To Compete or Not To Compete — the FTC’s New View on Unfair Competition

Non-compete agreements have long been a staple in the employment arena, despite their potentially anti-competitive effect. They are both common and highly controversial. In the best light, they are seen as a means of balancing the employee’s right to seek other employment with the employer’s legitimate interest in protecting itself from unfair competition by a trusted insider. But when non-compete agreements are abused to an extreme, they can unfairly restrain employees from re-entering the work force, frustrating everyday workers who need to earn a living and, in a larger sense, crippling to healthy competition. In the final analysis, the very existence and wide-spread proliferation of these contractual restraints has been tolerated as a necessary and incidental aspect of freedom of contract, free of governmental intrusion.

For more than a century, the use of post-employment restrictions — including covenants not to compete, non-solicitation agreements, non-disparagement agreements and confidentiality agreements — have grown in popularity by employers, large and small. Emboldened by the ability to set post-employment boundaries for former employees, corporate employers typically impose these robust restrictions “coming and going,” in both employment agreements and in separation agreements. Given the near universal use of these post-employment restrictive covenants, the disputes concerning their scope and enforceability have been the subject of a substantial volume of state and federal court litigation and, more recently, state legislation. Historically, the focus of the courts and state lawmakers has been on formulating a robust set of guidelines to ensure the overall reasonableness of any particular non-compete agreement. With or without the enactment of state laws designed to regulate the use of non-compete agreements, the state and federal courts have, on a case-by-case basis, articulated a number of factors to determine the reasonableness of the non-compete in question, and ultimately whether and to what extent it is enforceable. From state to state, the body of case law in each jurisdiction provides guidance to employer and employee alike as to whether a particular set of post-employment restrictions is considered reasonable and, therefore, binding on the parties.

After Decades of Silence, the FTC Enters the Fray

On November 10, 2022, the recently appointed Chair of the Federal Trade Commission (the “FTC”), Lina M. Khan, issued a Policy Statement Regarding the Scope of Unfair Methods of Competition Under Section 5 of the Federal Trade Commission Act (the “Act”), decrying the widespread use of non-compete agreements as an unfair means of stifling competition, and signaling a sharp change in the law. On January 5, 2023, the agency initiated the administrative rulemaking process to adopt a near total ban on the use of non-compete clauses, based ostensibly upon its preliminary finding that any non-compete agreement, by its very nature, constitutes an unfair method of competition and therefore violates Section 5 of the Act (the “Proposed Rule”).

The Proposed Rule

The FTC’s Proposed Rule is exquisitely direct, incredibly broad and boldly clears the field of any and all judicial or legislative impediments. In addition to a series of defined terms and a near absolute ban on non-compete clauses in parties’ agreements (with a single exception not applicable in the typical employment relationship), the Proposed Rule codifies a powerful mandate to rescind any existing agreements that might offend its definition of unfair competition, and makes an unequivocal declaration that the Proposed Rule supersedes any inconsistent rule, law or order. The Proposed Rule’s principal components are as follows:

• “Non-compete clause means 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 term non-compete clause “includes a contractual term that is 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.”

• Examples of a non-compete agreement as defined in the Proposed Rule include (i) “a non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer”; or (ii) any “contractual term between an employer and a worker that requires the worker to pay the employer or a third-party 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.”

• Unfair methods of competition includes an “employer enter[ing] into or attempt[ing] to enter into a non-compete clause with a worker; maintain[ing] with a worker a non-compete clause; or represent[ing] 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.”

• Rescission Requirement: Any “employer that [has previously] entered into a non-compete clause with a worker prior to the compliance date must rescind the non-compete clause no later than the compliance date set in the final Rule.”

• Limited Exception: The requirements of the Proposed Rule “shall not apply to a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets, when the person restricted by the non-compete clause is a substantial owner of, or substantial member or substantial partner in, the business entity at the time the person enters into the non-compete clause.”

• Supersedes All Inconsistent Rules or Orders: The Proposed Rule “shall supersede any State statute, regulation, order, or interpretation to the extent that such statute, regulation, order, or interpretation is inconsistent with this [Proposed Rule]. A State statute, regulation, order, or interpretation is not inconsistent with the provisions of this [Proposed Rule] if the protection such statute, regulation, order, or interpretation affords any worker is greater than the protection provided under this [Proposed Rule].”

A Significant Departure From Existing Laws

To call the Proposed Rule “groundbreaking” would be a gross understatement. If passed, it would catapult the FTC to the forefront of regulatory enforcement, a drastic departure from its historically undersized role in the administrative state. More importantly, the proposed per se proscription against non-compete agreements (with the sole exception of restrictions imposed as part of a transfer of business assets) completely upends almost a century of well-settled federal and state court jurisprudence, and eviscerates a wide range of more recent state legislation designed to more precisely regulate the use of such post-employment restrictions through a time-tested balance of interests.

The Proposed Rule abandons the rule of reason which, historically, has yielded a structured analysis of both the harms and benefits of post-employment restraints on a case-by-case basis. In New York, for example, non-compete restrictions must be no greater than necessary to protect the legitimate interests of the employer (which may include protecting an employer’s trade secrets and confidential information or preventing employees from unfairly using specialized skills gained on the job). The New York courts employ a four-point test to determine whether a non-compete is enforceable, including: (1) the extent to which the restriction is necessary to protect the employer’s legitimate business interests, (2) whether it imposes an undue hardship on the employee, (3) whether it harms the public, and (4) whether it is reasonable in duration and geographic scope. This type of reasonableness test, with certain variations from state to state, has been adopted by most of the states. Yet, the FTC’s near-per se approach discounts or ignores entirely the legitimate business rationales which justify the use of these covenants and the significant protections that the federal and state courts have employed to ameliorate any harm to the employee.

In addition to evaluating the reasonableness of the non-compete, many courts utilize a “blue pencil” approach which allows the court to strike out those aspects of the non-compete clause that it finds to be unreasonable under the circumstances and to enforce the remaining provisions in accordance with prior precedents. In some instances, where the court finds the employer grossly abused its out-sized bargaining power to require a patently unreasonable restriction, the court will strike the entire non-compete, refusing to enforce any aspect of it.

Many employers, large and small, tend to show restraint in the drafting of their non-compete agreements and other post-employment restrictions, and are fairly sensitive to avoiding overreaching and causing undue prejudice to the employee. These employee-friendly terms include, for example, (i) providing for the payment of salary and/or benefits during the post-employment restricted period, (ii) offering the employee an option to eliminate the non-compete in consideration of foregoing certain deferred payments; and (iii) permitting a narrowing of the scope of post-employment restrictions under certain circumstances at the option of the employee.

Aside from a well-developed state and federal jurisprudence, non-compete agreements have also been the subject of robust legislative activity in a growing number of states. While California, Oklahoma, and North Dakota have outright banned the enforcement of non-compete agreements, many other states, including Washington, Illinois, Virginia, Massachusetts, Rhode Island, Oregon, Maine, Maryland, and most recently Colorado, have passed legislation that limits enforceability to higher income earners, with the definitions of low-wage workers varying from state to state. Currently, there is legislation before both the New York and New Jersey state legislatures that would codify existing common law doctrine and would, if passed, further restrict the use of overly broad non-compete agreements. The proposed New York legislation, for example, incorporates the same factors used by our state courts to evaluate the validity of non-competes:

“A non-compete agreement is only enforceable if such agreement: (a) is no greater than required for the protection of the legitimate interest of the employer; (b) does not impose an undue hardship on the employee; (c) is not injurious to the public; and (d) is reasonable in time period and geographic scope.” New York Senate Bill S734.

What To Expect if the Rule Is Adopted

Most commentators concede that the administrative rulemaking apparatus does not provide for an efficient and streamlined process. The FTC has already indicated that after the public comment period is closed (60 days after the Proposed Rule is published in the Federal Register), the FTC likely will impose an effective compliance date no earlier than 180 days thereafter.

It is expected that the Proposed Rule, if passed, will engender substantial and wide-ranging litigation on a number of grounds, including the lack of delegated Congressional authority to impose such a sweeping new law that seems to interfere with parties’ freedom to contract with each other. It is likely that the new rule will face procedural and substantive challenges to the FTC’s unprecedented rulemaking on unfair methods of competition which, in turn, will lead to years of litigation and uncertainty. Indeed, a case currently pending before the Supreme Court, Axon Enterprise, Inc. v. Federal Trade Commission, may set limits on the FTC’s discretionary powers. The issue there is whether the federal courts have jurisdiction to hear constitutional challenges to the FTC’s procedure and adjudicatory structure, or whether such challenges must be first be tried in an administrative proceeding.

Practical Takeaways

It may take years for the Proposed Rule to become effective in one form or another. That said, employers in the meantime should remain disciplined as to how and when they impose non-compete agreements. New York employers who continue to utilize non-compete agreements would be wise to draft those covenants narrowly, taking care to tailor them to specific enumerated interests and a reasonable durational and geographical scope, while including blue pencil provisions to maximize enforceability.

It is also worth noting that other types of post-employment restrictions may come within the purview of the Proposed Rule which applies a “functional test for whether a contractual term is a non-compete clause.” Care should be taken to avoid the use of any contractual term that might be considered to be a “de facto non-compete clause” such as, for example, a non-solicitation clause that would, in effect, preclude an employee from working for a wide range of former employees, or soliciting business from large segments of the industry.

We also recommend avoiding the use of non-compete agreements for administrative employees where a legitimate basis for such a restriction cannot be readily articulated. Non-compete agreements that apply to more senior executives, or employees who are either client-facing or who are privy to proprietary customer/client information, are easier to defend and are more likely to be sustained in court. It is also advisable to review company policies and procedures for the use of non-compete agreements and to document the legitimate business interests that are implicated as justification for their use.

To discuss how the Proposed Rule may impact your business, please contact the authors or your regular Kleinberg Kaplan contact.