On April 23, 2024, the FTC, by a 3 -2 party line vote, passed a new rule, banning nearly all noncompetition agreements in the United States, in all businesses subject to FTC jurisdiction (the “Rule”).  Unless successfully challenged, the Rule will go into effect in early September 2024, 120 days after its publication in the Federal Register, on May 7, 2024.  The Rule is a modified version of a rule initially proposed by the FTC in January, 2023 (“Proposed Rule”), which was the subject of extensive comment.  Under the new Rule, employers will be required to notify affected workers that their noncompetes are unenforceable.

While enactment of the Rule has caused significant concern, major and potentially determinative judicial challenges to the Rule have been filed, and the impact of the new Rule has yet to be determined.   

Challenges to the Rule

Several major legal challenges to the Rule were filed immediately after its passage, and additional challenges are expected.  These challenges include applications to stay enforcement.  In one action filed by the United States Chamber of Commerce, the U.S. Supreme Court has directed that all papers in support and opposition to the application for a stay, and for and against a motion for summary judgment, are to be filed by June 19, 2024, suggesting that a ruling on the stay application is likely to occur well before the effective date. 

The legal challenges to the proposed FTC Rule are significant.  Both FTC Commissioners who voted against the Rule asserted that the FTC, an administrative agency, lacked statutory and Constitutional authority to impose this rule, noting that only Congress can enact legislation, and that this responsibility cannot be delegated.  As Commissioner Ferguson stated in his oral dissent on April 23, 2024:

“I do not believe we have the power to nullify tens of millions of existing contracts; to preempt the laws of forty-six States; to declare categorically unlawful a species of contract that was lawful when the Federal Trade Commission Act (FCT Act) was adopted in 1914; and to declare those contracts unlawful across the whole country irrespective of their terms, conditions, historical contexts, and competitive effects. …”

Under established precedent, the FTC needs clear Congressional authority to impose a substantive and highly impactful rule, in a context that will have a major economic or other effect.  In a recent case, West Virginia v. E.P.A., 597 U.S. 697 (2022), the United States Supreme Court relied on, among others, the "major questions” doctrine and held that a federal agency must establish that Congress has lawfully delegated the issue to the agency; where the economic or other impact of an issue is significant, this can be a very significant burden.^[1] Further, many have argued that the sections of the Federal Trade Commission Act relied upon by the FTC, Sections 5 and 6(g), do not permit this type of regulation.  Non-competes have been the subject of state regulation – rather than federal regulation – for many years, and sections 5 and 6(g) of the FTC Act, have not been a basis for federal rulemaking in the noncompete area, despite the many years since the Act's enactment.  Accordingly, a key, perhaps determinative basis for the challenge, will be that the FTC lacks authority to impose the Rule.   

Terms of the Rule as Enacted by the FTC

In the event the Rule does go into effect, it will have a profound impact, but certain restrictive covenants will survive:

Section 910.1 of the Rule defines “non-compete clause” as a “term[s] or condition[s] of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from” working for another employer or starting a business.

The Rule provides, “[w]ith respect to a worker other than a senior executive, it is an unfair method of competition for a person: (i) To enter into or attempt to enter into a non-compete clause; (ii) To enforce or attempt to enforce a non-compete clause; or (iii) To represent that the worker is subject to a non-compete clause.” FTC Supplementary Information, p. 564. 

 With respect to “senior executives”, the rule provides that “…it is an unfair method of competition for a person: (i) To enter into or attempt to enter into a non-compete clause; (ii) To enforce or attempt to enforce a non-compete clause entered into after the effective date; or (iii) To represent that the senior executive is subject to a non-compete clause, where the non-compete clause was entered into after the effective date.” Id. (emphasis added)

In other words, non-competition agreements with “senior executives” entered into prior to the effective date of the Rule are not eliminated by the Rule. However, as of the effective date, new non-competition agreements may not be entered into with workers or senior executives.   

Under Section 910.1, a “senior executive” is a worker who was in a “policy-making position”, and whose total annual compensation for the prior year was at least $151,164.  A “policy-making position” under the Rule is “… a business entity’s president, chief executive officer or the equivalent, any other officer of a business entity who has policy-making authority, or any other natural person who has policy-making authority for the business entity similar to an officer with policy-making authority.” 

Over the past several years, many states have tightened the requirements for enforcement of noncompetes, including requirements for enforcement against senior executives; those requirements will still need to be satisfied.  But the FTC’s new Rule will not prohibit enforcement of a noncompete with a senior executive entered into prior to the effective date (which is currently in early September). 

Other than these special circumstances applicable to senior executives, the Rule will apply to all workers, including full-time and part-time workers, independent contractors, interns, externs, volunteers and apprentices.

 Forfeiture for Competition

The FTC’s Supplementary Information makes clear that “forfeiture for competition” agreements are prohibited by the Rule (pp. 76 – 77).  These are agreements where an employee loses a bonus or other financial benefit, if the employee leaves an employer and goes into competitive work during the term of a contractual restriction.  The FTC sees these agreements as “…inherently restrictive and exclusionary conduct”, and thus, barred under the Rule.  Id. at p. 77.  

Whether “forfeiture for competition” agreements should be treated as noncompetes -- whether they are more akin to deferred compensation for executives, or whether they should be regarded as “employee choice” agreements, where an employee can choose to receive the compensation and avoid, for a time, the competitive conduct, or to forfeit the compensation and compete – has been the subject of extensive litigation, including, most recently, extensive litigation in the Delaware courts.  The Supreme Court of Delaware, held in Cantor Fitzgerald v. Ainslie, a major case decided in January 2024, that “forfeiture for compensation” clauses are not penalties, that they are to be evaluated under the “employee choice” doctrine, and that their enforceability should not be analyzed as if they were noncompetes.  Not only did the FTC decline to accept this view, the FTC did not even acknowledge the debate on this issue, or cite and distinguish the extensive legal analysis of the Delaware Supreme Court. 

Garden Leave and Severance Agreements

 While declining to review and analyze each of the many variations of the concept, the FTC determines that the traditional “garden leave” clause would be lawful under the new Rule.  This would be an agreement under which the employee remains employed and fully compensated by the employer, and subject to a duty of loyalty, but removed from and uninvolved in the actual work of the employer.  Rather, the concept goes, the employee is paid for “sitting in the garden.”  The FTC’s view is 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 [Rule]… because such an agreement is not a post-employment restriction. Instead, the worker continues to be employed, even though the worker’s job duties or access to colleagues or the workplace may be significantly or entirely curtailed (footnote omitted).”  Supplementary Information at p. 83. 

 Further, the FTC states that this type of garden leave could still be lawful if the employee on leave did not qualify for an expected bonus: “…where a worker does not meet a condition to earn a particular aspect of their expected compensation, like a prerequisite for a bonus, the Commission would still consider the arrangement ‘garden leave’ that is not a non-compete clause under this final rule even if the employer did not pay the bonus or other expected compensation.” Id.

On the other hand, the FTC regards severance agreements -- where employment is terminated, and the employee receives payments if they do not compete for a period of time – as unlawful under the Rule, since the FTC regards this as penalizing a worker in violation of § 910.1. Id. at p. 77.  

Not All Industries Are Covered by the Rule

As confirmed in the Noncompete Clause Rule: A Guide for Businesses and Small Entity Compliance Guide (“Guide”), which was prepared by the FTC staff, the Rule will not cover industries outside of the FTC’s jurisdiction, such as banks, savings and loan institutions, federal credit unions, common carriers, air carriers, and certain non-profits.^[2] See FTC Act Sec. 6(a), 15 U.S.C. Sec. 46(a).  Nevertheless, with regard to nonprofits, the FTC has already stated that it will evaluate whether a nonprofit actually makes a profit for itself or its members, in order to determine if it is covered.  Federal banking regulators can determine whether to apply similar regulations to banking institutions.   

Also, the Rule applies to “workers”; it does not apply to business to business non-competes; according to the Guide, that exclusion also excludes franchisees in relation to a franchisor. See Guide, p.3, para. 12.

Sale of Business 

An additional critical exception from the Rule concerns the sale of business, which was the subject of extensive comment when the FTC published the prior, Proposed Rule.   The Rule now expressly carves out noncompete clauses entered into pursuant to bona fide sales of a business entity or of a person’s ownership interest in a business entity, as well as in connection with a sale of all or substantially all of a business entity’s assets.  This is a context in which non-compete clauses can be critical, and the Rule, by its express terms, “shall not apply to a noncompete clause” entered in this context.

Notably, the Rule dropped the previous requirement of the Proposed Rule, that the exception for “sale of business” would apply only where the seller was selling at least 25% of the business being sold.  The 25% requirement was the subject of extensive critical comment.  On another ‘sale of business’ issue, according to the Staff’s Guide, while the “sale of business” exception applies between the buyer and seller of a business, the Rule prohibits noncompetes for the non-owner workers in a sale of business context; however, the actual language in the Rule in this regard is somewhat unclear, and the fact that no ownership requirement appears in the Rule suggests that a significant ambiguity exists between the language in the Rule and the language asserted by the FTC Staff in its Guide.  The non-compete exemption in the Rule does not, by its express terms, apply only to agreements between buyers and sellers, but rather, requires that the exempt non-compete must be entered into "pursuant to” an agreement involving the bona fide sale of a business. ^[3]         

Accrual of Cause of Action   

The Rule does not prevent enforcement of causes of action that accrue prior to the effective date of the Rule.  Section 910.3(b) provides that “[t]he requirements of [the Rule] do not apply where a cause of action related to a non-compete clause accrued prior to the effective date.”  While the specifics of this exception will doubtlessly be litigated, at least where a claim has fully accrued prior to the effective date, the Rule is not to apply. 

NDAs and Non-solicitation Agreements

A major criticism of the Proposed Rule was that it purported to apply to all “functional equivalents” of noncompetition agreements.  The formulation was vague and seemed likely to prompt extensive litigation. 

In the final Rule, the FTC has provided some clarification.  The “function[s] to prevent” criteria of Section 910.1 will undoubtedly still be a basis for significant litigation, but the Supplementary Information issued by the FTC reference some of the leading caselaw concerning when an NDA or other agreement may be found to be a non-compete, see pages 69 – 85, and the Rule identifies terms that would generally be regarded as acceptable under the Rule.  

The Rule does not have a carve-out to protect trade secrets, but recognizes that properly scoped NDAs can be appropriate and enforceable.  The FTC’s Supplementary Information states that “…an NDA would not be a non-compete under § 910.1 where the NDA’s prohibitions on disclosure do not apply to information that (1) arises from the worker’s general training, knowledge, skill or experience, gained on the job or otherwise; or (2) is readily ascertainable to other employers or the general public.” (Supplemental Information at p. 80; emphasis supplied; footnote omitted.)  However, NDAs may be regarded as noncompetes “…under the ‘functions to prevent’ prong of the definition where they span such a large scope of information that they function to prevent workers from seeking or accepting other work or starting a business after they leave their job.”  Id., at p. 81. 

While this formulation is far from a model of clarity, it is a significant improvement over the prior draft.  

The FTC further clarifies that, as with NDAs, while non-solicitation clauses are not necessarily barred by the Rule, an overly expansive clause could potentially be viewed as a non-compete.  The Supplementary Information states that: “Non-solicitation agreements are generally not non-compete clauses under the final rule because, while they restrict who a worker may contact after they leave their job, they do not by their terms or necessarily in their effect prevent a worker from seeking or accepting other work or starting a business. However, non-solicitation agreements can satisfy the definition of non-compete clause in § 910.1 where they function to prevent a worker from seeking or accepting other work or starting a business after their employment ends. Whether a non-solicitation agreement—or a no-hire agreement or a no-business agreement, both of which were referenced by commenters, as discussed previously—meets this threshold is a fact-specific inquiry.” (emphasis added), Supplementary Information at p. 81. 

The Supplementary Information asserts that trade secret laws, and contractual restrictions on trade secrets use or disclosure, in addition to NDAs and patents, provide effective remedies to protect a business’s investment, and ameliorate the effect of the non-compete ban on a business.  While this may or may not be true, risks remain when utilizing NDAs, non-solicitation agreements, and other agreements under the Rule. 

Notification

The Rule requires employers to provide notice to their workers that they are no longer subject to their non-compete agreements.  This is to be done before the effective date.  The FTC has provided model language for this purpose.  The Rule also provides that employers do not have to provide notice to a former worker if the employer does not have the relevant contact information.  Given that the notice requirement requires action before the effective date, employers need to monitor legal developments as to whether there will be a stay of enforcement pending the outcome of the judicial challenges. 

Takeaways

If the FTC Rule does take effect, there undoubtedly will be many other questions of interpretation to resolve, and the FTC has released 570 pages of Supplementary Information with its views on most of these questions. 

For now, however, a few takeaways:

(i)The FTC Rule has been passed but has not taken effect.  Given the legal challenges, it may never take effect.  Businesses can continue to use restrictive covenants that are compliant with state and local law.  Such agreements should be appropriately and reasonably tailored to the applicable position and needs of the company. 

(ii) If the Rule does take effect, appropriately scoped non-solicitation agreements, NDAs and garden leave provisions can still be enforced.  Evaluation of the use of such agreements will likely be helpful in evaluating the impact.

(iii) If implementation of the Rule is not stayed by the courts, employees will need to be given notice prior to the September 4 effective date.  The relevant agreements need to be evaluated, notices prepared and scheduled, and addresses for notification, determined.  

Moses & Singer attorneys can assist in navigating the changes in the employment landscape as a result of this FTC action.  If you need assistance or have questions, please contact Avi Skoff, Allan Grauberd, or Kimberly Klein.