Under FTC’s New Proposed Rule, Employers Will No Longer Be Able to Rely on Noncompete Agreements

The Federal Trade Commission (FTC) has proposed a rule that would prohibit the use of noncompete agreements in employment contracts. Noncompete agreements prevent employees and independent contractors from pursuing certain forms of employment – such as working for a competing employer or starting a competing business – after their relationship with the hiring entity ends. The FTC’s rule would provide that noncompete agreements are an unfair method of competition in violation of Section 5 of the Federal Trade Commission Act. As a result, employers would be required to rescind any existing noncompete agreements with workers and take measures to inform their employees that such agreements are no longer in effect.[1]

In justifying its proposed rule, the FTC published a thorough Notice of Proposed Rulemaking (NPRM) detailing the current effect of noncompete agreements on competition. According to the NPRM, noncompete clauses bind one in five workers in the U.S., approximately 30 million workers. The FTC alleges that this use of a large number of noncompete clauses across an entire labor market affects the opportunities of all workers in that market – materially reducing wages, preventing workers from pursuing better opportunities, and preventing employers from hiring the best available workers. The FTC estimates that banning the use of noncompete agreements could increase workers’ earnings throughout the workforce by $250 billion to $296 billion per year.

For 60 days from January 5, 2023 – when the NPRM was released – the FTC will be accepting comments from the public to take into consideration before announcing its official regulation. Specifically, the agency seeks comments regarding potential alternatives to its proposed rule, including whether the rule should impose a categorical ban on non-compete clauses or a rebuttable presumption of unlawfulness, and whether certain categories of workers like franchisees or senior executives should be exempt from the rule or subject to a different standard.

The FTC’s authority to make such a regulation will almost certainly be challenged in court. While existing law on noncompete agreements varies across jurisdictions, nearly all states enforce noncompetes at least under certain circumstances. Whether a noncompete clause will be enforced typically depends upon the relevant industry, the territoriality and duration of the noncompete clause, and the reasonableness of enforcing the clause in the given instance.  For example, in California, noncompete agreements are generally prohibited with a narrow exception for noncompetes executed in connection with the sale of a business entity or subsidiary. See Cal. Bus. & Prof. Code §§ 16600, 16601. The FTC’s proposed rule contains a similar carveout for noncompetes executed in connection with the sale of a business.

Notably, given the variety of state law approaches to non-compete agreements, the FTC’s proposed rule would preempt dozens of narrower state laws. Under the Supremacy Clause of the U.S. Constitution, federal law preempts any state law with which it conflicts. Where agencies – such as the FTC – implement federal statutes, they can expressly preempt conflicting state laws. See, e.g., Fid. Fed. Sav. & Loan Ass'n v. de la Cuesta, 458 U.S. 141, 154-155 (1982).  However, agency’s regulations must be within the agency’s power – they must not be “unreasonable, unauthorized, or inconsistent with the underlying statute.” Id., 154. Here, the FTC points to the broad language found in Section 5 of the Federal Trade Commission Act empowering the agency to regulate any “unfair competition,” and the NPRM specifically argues that the aggregate effect of all the noncompetes rises to the level of “unfair competition” that the FTC is authorized to tackle. Based on this authority, the FTC has included an express preemption provision in its rule, preempting narrower state laws that conflict with this proposed ban while explicitly allowing for those state statutes which provide workers greater protection to survive. However, such expansive use of Section 5 will likely invite lawsuits alleging that the rule is beyond the FTC’s authority. If the FTC violated the nondelegation doctrine or the major questions doctrine, as Commissioner Wilson has raised in her dissent to the proposed rule, the proposed ban must be stricken.

While there will no doubt be numerous legal challenges to the rule, the immediate impact of the rule should be taken seriously. Employers should review their existing noncompetes and other restrictive covenant agreements with employees to determine whether they are at risk of rescission in connection with the FTC’s proposed rule. Notably, the FTC’s proposed rule extends to “de facto” noncompete clauses – i.e., other contractual provisions that have the effect of prohibiting workers from seeking other employment or operating a business after their relationship with the hiring entity ends. This will likely lead to many comments during the 60-day notice period and eventual litigation around the use of broadly drafted nondisclosure agreements, non-solicitation provisions, patent assignments that trail employees after their departure, or agreements to repay or forfeit an employment-related benefit if the worker resigns before a specified date.  Employers might consider revising such agreements to ensure they are as narrow in time, scope, and geographic area as possible so that the clauses be deemed reasonable by a reviewing court.  Employers should also ensure that their employment agreements with high-value employees contain robust confidentiality provisions and trade secret protections that come with agreed-upon injunctive relief provisions, but that those provisions are not drafted so broadly as to prevent an employee from working in a given field.[2]