test could potentially invalidate many non-solicitation agreements depending on whether they “effectively preclude the worker from working in the same field after the conclusion of the worker’s employment.”
FTC Chair Lina M. Khan’s Statement in support of the Proposed Rule indicates that the Proposed Rule was not intended to invalidate non-solicitation agreements: she distinguishes a study cited by Commissioner Christine S. Wilson’s Statement dissenting from the Proposed Rule by stating “under the proposed rule, firms will still have contractual methods to protect their client lists, unlike the firms observed in this study, which were prohibited from using non-solicitation agreements in addition to noncompete clauses.”
The Proposed Rule’s language could be clearer in anticipation of heated disputes over the intended breadth of the ban and application to real-world non-solicitation agreements and other restrictive covenants.
Next Steps: Notice and Comment Period
Before the Proposed Rule can go into effect, the agency must provide for a 60-day “Notice and Comment” period during which interested parties and the general public may respond to all parts of the Proposed Rule’s solicitation of public comments. Comments are placed on the publicly accessible website at https://www.regulations.gov. In the Fact Sheet the agency published along with the Proposed Rule, the FTC specifically requested public comment on a number of topics, including “whether senior executives should be covered by the rule, or subject to a rebuttable presumption rather than a ban” and “whether low- and high-wage workers should be treated differently under the rule.”
Following the close of the Notice and Comment period, the FTC will review the Comments and make changes in a Final Rule. The Rule would go into effect 180 days after publication of the Final Rule.
The Proposed Rule, as written, provides broad protections for employees from potentially a wide variety of restrictive employment agreements. We hope that the FTC retains most of its language in the Final Rule.