At its core, the FTC’s proposed rule deems it an unfair method of competition for an employer to:
- Enter into or attempt to enter into a non-compete clause with a worker;
- Maintain a non-compete clause with a worker; or
- Represent 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 clause of that kind.
The proposed rule would bar future workplace non-compete clauses with any paid or unpaid workers, including employees, independent contractors and interns. It would also invalidate any preexisting non-compete clauses and would in fact require business to (i) rescind such clauses and (ii) notify workers of the same in an individualized written communication. The same notification requirements would likewise apply with regard to former workers who remain bound by non-compete clauses, so long as the employer has the worker’s contact information readily available.
Notably, however, there is an exception – albeit a limited one – to the FTC’s proposed rule. Specifically, the FTC carves out non-compete agreements that are “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.”
Under this narrow exception, only individuals with a 25% or greater ownership stake are considered a “substantial owner,” “substantial member,” or “substantial partner.” The FTC explains that it set this threshold for two reasons. First, so the exception is only available when the seller’s stake in the business is large enough that a non-compete agreement may be necessary to protect the value of the business being acquired by a buyer. And second, so that sellers of a business may be sure whether or not they are a substantial owner, member, or partner. The FTC recognized that if the terms “substantial owner,” “member,” or “partner” remain undefined, their interpretation could be made on a case-by-case basis and vary as a result.
That said, the 25% threshold may receive pushback during the currently ongoing public comment period. This is for a host of reasons, including that the figure is seemingly arbitrary and because state non-compete laws do not currently set specific ownership thresholds for non-competes related to the sale of a business. Indeed, under state laws, courts typically analyze the terms of the non-compete agreement and determine whether they are reasonable compared to the percentage stake in the business that the seller owns (for example, the percentage owned compared to the term and restrictions in the non-compete to determine whether it is reasonable).
By acknowledging that non-compete agreements between the seller and buyer of a business may be distinct from more typical non-compete agreements between an employer and employee, the proposed rule recognizes that most states review non-compete agreements in the context of a business sale under a more lenient standard than non-compete agreements that arise solely out of an employment relationship. (One of the primary reasons for this difference is that non-compete agreements entered into between a buyer and seller are meant to protect the value of the business acquired by the buyer.) Also by including this exception, the FTC’s proposed rule aligns with the non-compete laws in California, North Dakota and Oklahoma. Even in these three states, which bar post-employment non-competes generally, the law nevertheless permits reasonable non-compete agreements in the business sale context.
Lastly, it is important to note several clarifying matters. The first is that, under the proposed rule, the continued use of non-disclosure agreements, as well as customer and employee non-solicitation agreements, generally would not be prohibited – unless they are so broad as to act as a de facto non-compete by having the effect of prohibiting the employee from seeking subsequent employment.
And second, that the proposed rule would only apply to “workers,” defined as natural persons who provide paid or unpaid work for a business. “Where the person restricted by the non-compete clause is not a worker,” the FTC notes, “the Rule would not apply as an initial matter.” This means that, in the context of a typical private equity transaction, for instance, an individual with a less than 25% ownership interest could still be subject to a non-compete clause if they will not perform any work for the buyer or seller post-closing. So, while a non-compete agreement between a private equity buyer and individual who will not perform any work for the buyer post-closing will likely not be impacted by the FTC’s proposed rule, a private equity buyer should remember how the proposed rule relates to non-compete agreements with workers at the portfolio company level (as these workers would likely not trigger the business sale exception).
The public comment period remains open through March 20, 2023, so this proposed rule is far from being final. Businesses should therefore continue to include non-compete clauses in purchase agreements and related transaction documents, to the extent permitted by applicable state law. This is particularly true because it remains at least reasonably likely that the agency’s final rule will include some sort of business sale exception (which would mean, among other things, that non-competes in the context of a private equity transaction would be exempted from any retroactivity requirements in the final rule). Employers nevertheless will want to monitor the progress of the proposed rule over the coming months, as it could present a seismic change to the U.S. business landscape.
Client Alert 2023-043