More to Consider Concerning the FTC’s Proposed Rule Prohibiting Non-Competition Clauses

Updated 2/9/2023: The proposed rule is open to public comment for a period ending March 20, 2023.

As previously reported by Verrill attorney Tawny Alvarez in the firm’s “Taking Care of HR Business” blog on January 5, 2023, the Federal Trade Commission (FTC) proposed a rule that, as drafted by the FTC, would both prohibit U.S. employers from entering into non-compete agreements with U.S. workers and rescind any existing agreements’ non-compete clauses.

You read that right. From a strategy standpoint, we’re not in a “hurry up and enter into non-compete agreements now before the rule takes effect,” mode, but instead, a “what would the effect of not having non-competes be on my business”.

The proposed rule would apply to an extremely broad range of “workers,” including independent contractors, externs, interns, volunteers, apprentices, or sole proprietors who provide services to employers’ customers. The prohibition would apply not only to contractual clauses that are clearly defined or understood as non-competes, but also to any clauses, however named or styled, that “de facto” serve to prohibit competition—which could include some forms of non-solicitation and non-disclosure provisions depending on how burdensome they prove. The proposed rule is open to public comment for a period ending March 20, 2023.

Commentators surmise that many members of the business community across the country, but particularly in tight labor markets such as New England, either individually or jointly through industry or trade associations, will be submitting comments to the FTC on the potential impact of the proposed rule. This includes to suggest modifications for the FTC’s consideration and to question whether the FTC has appropriately weighed the costs of the rule to employers against the assumed benefits to workers of what in effect would be a near-complete ban on non-compete and many typical non-solicitation and non-disclosure provisions commonly found in employment and consulting agreements.

Our team at Verrill, led by Tawny Alvarez, has been following developments closely, and will continue to do so through the end of the comment period and beyond. There are a number of different concerns that are set forth for many industries, but let’s touch on just a few:

Tax/Employee Benefit Implications:

Bill Jewett, a Partner in Verrill’s Employee Benefits & Executive Compensation Group, notes that “if the proposed rule or even some version of it is finalized and becomes law, it without a doubt will face several legal challenges in the courts.” Bill points out that the proposed rule has far-reaching implications in areas beyond the purview of the FTC, including:

• As drafted, the FTC rule would turn a variety of common compensation arrangements into “ticking tax bombs”. Forfeiture-for-competition clauses are routinely used by tax-exempt employers, such as universities and hospitals, to provide compensation to workers on a tax-deferred basis. If such clauses were to become unenforceable—as appears would be the case per current drafting—all such compensation would become taxable immediately, even if the workers will not receive payment of the underlying compensation per their contracts or other arrangements for many years.

• In mergers and acquisitions, a forfeiture-for-competition clause is often used to reduce the value of IRC Section 280G “golden parachute” payments for purposes of determining whether an excise tax is payable. Executives of public companies who are relying on such a clause to avoid a punitive excise tax would be penalized unexpectedly, and a time-tested, reliable tax planning strategy would in effect no longer be available.

Financing/Mergers & Acquisitions

Kevin O’Connell, Chair of Verrill’s Business Law Group, adds that mergers and acquisitions would be further impacted by the FTC’s proposed rule, should it be enacted:

• Although the proposed rule as currently drafted provides an exception for non-compete clauses that are entered into by a person selling a business or substantially all of a business’s assets, that exception covers only a “substantial” owner, member or partner, which is defined as an owner, member or partner holding at least a 25% ownership interest in the business. Further, the proposed rule’s requirement that employers notify workers that their non-compete agreements are rescinded, if to also apply in the context of the sale of a business, would require buyers to notify individual sellers who held less than 25% ownership of the sold business that their existing sale-of-business noncompete agreements are rescinded.
• As Kevin explains: “Proponents of this new rule argue that this 25% ownership exception should assuage the concerns of M&A dealmakers and deal participants. But it’s nothing that gives me, as counsel to a buyer, any comfort whatsoever. I understand the argument that non-competes for low-level employees should be outlawed, and I can see the argument being made even for high-level employees. But if I’m a buyer of a business, paying millions of dollars for it, I don’t expect to be told that someone that owns, say, 24% of that business and who knows everything about how to run such a business can take his share of the millions I just paid and walk across the street and set up his own competing shop. It’s little comfort to me that I can bar the shareholder who owned 26% but can’t stop the shareholder who owned only 24%. If I’m buying a company, I’m going to want to pay a heck of a lot less if you can’t promise me (or I can’t enforce your promise to me) that you will sit on the sidelines for a few years and won’t use the money I’m paying you for your business to build another business to compete with me.”

Labor and Employment

Tawny Alvarez, identifies multiple concerns that companies should keep at top of mind as it relates to relationships with employees:

• By applying to both employees and independent contractors, companies who currently have exclusivity clauses in agreements with independent contractors would need to remove them—meaning that a contractor can be working with your competitive data from 9 to 1, and your competitors from 2 to 6. While a confidentiality agreement may provide some protection, it’s unlikely to provide employers with the security and confidence they previously provided.
• There is currently no wage element to the proposed rule. Accordingly, employees being paid high six figures for their positions could bounce from one competitor to another with full access and understanding of financials, business plans, and general operations.

Other Areas of Concern

• Franchisee/franchisor relationships. The current proposed rule does except from the definition of worker franchisees in a franchisee-franchisor relationship. While the FTC has asked for comment on this specific issue, it remains unclear how (if at all) the FTC will respond to comments concerning these relationships.
• Employee training. The proposed rule provides that a contract term that requires a worker to pay an employer or third-party for training costs if employment is terminated within a specified time may constitute a non-compete clause if the “required payment is not reasonably related to the costs the employer incurred for training the worker.” For many highly skilled positions, where on-the-job training is the primary form of education, and the time expended to do so is significant, attempting to guarantee employment for a set period of time may become harder to accomplish without specific data concerning the training costs associated with the on-the-job training.

For now, employers should review agreements with employees and third parties to see where they are currently using non-compete clauses. Once this is determined, senior team members should begin consideration of other ways to protect confidential and proprietary information—including additional security measures internally, confidentiality provisions, and reasonable non-solicitation agreements.

Our team at Verrill stands ready to assist our clients and contacts with regard to the FTC’s proposed rule, including to work with employers and others to submit comments on the proposed rule prior to the March 10 closing of the public comment period. If you have questions concerning any of the above, please reach out to any of the quoted attorneys directly, or Tawny Alvarez can direct you to the appropriate resource. We look forward to hearing from you as to how we may be of assistance.