FTC Issues Rule Banning Worker Noncompete Agreements

WHEN DOES THE FINAL RULE GO INTO EFFECT?

The Final Rule is slated for publication in the Federal Register on May 7, 2024.  It’s currently under public inspection. If not enjoined by a federal court, the effective date will be September 4, 2024.

WHAT’S A NONCOMPETE AGREEMENT UNDER THE FINAL RULE?

The Final Rule applies to all workers, including independent contractors and volunteers. It defines a “non-compete clause” as “a term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from (1) seeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment that includes the term or condition; or (2) operating a business in the United States after the conclusion of the employment that includes the term or condition.” A “term or condition of employment” includes, but is not limited to, a contractual term or workplace policy, whether written or oral.

WHAT DOES THE FINAL RULE PROHIBIT?

As discussed below, the Final Rule draws a distinction between “workers” and “senior executives.”

• Non-“Senior Executive” Workers

The Final Rule renders existing noncompete agreements with non-“senior executive” workers unenforceable. After the Final Rule’s effective date, subjecting such employees to noncompete agreements violates the Final Rule.

Additionally, the Final Rule provides that “[e]mployers must provide . . . workers with existing non-competes notice that they are no longer enforceable” by the effective date of the Final Rule. The FTC has provided model language that employers may use to communicate the required notice.

• “Senior Executives”

Noncompete agreements entered into with “senior executives” before the Final Rule’s effective date remain enforceable. However, the Final Rule precludes new noncompete agreements with “senior executives” after the Final Rule becomes effective.

The Final Rule defines a “senior executive” as a worker who (i) received annual compensation of at least $151,164 in the preceding year and (ii) is in a “policy-making position.” A “policy-making position” means a business entity’s president, CEO 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. “Policy-making authority” means final authority to make policy decisions that control significant aspects of a business entity or common enterprise and does not include authority limited to advising or exerting influence over such policy decisions or having final authority to make policy decisions for only a subsidiary or affiliate.

WILL THE FINAL RULE BE CHALLENGED AND ON WHAT LEGAL BASES?

Yes. Within hours of the vote, the US Chamber of Commerce (the Chamber) vowed to challenge the Final Rule in court and filed a lawsuit the next day in the US District Court for the Eastern District of Texas.

The Chamber, in a statement, argues that “the FTC has never been granted the constitutional and statutory authority to write its own competition rules” and seeks to “block [the] . . . rule and put other agencies on notice that such overreach will not go unchecked.” Additional litigation over the ban’s legality is anticipated.

Another lawsuit was filed in the US District Court for the Northern District of Texas by a private tax services firm, Ryan, LLC, challenging the Final Rule.

DOES THE FINAL RULE MATERIALLY DIFFER FROM THE PROPOSED RULE?

Yes. The notice of proposed rulemaking (Proposed Rule) concerning noncompetes published on January 19, 2023, would have rendered all noncompete agreements unenforceable. As noted above, unlike the Proposed Rule, the Final Rule leaves existing noncompete agreements with “senior executives” undisturbed.

Additionally, as noted below, the Final Rule doesn’t impose an ownership threshold for its sale-of-business exception.

IS THERE A SALE-OF-BUSINESS EXCEPTION?

Yes. There is a sale-of-business exception to the Final Rule’s prohibition against noncompete agreements.

Unlike the Proposed Rule, the Final Rule does not impose an ownership threshold for the exception to apply. The Final Rule “does not apply to non-competes entered into by a person pursuant to a bona fide sale of a business entity.”

WHAT ABOUT PENDING LITIGATION INVOLVING NONCOMPETES?

The Final Rule provides that it “does not apply where a cause of action related to a non-compete accrued prior to the effective date.” This includes, for example, where an employer alleges that a worker accepted employment in breach of a noncompete if the alleged breach occurred prior to the effective date. The FTC explained that “[t]his provision responds to concerns that the final rule would apply retroactively by extinguishing or impairing vested rights acquired under existing law prior to the effective date.”

WHAT ARE THE IMPLICATIONS OF THE FINAL RULE FOR NONPROFITS?

Pursuant to Section 5 of the Federal Trade Commission Act (the Act), the FTC’s proffered authority for the Final Rule, the FTC may only enforce the Act against “persons, partnerships, or corporations.” The Act defines the term “corporation” as an entity “organized to carry on business for its own profit or that of its members.” Therefore, nonprofits, like many health systems and hospitals, may be beyond the enforcement ambit of the FTC and exempted from the Final Rule. Merely claiming tax-exempt status, however, does not suffice.

Specifically, the Final Rule warns that “[m]erely claiming tax-exempt status in tax filings is not dispositive.” Courts and administrative law judges have scrutinized actual private benefits being derived by an organization’s members to assess the FTC’s jurisdiction over tax-exempt organizations.

In assessing its jurisdiction to enforce the Final Rule, the FTC will likely examine:

• Whether there is “an adequate nexus between an organization’s activities and its alleged public purposes” and whether “its net proceeds [are] properly devoted to recognized public, rather than private, interests.”
• The “source of the income, i.e., … whether the corporation is organized for and actually engaged in business for only charitable purposes, and … the destination of the income, i.e., … whether either the corporation or its members derive a profit.”

For example, the FTC “has exercised jurisdiction … over a physician hospital organization [which consisted of over 100 private physicians and one non-profit hospital] because the organization engaged in business on behalf of for-profit physician members.” There, the nonprofit label did not shield the entity from the FTC’s jurisdictional reach because the entity was “organized for the pecuniary benefit of its for-profit members,” the FTC noted.

Further, the Final Rule explained that Internal Revenue Service (IRS) precedent examining purportedly tax-exempt nonprofit hospitals and other related entities that partner with for-profit entities found the entity loses tax-exempt status where the purportedly nonprofit entity “has ceded effective control” to a for-profit partner, thus “conferring impermissible private benefit.”   Additionally, “the IRS has also rejected claims of nonprofit tax-exempt status for entities that pay unreasonable compensation, including percentage-based compensation, to founders, board members, their families, or other insiders.”

Within a nonprofit health system, additional scrutiny may be warranted for the following operations, among others:

• Physician hospital organizations, independent physician associations, clinically integrated networks and accountable care organizations
• Health plans
• Joint ventures with for-profit entities
• Taxable and for-profit subsidiaries

Overall, some nonprofit entities may be subject to the Final Rule’s ban on noncompetes; however, a case-by-case analysis is required to make a fact-specific determination of the FTC’s enforcement jurisdiction and a nonprofit organization’s exposure to the Final Rule.

HOW CAN CORPORATIONS PROTECT CRITICAL BUSINESS INTERESTS THAT HAVE LONG BEEN SAFEGUARDED BY NONCOMPETES?

There are alternatives to noncompete agreements that do not run afoul of the Final Rule and that firms should consider implementing or refining in anticipation of the Final Rule’s effective date, including:

• Nondisclosure agreements (NDAs)
• Training-repayment agreements (TRAPs)
• Customer and employee nonsolicit agreements
• Employee no-hire agreements

The Final Rule provides that the definition of a noncompete agreement “does not categorically prohibit other types of restrictive employment agreements,” including those listed above.

The restrictive covenants, however, cannot be so onerous that they function as a noncompete agreement in operation. A restrictive covenant may function as a noncompete that violates the Final Rule if it has the same effect as a noncompete – by, for example, substantially restricting worker mobility. This is a highly fact-specific inquiry. For example, a TRAP program that requires minimum wage workers to repay tens of thousands of dollars in training expenses or requires workers to repay all compensation earned over three years if they leave before a defined period of time “may be functional non-competes because, faced with significant out-of-pocket costs for leaving their employment . . . workers may be forced to remain in their current jobs, effectively preventing them from seeking or accepting other work or starting a business,” the Final Rule noted. A customer nonsolicit or employee no-hire agreement could similarly satisfy the definition of a noncompete under the Final Rule if it was so restrictive as to prevent a worker from seeking or accepting other work or starting a business after their employment ends.

• State and Federal Laws Protecting Trade Secrets

Trade secrets are protected against misappropriation by state and federal statutes. The District of Columbia and 47 states have adopted the Uniform Trade Secrets Act (UTSA) or a version of UTSA. On the federal level, the Defend Trade Secrets Act (DTSA) of 2016 provides a civil cause of action under federal law for trade secret misappropriation. DTSA and most state trade secret statutes provide injunctive relief, compensatory and punitive damages and the recovery of attorneys’ fees.

Additionally, federal statutes such as the Computer Fraud and Abuse Act and the Economic Espionage Act provide an additional backstop to protect competitively sensitive information.

WHAT HAPPENS IF THE FINAL RULE IS VIOLATED?

The FTC may either pursue an “adjudication” (an administrative complaint that is filed against an organization and redressed by an administrative law judge) under section 5(b) or seek an injunction in federal court under section 13(b). In both instances, the FTC bears the burden of proof. Final FTC decisions stemming from adjudications may be appealed to a US Court of Appeals.

The FTC cannot obtain civil penalties or other monetary relief against parties for violating the Final Rule, although it can obtain civil penalties in court if a party is ordered to cease and desist from a violation and fails to do so. Importantly, the FTC issued the Final Rule pursuant to the FTC Act, which does not provide for a private right of action for violations of the Act.

Companies should be aware that employees and competitors have the right to submit complaints to the FTC regarding noncompliance with the Final Rule, and the FTC has the authority to initiate investigations that are typically burdensome and costly. The FTC frequently issues civil investigative demands (CIDs) to investigation subjects to compel production of documents, data and information related to the investigation. CIDs are enforceable in court, and firms typically retain litigation counsel to ensure compliance and minimize exposure during investigations.

Companies should consult with counsel to assess their existing use of noncompetes and other restrictive covenants before the Final Rule’s effective date. They should also work with counsel to discuss additional strategies to protect competitive interests without running afoul of the Final Rule.

IMMEDIATE NEXT STEPS

For any questions regarding the Final Rule, please contact your regular McDermott lawyer or one of the authors of this article. McDermott will report on additional developments as litigation challenging the Final Rule proceeds.