Proposed FTC ban on noncompete clauses: Why, when, and who it affects
Following the Federal Trade Commission (FTC)’s proposed ban on noncompete clauses, Tim Twigg, president of Bent Erickson & Associates, talked with DentistryIQ about its likely impact on dental professionals. Here, Twigg provides more detailed answers to questions on the proposal.
What happened initially?
The FTC issued a proposed rule on January 5, 2023, that would prohibit employers from using noncompete clauses with workers.
When will the proposed rule become effective?
There was a 60-day notice and comment period during which the public could provide input concerning the proposed rule. This time period was extended past the due date of March 20, 2023, to April 19, 2023.
After the comment period closed, the FTC could move to finalize the rule or adopt alternatives. It’s anybody’s guess how long this will take. Even if enacted as is, once finalized, the rule would not become effective until 60 days after publication of the final rule in the Federal Register. In addition, there would be a 180-day compliance period (running from the date of publication) during which employers would be allowed to work toward compliance.
What does the proposed federal rule do?
The proposed rule, if adopted in its current form, would require employers to:
- rescind all existing noncompetes no later than the rule’s compliance date (which is not yet determined); and
- provide notice to current and former workers that the workers’ noncompete clauses are no longer in effect. The proposed rule provides model language employers can use to satisfy this notice obligation.
How does the agency define noncompete clauses?
The proposed rule defines “noncompete clause” to mean a contractual term that blocks a worker from working for a competing employer, or from starting a competing business, within a certain geographic area and period of time after the worker’s employment ends.
Why did the FTC do this?
In July 2021, President Biden issued an executive order titled “Promoting Competition in the American Economy.” It directed the FTC to exercise its “statutory rulemaking authority under the Federal Trade Commission Act to curtail the unfair use of noncompete clauses and other clauses or agreements that may unfairly limit worker mobility.”
More than a year later, the agency followed through on the president’s request. With the release of the proposed rule, FTC chairperson Lina Khan opined that noncompete clauses “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.”
The agency further stated that it believes noncompete clauses negatively affect competition in labor markets by suppressing wages and labor mobility, and by preventing new businesses from forming, which stifles entrepreneurship and prevents novel innovation that might otherwise occur if workers were not restricted from sharing their ideas. The FTC estimates that the proposed rule would increase workers’ earnings in the US by between $250 and $296 billion per year, and that the ban will close racial and gender gaps by 3.6%–9.1%.
Would the proposed rule prohibit nonsolicitation, nonrecruit, or confidentiality clauses?
Generally speaking, the answer is no. However, employers will need to proceed with caution with restrictive covenants such as customer nonsolicitation, employee nonrecruit, or confidentiality provisions. While the rule’s definition of a noncompete clause does not mention other types of covenants—and the FTC’s main concern is focused on clauses that prevent a worker from seeking or accepting employment with another person or entity or starting their own business after the conclusion of the worker’s employment with the employer—there could be trouble ahead.
This is because the FTC has made clear that the title of any given clause is not outcome determinative. Just because a clause is called, for example, “a nondisclosure” clause, it may still violate the proposed rule if its scope and burden is so broad as to be the functional equivalent of a noncompete clause. To that end, the agency will use a functionality test to make this determination.
What is the functionality test?
The title of a contractual provision will not dictate whether it is a noncompete clause. If a covenant is so broad that it serves as a de facto noncompete, it would not be permitted under the proposed rule.
For example, a nondisclosure provision prohibiting use or disclosure of confidential information is generally fine, but it would become problematic if confidential information is defined too broadly. A recent case in the securities industry involved a nondisclosure clause that prohibited use or disclosure of any information concerning the securities industry. That clause was deemed by a court to be a de facto noncompete that precluded employment with a competitor. The FTC cited this case as an example of a nondisclosure provision that would be a de facto noncompete.
What are the potential penalties for violations of the proposed rule?
The FTC has the authority to issue a complaint in situations where it believes its rules have been violated. If a respondent contests the charges, the complaint is adjudicated before an administrative law judge (ALJ) in a trial-type proceeding. Upon conclusion of the proceeding, the ALJ issues an initial decision setting forth findings of fact and conclusions of law and a recommendation for either a cease-and-desist order or dismissal of the complaint. The FTC and the respondent may appeal the initial decision to the full Commission. After the Commission issues a final decision, the matter may be appealed in court.
After a cease-and-desist order is finalized, the Commission may seek an array of remedies in court, including civil penalties, restitution, damages, injunctive relief, orders of rescission, or reformation of contracts. The FTC may also make referrals to the US Department of Justice for criminal prosecution.
Will the proposed rule be retroactive?
Yes, the rule would invalidate prior noncompete clauses. In addition to prohibiting the future use of noncompetes, the proposed rule would prohibit employers from maintaining noncompetes with workers. It would require employers to rescind such clauses and notify workers that they are no longer bound by them.
Would the retroactive provision of the proposed rule invalidate an entire existing agreement containing a noncompete clause, or just the noncompete clause itself, leaving other restrictive covenants intact?
Only the noncompete clause would be impacted by the proposed rule. The model language for notification to workers of rescission contained in the proposed rule includes the following: “The FTC’s new rule does not affect any other terms of your employment contract.”
Could employers face retroactive liability for existing agreements?
Employers should not face retroactive liability for use of a noncompete clause prior to enactment of the rule. The proposed rule states that an employer can comply with the rule by rescinding prior noncompete clauses no later than the compliance date, which would be 180 days after the date of publication of the final rule.
Does the proposed rule preclude all noncompetes?
The proposed rule would not apply to a noncompete clause entered into in a sale-of-business context. This includes agreements between a person selling a business entity or otherwise disposing of all the person’s ownership interest in the business entity, or someone who is selling all or substantially all of a business entity’s operating assets. This exception only applies when the person restricted by the noncompete clause is a substantial owner of, or a substantial member or substantial partner in, the business entity at the time the person enters into the noncompete clause.
The terms “substantial owner,” “substantial member,” and “substantial partner” are defined to mean an owner, member, or partner holding at least a 25% ownership interest in a business entity. The FTC’s notice of proposed rulemaking (NPRM) notes that after the 60-day comment period, the FTC may elect to change the percentage of ownership interest for purposes of these definitions to a smaller or larger percentage, “for example, 50% or 10%.”
Does the proposed rule preclude noncompetes with independent contractors?
Yes, the proposed rule would apply to independent contractors, as well as anyone who works for a business, whether paid or unpaid.
My state has a statute that allows noncompetes. What effect would the proposed rule have on state law?
The proposed rule states that it supersedes any inconsistent state statute, regulation, order, or interpretation. State statutes, regulations, orders, or interpretations that afford greater protection to workers would be allowed. For example, a state law prohibiting noncompetes and nonsolicitation provisions would be permissible; a state law allowing noncompetes would not.
Does the FTC have the authority to do this?
Since the proposed rule was issued, many have questioned the FTC’s authority. The first to do so was the sole Republican Commissioner on the FTC, Christine Wilson.
Here’s what she had to say. “The NPRM is vulnerable to meritorious challenges that (1) the Commission lacks authority to engage in ‘unfair methods of competition’ rulemaking, (2) the major questions doctrine addressed in West Virginia v. EPA applies, and the Commission lacks clear Congressional authorization to undertake this initiative; and (3) assuming the agency does possess the authority to engage in this rulemaking, it is an impermissible delegation of legislative authority under the nondelegation doctrine, particularly because the Commission has replaced the consumer welfare standard with one of multiple goals. In short, today’s proposed rule will lead to protracted litigation in which the Commission is unlikely to prevail.”
Will the proposed rule pass?
The proposed rule is likely to pass in some shape or form. It is a culmination of many efforts dating back at least to the FTC’s January 2020 workshop on noncompete clauses, which the FTC mentions multiple times in its NPRM. It also has behind it the weight of President Biden's July 2021 “Executive Order on Promoting Competition in the American Economy.”
Wilson seems to believe the rule will pass. In her dissenting statement, she strongly encourages the submission of comments from “all interested stakeholders,” noting “this is likely the only opportunity for public input before the Commission issues a final rule.” As noted, after outlining the proposed rule, the NPRM proceeds to invite comment on certain alternatives. All the signs indicate the Commission fully intends to pass a rule in some shape or form.
