May 2024

On April 23, 2024, the Federal Trade Commission (“FTC”) issued a final rule that would ban employment non-compete agreements for most employees in the United States.  The new rule was published in the Federal Register on May 7, so it is projected to go into effect on September 4, 2024.  Multiple parties, including the U.S. Chamber of Commerce, have filed lawsuits challenging the rule and seeking to stay its enforcement as the challenges work their way through the courts. 

What Does the New Rule Do?

Simply put, the FTC’s new rule would ban non-compete agreements for almost all employees by invalidating most existing non-compete agreements and banning employers from mandating non-competes for new employees.  The FTC estimates that one in five employees is subject to some form of non-compete agreement.

The rule would permit continued enforcement of existing non-compete agreements for “senior executives,” but would bar employers from entering into future non-competes with those same employees. 

Employers would be required to provide notice to employees who are currently covered by non-compete agreements that the non-compete agreements will not be enforced against them in the future.  The FTC has provided model language that employers can use for such notices. 

Notably, the rule will also apply to de facto non-compete agreements, or terms of employment that have a similar effect of preventing employees from seeking future work in the same industry.

What are the Potential Impacts of the Rule?

The obvious impact from this rule is that employees will be free to explore new employment options or even start up new businesses, even if they are directly competing with a former employer.  The FTC estimates that this will lead to an increase in earnings for the average employee by as much as $524 per year.  The FTC also estimates that the rules will lead to as many as 8,500 new business forming each year and may lead to 17,000 and 29,000 new patent filings each year.

Groups representing employers, however, argue that this will have a significant financial impact on employers given the high costs associated with recruiting and training employees.  The new rules may have an outsized impact on younger workers, as employers may hesitate to hire employees who require training only to see those employees take those skillsets to competitors. 

Who Qualifies as a Senior Executive?

Two tests apply to determine whether an employee qualifies as a senior executive—a compensation test and a job duties test.  First, an individual must have earned a minimum of $151,164 in total annualized compensation in the prior year.  Second, the individual must hold a “policy-making position.”  Presidents, chief executive officers, and their equivalents are presumed to be senior executives, but other officers such as vice-presidents, secretaries, treasurers, principal financial officers, and comptrollers could also qualify where they routinely make policy decisions that control significant aspects of a business.  The FTC estimates that less than 1 percent of the workforce qualify as senior executives under the rules.

How Does the Rule Impact California Employers?

The FTC rule will have the least impact in California, where non-compete agreements have been barred for decades, notwithstanding a few limited exceptions.  California has taken steps in recent years to strengthen its laws against non-compete agreements by, for example, requiring employers to notify employees who signed non-compete agreements that those agreements are not enforceable and by making employers potentially liable for having employees enter into unenforceable non-compete agreements. 

The rule will, however, have varying implications for the exceptions to California’s non-compete ban.  For example, per Business and Professions Code Section 16601, when a California business is purchased, a buyer can protect the goodwill acquired in the transaction by contracting with the seller to refrain from carrying on a similar business within a specified geographic area nearby.  The FTC’s rule creates an analogous exception for non-competes “entered into by a person pursuant to a bona fide sale of a business entity”, so reasonable California business sale non-competes will remain enforceable.

However, Business and Professions Code sections 16602 and 16602.5 allow California partnerships and LLCs to impose geographically limited non-competes from departing partners/members when a business entity dissolves or the partner/member dissociates or terminates their interest in the business, so long as another entity owner continues to carry on a like business.  The FTC rule does not exempt nor even reference business dissolution and dissociation non-competes.  Partnerships and LLCs, therefore, should consider refraining from entering into non-compete agreements with departing owners until the FTC provides additional guidance if these non-competes are excluded from the new rule.

How Might Employers Respond?

Employers should consider options other than non-compete agreements to safeguard their businesses. Alternative options include non-disclosure agreements (“NDAs”), non-solicitation agreements, and training repayment plans. 

NDAs are meant to protect employer trade secrets and confidential information, such as customer lists and pricing.  NDAs are still enforceable under the new FTC rules and are also enforceable in California. NDAs should be drafted with precision to ensure that they do not go too far and violate the new FTC rule by creating a de facto bar competition.  An NDA will remain enforceable if it does not prohibit the disclosure of 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.”

The Rule acknowledges that non-solicitation agreements generally do not constitute non-competes, but also states that they will be treated as a non-compete 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 meets this threshold is a fact-specific inquiry relative to the industry, so they should be used cautiously.

The use of training repayment plans has risen over the years. A training repayment plan is a provision in employment contracts requiring an employee to repay their employer a sum for on-job training if they leave employment within a certain period of receiving training.  The FTC’s rule declined to either categorically prohibit or exempt training repayment plans from the ban.  Therefore, as with NDAs and non-solicitation agreements, training repayment plans should be used cautiously if they could create a bar to competition.  Training repayment plans that impose penalties on employees, instead of being based on the actual training costs, could violate the FTC’s rule. 

Will Legal Challenges to the Rule be Successful?

Opponents, led by the U.S. Chamber of Commerce, have already sued on constitutional grounds seeking a nationwide injunction of the non-compete ban. The parties argue that the ban exceeds the FTC’s statutory authority. 

The FTC defends the rule, arguing that Congress authorized the FTC to prohibit “unfair or deceptive acts or practices in or affecting commerce,” and to “make rules and regulations for the purpose of carrying out the provisions of” the Act.  The FTC argues that taken together, these statutory provisions broadly empower it to promulgate rules to prevent perceived unfair methods of competition, such as non-competes.

Opponents rely on three separate arguments to justify a stay of the rule: (1) the FTC Act does not grant the FTC the authority to promulgate any rules regulating the national economy; (2) the rule violates the non-delegation doctrine, which prevents Congress from delegating its legislative powers to another branch of government.  Historically, the Supreme Court has been reticent to strike down agency action under this rationale; so long as Congress provides an “intelligible principle” in authorizing legislation, an agency is free to act pursuant that principle; (3) the rule does not meet the Supreme Court’s newly minted “Major Questions Doctrine.”

The Major Questions Doctrine is a test created by the Supreme Court when it ruled to invalidate the EPA’s “Clean Power Plan” in 2022.  The Doctrine was invoked again to strike down President Biden’s student loan forgiveness initiative last year. The Doctrine bars agencies from resolving questions of “vast economic and political significance” without clear statutory authorization from Congress.  In other words, agency rules and regulations with significant national impact require more explicit Congressional approval. 

By the FTC’s own estimation, the rule will affect 20 percent of American workers and increase wages by over $400 billion over the next ten years.  This tremendous economic impact could convince courts to invoke the Major Questions Doctrine to stay the rule while challenges move forward.  However, both the Doctrine’s novelty and limited case law render it difficult to predict the challengers’ likelihood of success on the merits.  For now, businesses should prepare for the full rule to become effective on September 4 but should remain abreast of court injunctions delaying the rule’s enforcement over the coming months.

For more information contact:

Matthew Wallin

mwallin@gibbsgiden.com

(424) 317-4423

Matthew Wallin is a partner in the Los Angeles office where he practices labor and employment law.  He has extensive experience defending private business and public entities in litigation and advising clients on labor compliance issues.  

Thanks to contributor Taylor Jennings, JD Candidate at Pepperdine Caruso School of Law, 2024 

tjennings@gibbsgiden.com

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