Report on Federal Trade Commission Proposed Rule

REPORT ON FEDERAL TRADE COMMISSION PROPOSED RULE 

FTC Notice of Proposed Rulemaking, Non-Compete Clause Rule (proposed Jan. 5, 2023) (to be codified at 16 CFR § 910)

A RULE that provides, among other things, that it is an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker; to maintain with a worker a non-compete clause; or, under certain circumstances, to represent to a worker that the worker is subject to a non-compete clause.

This Proposed Rule is Disapproved

The New York City Bar Association (“City Bar”) does not support the Federal Trade Commission’s proposed Non-Compete Clause Rule (“Proposed Rule”).[1]  We suggest that, if federal action is warranted, certain alternatives to the Proposed Rule, such as the promulgation of guidelines, would be more appropriate given the long-standing and developing law in various states and the limited research and data currently available with respect to how non-compete agreements work in the myriad employment law situations in which they may arise.  As discussed in Section V below, the City Bar considers guidelines to be more consistent with the FTC’s practices and knowledge.  Guidelines may also be more readily revised than a rule, facilitating the FTC adjusting its policy as it gains experience in this area.

If adopted, the Proposed Rule would broadly ban virtually all non-compete clauses with workers as an “unfair method of competition” under Section 5 of the Federal Trade Commission Act.  It would also retroactively invalidate existing non-compete agreements with workers.  The Notice of Proposed Rulemaking (“NPRM”) follows the FTC’s November 2022 statement articulating an expansive view of the scope of its authority to challenge “unfair methods of competition” under Section 5 of the FTC Act.[2]  The day before the NPRM was announced, the FTC also announced two uncontested enforcement actions, challenging three companies’ noncompete clauses as violating Section 5.[3]

The Proposed Rule raises several threshold questions pertaining to: the FTC’s authority to adopt conduct rules generally; its authority to engage in rulemaking premised only on “unfair methods of competition” more specifically; the Proposed Rule’s retroactive invalidation of already executed agreements; and the resulting legality of the Proposed Rule in light of these questions, especially given the extensive and longstanding State regulation in this area and the major question doctrine.[4]  Moreover, the Proposed Rule (1) raises federalism considerations in light of the many state laws addressing non-competes; (2) is based on insufficient research and data on the effects of non-compete agreements in different employment contexts; (3) does not stand up to scrutiny under an antitrust law analysis; and (4) raises significant concerns in the business sale and capital structuring context.  The City Bar’s view is that the adoption of guidelines is more consistent with the level of the FTC’s expertise and would likely better withstand judicial scrutiny predicated on any or all of the above questions.

I. State Law

Beyond the threshold questions noted above, there may also be federalism considerations, given the numerous state laws addressing non-competes.[5]  Indeed, for more than 200 years, and continuing recently at an increased pace,[6] non-competition agreements have been regulated by the States.  State legislatures and courts have repeatedly addressed relevant interests, to establish and adjudicate the circumstances under which non-competition agreements may be enforced.  Much of this required carefully balancing to appropriately reflect the circumstances presented.

New York’s highest court, the Court of Appeals, has recognized that a non-competition agreement may be enforced “to forestall unfair competition,”[7] and New York courts have recognized legitimate employer interests that support enforcement of non-compete agreements to include the protection of trade secrets and confidential information, the employer’s client base, customer relationships and good will, as well as protection against irreparable harm where the employee’s services are unique or extraordinary.  In BDO Seidman v. Hirshberg, 93 N.Y.2d 382, 391 (N.Y. 1999), a leading New York case on enforcement of non-competes, the Court of Appeals noted:  “Professor [Harlan] Blake, in his seminal article in the Harvard Law Review, explains that the legitimate purpose of an employer in connection with employee restraints is ‘to prevent competitive use, for a time, of information or relationships which pertain peculiarly to the employer and which the employee acquired in the course of employment’ (Blake, op. cit., at 647).”

The Proposed Rule asserts that measures other than non-competes are “viable alternatives” to non-competes for protecting employers’ legitimate business interests, including trade secrets laws and nondisclosure/confidentiality agreements.  The assertion does not adequately consider the actual experience in the States on this issue, and does not fully credit other significant factors that justify non-competes.  In fact, the FTC concedes that these alternatives “may not be as protective as employers would like,” but asserts that they “reasonably accomplish the same purposes as non-compete clauses while burdening competition to a less significant degree.”[8]

The Proposed Rule notes the example of California’s ban on most non-competes, but proposes a rule concerning selling business owners that is more restrictive than California’s, and that could jeopardize and devalue the sales of closely-held and family businesses, when the number of owners exceeds four, and owners hold ownership stakes of less than 25%.

Over the last several years, many states have recognized a need for greater protection of low wage earners, and have responded with legislation appropriate for those states.[9]  In addition, several states Attorneys General, including New York’s, have acted on behalf of their citizens, to foreclose enforcement of non-competes against low wage and hourly workers.[10]  These solutions are both less disruptive, and more focused, than the Proposed Rule.

In 2021, the City Bar’s Trade Secrets Committee issued a report, “Legislating Fairness: Regulating the Use of Noncompetes for Lower-Salary Employees February 2021”.[11]  In that Report, the Trade Secrets Committee recommended legislation that would substantially restrict the use of non-compete agreements for lower-wage employees, while preserving the flexibility of New York’s common law approach, which recognizes important commercial considerations for New York’s economy.  The Trade Secrets Committee recommended a New York State statute imposing a presumptive prohibition on non-compete agreements for employees whose salaries fall below a statutorily-defined limit.  The presumptive prohibition would be rebuttable when the non-compete is for the protection of protectable interests recognized under decades of New York common law (e.g., trade secrets, protectable customer relationships, employees possessing unique skills or expertise), and when (1) the employer agrees to pay the affected employee’s full pro-rated compensation for the duration of any non-competition period; and (2)  the employee was provided with notice, prior to the employee’s agreement to enter into the employment relationship, of any non-compete agreement and of the employer’s intention to enforce the non-compete with respect to the particular position.

In preparing its Report, the Trade Secrets Committee reviewed and reaffirmed New York’s common law in this area.  The Committee recognized the strength of New York’s well-developed decisional law in the area of trade secrets and non-competes, and that this jurisprudence serves New York’s enterprise economy by allowing flexibility to enforce non-competes where reasonable and necessary.  Other states have passed or proposed legislation similar to that recommended in the Trade Secrets Committee Report.[12]  These alternatives, focused on the same competitive concerns espoused by the FTC,  offer more focused solutions than the Proposed Rule.

II. The Proposed Rule is Based on Insufficient Research and Data

The City Bar recognizes both the breadth and limitations of the research cited in the NPRM to support the proposed rules.  The FTC’s justification for the Proposed Rule is predicated on data highlighting anticompetitive effects of non-compete clauses—specifically, on research suggesting that the prevalence of non-compete agreements results in lower pay for workers subject to such clauses; lower pay for other workers because of the aggregate effects on the labor market; potential harm to competition in products and services; and potential harm to innovation.[13]  The NPRM cites multiple studies suggesting that non-compete agreements are generally problematic in certain employment contexts, such as when applied to entry-level and low wage positions.  Virtually all research cited in the NPRM indicates that non-compete clauses reduce labor mobility and job turnover.  With a few exceptions, the research cited supports the Commission’s conclusions that non-compete clauses for low-wage workers result in lower wages and earnings.  However, some research finds that non-compete clauses can have beneficial effects, namely with respect to increasing employee training and investment, and also to increased employment levels.[14]  Moreover, relatively little of the empirical research systematically evaluates how non-competes affect low-wage workers, specifically.[15]  More generally, the data offer weak support to a conclusion that non-compete agreements are harmful to groups such as company executives and higher paid workers, where there is no “unequal bargaining power” between the parties, or where non-competes reasonably protect a business’s legitimate interest and are otherwise not exploitative.  In fact, the NPRM has specifically requested more information on the impact of non-competes, suggesting that adoption of any rule, particularly one as broad and far-reaching as the Proposed Rule, is inappropriate and premature.[16]

The City Bar suggests that additional data gathering is warranted in a number of areas:

First, it is crucial to consider whether the Proposed Rule could result in unintended “unfair” consequences for employers, employees and/or consumers across industries.[17]  For example, if non-competes suppress compensation and a prohibition will allow compensation to rise, what impact would a prohibition have on employment levels?[18]

The NPRM cites no data to identify or address potential unintended consequences of the application of the Proposed Rule to former employees with non-competes, or regarding the proposed identification of “de facto” non-competes.  The application of the Proposed Rule to former employees and other former workers, for example, would require firms to furnish individualized notice that restrictions are rescinded, an administrative task that may take substantial time and resources.[19]  Where non-competes are the consideration for employment, separation and other compensation agreements, substantial additional work will be required around restructuring the agreements, work that cannot be achieved unilaterally by the employer.  If previously entered non-competes are invalidated, thorny questions arise about consideration previously paid or promised to be paid in the future in exchange for the invalidated restrictions.  For example, an employee subject to a post-employment covenant corresponding to a severance payment period could experience a cessation of payments or clawback demand.  The costs of these activities may be prohibitive for many employers, who, depending on the circumstances (e.g., if a newly released employee begins competing), may find themselves less able to afford the additional costs of compliance.  The application of the Proposed Rule to existing agreements will likely prove particularly problematic in an M&A context, where post-closing compensation is frequently negotiated on the basis that a broad and presumptively valid non-compete covenant can be included in the employment agreement.  The value of any disputes arising from forced rescission under the Proposed Rule may be greater than under non-M&A-related agreements.  In short, the Proposed Rule would upset reasonable expectations based on existing law as well as impermissibly modify the legal consequences of past actions.[20]

Second, the NPRM suggests that non-disclosure agreements and trade secret law may be used in place of non-competes to protect employers, but does not provide any evidence about the efficacy of these mechanisms, or address the actual experience with these laws in the fifty states.  For example, enforcement of a trade secret or a non-disclosure agreement may be a costly and lengthy process that attempts to shut the barn door after the horse has escaped.  And non-disclosure agreements can over- or under- deter, depending on their enforcement, rendering them anywhere between ineffective and de facto non-competes.[21]  The NPRM assumes, moreover, that ordinary non-disclosure agreements would remain enforceable.  However, non-disclosure agreements themselves are being restricted, making them potentially less available over time to protect legitimate employer interests than at the time the NPRM was issued.[22]  More data is thus needed on the costs and benefits of these alternatives.

Third, the NPRM observes that companies are successful in states where non-competes are unenforceable (even if still often ubiquitous),[23] but provides no significant quantitative or qualitative cross-state data to compare company success or competition.

Fourth, even if one were to assume a correlation between non-competes and the harms cited by the FTC, the NPRM lacks data to measure whether other justifications for non-competes offset the harms in some instances.  For example, an entry-level worker may have detailed information about specific trade secrets, which may suggest that the need for a targeted restriction to protect the company’s secret business information outweighs potential harm in that situation.

Finally, where the data support a conclusion that non-compete agreements are problematic, and even assuming the FTC’s jurisdiction in this area, there still remains the question of the appropriate remedy.  Specifically, the NPRM does not clearly articulate why rulemaking would necessarily be the appropriate remedy, even if it were a valid exercise of the Commission’s authority—as opposed to, for example, the publication of guidelines, a more traditional remedy the FTC has successfully implemented in several areas.[24]

Given that the data in the NPRM do not adequately identify and address the benefits and harms of non-compete agreements and the different ways in which non-compete agreements arise in the employment context, the issuance of a blanket per se rule that would apply broadly to all groups of workers in all situations is controversial and, in the view of the City Bar, likely counterproductive.  A more modest approach, which recognizes both the strengths of the data collected to date and their limitations, would be advisable.

III. Antitrust Analysis

Consistent with modern-day antitrust jurisprudence, non-compete agreements should not be the subject of a blanket per se ban.  In antitrust law, per se rules of illegality have been adopted “only when they relate to conduct that is manifestly anticompetitive”, Cont’l T. V., Inc. v. GTE Sylvania Inc., 433 U.S. 36, 50 (1977), such that the court “can predict with confidence that [the type of restraint at issue] would be invalidated in all or almost all instances.”  Nat’l Collegiate Athletic Ass’n v. Alston, 141 S. Ct. 2141, 2156 (2021) (internal citation omitted).  In fact, there has been a trend in antitrust case law away from per se illegality and towards a fact-specific rule of reason analysis.  For example, courts have moved from treating tying claims as per se illegal to analyzing virtually all such claims under the rule of reason, recognizing that tying may be anti- or pro-competitive, depending on the circumstances.  Similar changes in the law have occurred with respect to vertical market allocation and retail price maintenance.[25]

For over 100 years, federal and most state courts have rejected per se bans on non-compete agreements, as they consistently recognize that non-compete clauses may have a broad spectrum of competitive effects.[26]  This broad spectrum is in fact supported by some of the studies cited in the NPRM.  The FTC posits that the proposed rule addresses an antitrust problem, arguing that non-competes are often followed by lower wages and reflect monopsony power on the part of employers.[27]  But such monopsony power may exist only in certain industries or markets, and affect only some employees in those industries or markets.

As noted above, the FTC’s data are much less robust with respect to effects of non-compete agreements in other circumstances.  In particular, the FTC does not present robust data showing anticompetitive effects on products and services.  Moreover, the FTC’s data are at most neutral and likely suggest some pro-competitive benefits of non-compete clauses in terms of their effect on employers’ incentive to invest in employee training and in terms of their effect on innovation.[28]  The NPRM also cites data which suggest that, while non-compete agreements are problematic in certain situations, they do offer concrete benefits in other circumstances – for example, when applied to high-level executives, in industries that depend on heavy investment in employee training, and in innovation-driven industries.

These disparate effects of non-compete clauses in different circumstances strongly suggest that a “one size fits all” blanket rule declaring all non-competes illegal per se is inappropriate.  Indeed, a rule that would apply uniformly to all workers, regardless of industry, role or responsibility, would likely outlaw extensive economic activity that is not anticompetitive or “unfair”, but procompetitive and welfare-enhancing.  Therefore, we believe that non-compete agreements should continue to be assessed under a more nuanced set of rules akin to the rule of reason approach.  By adopting guidelines, the FTC can allow for a nuanced approach while still addressing the concerns raised in the NPRM.

IV. Non-Competes in Business Sales, Business Combinations and Capital Structure Transactions

The NPRM appears to state that non-compete agreements that are not entered into with workers are not covered by the Proposed Rule, but the Proposed Rule lacks clarity and is unduly restrictive on this point, ignoring the substantial experience in the fifty states regarding covenants entered into by business owners.  While the City Bar does not believe the FTC should issue the Proposed Rule, and is not addressing many of the substantive concerns with specific provisions of the Proposed Rule, the City Bar does address some of the specific concerns that arise in a business sale and capital structuring context.  These concerns are significant, particularly because the values of numerous sales of businesses are dependent upon effective non-competes, and, if existing non-compete covenants are required to be rescinded on the enforcement date of the Proposed Rule, the consideration for prior and prospective payments under those existing agreements will be called into question, and the existing value of many closely held and family businesses will be undercut.[29]

A. Sale of Business Transactions

Courts have long recognized that covenants not to compete entered into in connection with the sale of a business are to be more liberally enforced than those entered into in a pure employment context.[30]

Section 910.3 of the Proposed Rule contains an exception from the Proposed Rule’s general prohibition of non-compete covenants for covenants entered into in connection with the sale of a business or a substantial equity interest in a business, but the exclusion is so narrowly drawn as to make it inoperative for many sales.  Although the City Bar endorses neither a national standard, nor the use of any individual state’s laws as the basis for a national standard, we note that California, North Dakota and Oklahoma, the three states that have imposed the most severe restrictions on non-compete covenants, permit non-compete covenants for selling owners under a more flexible approach than that set forth in § 910.3.[31]  Indeed, at a minimum, the FTC failed to consider the actual experience of thousands of buyers and sellers of businesses under these well-established standards, and the impact such experience should have on any standard the FTC considers.

In order to fall within the § 910.3 exception in the Proposed Rule, the party bound by the non-compete must be at least a 25% owner of the relevant business entity at the time of the transaction and, in a transaction structured as a sale of equity, is required to dispose of all of such party’s ownership interest in the business.  These constraints will result in the exclusion being available in only an arbitrary set of cases.  The value of a business is equally threatened by competition from a 24% or 26% owner as well as, potentially, much smaller owners.  The requirement that the seller hold a 25% ownership stake in the business entity in order to be subject to an enforceable non-compete would reflect a departure from current M&A practice and would be disruptive to the market for purchases and sales of businesses, particularly those that are privately held.  Comparable businesses being considered for purchase would be valued based not only on their operating results but also on the distribution of their capital stock.

When a selling owner contracts to provide post-closing services to the target business, it is typical for the parties to enter into both an unconditional non-compete covenant for a set period of time and a second non-compete covenant that continues for a year or two after the selling owner ceases to be employed.  There is no rational reason that the value and goodwill preservation function of these unconditional non-compete covenants should be undermined by the continued employment of a selling owner.  A covenant tied to worker status may be fair and appropriate within a framework that recognizes the unique value of such post-closing service arrangements in protecting the value of the business sold.

The City Bar believes that it is fair and appropriate for an enforceable non-compete to be based on (1) a much lower minimum ownership threshold,[32] or, (2) the receipt of substantial proceeds from a business sale or disposition of capital stock.[33]  In any case, the issue needs to be carefully considered in light of many years of real world experience, and any policy adopted by the FTC should be grounded in data supporting the consistency of such requirements with the transaction practices that buyers and sellers of businesses have determined over time, at arms’-length, to be necessary to protect the value and goodwill of businesses sold.  The FTC has recognized in the NPRM that non-competes between buyers and sellers of businesses have not yet been subject to the same types of empirical studies as non-competes entered into in a pure employment context, and such data is essential before the FTC adopts any views on the matter.

The Proposed Rule requires that an owner dispose of all equity in the business as a condition to the creation of an enforceable non-compete covenant.  This requirement would inappropriately prevent the entry into a non-compete with a selling owner whose interests are aligned with those of the purchaser through the retention of an equity stake in the business, even though such a transaction structure is often seen as enhancing value and ensuring that the seller and buyer are equally committed to the effective transfer of the goodwill of the business.  This requirement also wrongly disregards the receipt by sellers of rollover equity consideration and/or stock options and other equity-based incentives.

In its effort to preserve worker mobility and protect low wage workers, there is no reason why the FTC should adopt methods such as the Proposed Rule, which could radically undercut a key aspect of the economy and the value of businesses built through years of effort.

B. Considerations Relative to Executives and Other Key Employees

The entry into non-competition covenants by executives and other key employees is often critical to the success of an M&A initiative, even where these individuals are not substantial equity sellers in the transaction.  The NPRM acknowledges that non-competes entered into with executives and other highly compensated individuals are unlikely to be “coercive” or “exploitative” but contends that they may nevertheless be “unfair” under certain circumstances.  Any determination that such an arrangement is “unfair” is questionable given their critical role in acquisitions, and is likely fact dependent.  In stark contrast to non-competition covenants imposed uniformly on low-level employees, executives and key employees often have substantial leverage in negotiating acquisition-related restrictive covenants, and those covenants are generally integral to a sophisticated post-transaction employment compensation package.  Such individuals may also be the recipients of transaction-related bonuses that substitute for the absence of pre-transaction equity ownership, obtain post-closing equity incentives or otherwise be compensated for their non-competes in a variety of forms.

Employees provided with the opportunity to purchase, or who are granted, material equity in an employer in connection with the purchase or sale of a business are typically required to enter into a non-compete covenant simultaneously as part of a value preservation strategy by the acquiror.  Similar to non-compete covenants entered into by the disposition of equity interests in a seller, non-compete covenants entered into by the purchaser or grantee of interests in an acquiror take place in an environment distinct from a traditional employment relationship negotiation, and have not been the subject of rigorous empirical analysis establishing anticompetitive effects or other harms that justify their inclusion in any policy adopted by the FTC.

V. Guidelines Instead of Rule

As detailed in Section II, there remain significant gaps in data and areas covered by the Proposed Rule that would benefit from further study before any remedy is determined to be necessary or adopted.[34]  It is clear that even with respect to low-wage workers, data is limited.

The City Bar suggests that the FTC consider issuing guidelines to inform businesses and the public of its interpretation and intended enforcement policy of Section 5 of the FTC Act with respect to non-compete agreements, rather than issuing a rule.  These guidelines should be informed by the substantial body of state common and statutory law on non-competes.  Guidelines would be more consistent with FTC practices and, as noted above, may avoid some of the thorny threshold constitutional, jurisdictional and procedural issues that the Proposed Rule may raise.  Guidelines may also be more susceptible to future revisions, enabling the FTC to develop its policy as it gains more experience in this area.  We suggest that these guidelines consider the substantive steps taken or being considered by many states, distinguishing between different groups of workers.

Existing antitrust guidelines issued by the FTC—such as the Antitrust Guidelines for the Licensing of Intellectual Property, Horizontal Merger Guidelines, and Antitrust Guidelines for Collaborations Among Competitors[35]–can serve as examples of a framework where guiding principles and general policies are outlined to help an employer predict whether a non-compete agreement will be considered by the FTC to be a violation of Section 5 or an enforceable, pro-competitive measure.  Guidelines can provide a number of benefits, such as greater transparency, predictability, and consistency to the antitrust community (legal practitioners, antitrust economists, scholars, businesses, individuals, and journalists, among others) as to how the agency will generally conduct non-compete investigations and make enforcement decisions.  This involves: identifying the central questions that agency staff will ask during a review of a non-compete; helping businesses and their legal counsel understand the kinds of evidence that will be the focus of agency attention; and explaining how that evidence will be analyzed.  An equally important objective of agency enforcement guidelines is to ensure that the analytical framework adopted promotes sound antitrust policy.  This can be done by connecting the guidelines to economics and other empirical studies.[36]  Guidelines have been effective in other antitrust contexts, and we believe that guidelines would be effective in the non-compete context as well.

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Antitrust & Trade Regulation Committee

Employee Benefits & Executive Compensation Committee

Mergers, Acquisitions & Corporate Control Contests Committee

Trade Secrets Committee

April 2023