FTC Proposes Ground-Breaking Rule Banning Non-Compete Clauses in Employment Contracts Nationwide

By Joshua R. Woodard, Jennifer R. Yee, Anne E. Dwyer, and Delilah R. Cassidy

On January 5, 2023, the Federal Trade Commission (“FTC”) proposed a sweeping rule that would ban the use of non-compete provisions in employment contracts and require employers to nullify any existing non-compete clauses within six months. Other than certain agreements related to the sale of a business and businesses exempt from the FTC Act, the proposed rule applies across the board to all employees and independent contractors, paid and unpaid workers, and businesses no matter their size or location.

The proposed rule’s breadth goes beyond banning standard non-compete agreements. Any contract term that effectively prevents the employee from seeking or accepting employment or from operating a business after leaving their employer violates the FTC’s proposed rule. Examples of such “de facto” non-compete clauses are: (i) non-disclosure agreements written so broadly to effectively prevent the worker from working in the same field, and (ii) provisions requiring employees whose employment ends before a certain period of time to pay their employer for training costs not reasonably related to costs the employer actually incurred to train them. The proposed rule is silent about non-solicitation agreements.

The lone exception in the proposed rule is for a non-compete clause entered into by a person who is selling, or otherwise disposing of, their entire 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 agrees to the non-compete clause. 

“Substantial owner, substantial member, and substantial partner” is defined as an owner, member, or partner holding at least a 25 percent ownership interest in a business entity. Such a 25 percent threshold, if enacted, would have far-reaching implications in many asset sale transactions where sellers who have less than a 25 percent ownership interest could not be bound by a non-compete, despite owning a potentially sizable portion of the business asset being sold. Non-compete clauses covered by this exception, however, would remain subject to federal antitrust law and other applicable law.

While the proposed rule is unprecedented federal action, three states—California, North Dakota, and Oklahoma—already prohibit non-competes in most instances, and dozens of other states’ laws constrain the use of non-competes in various ways. 

Additionally, there have been increased federal efforts by the Biden Administration to combat this common employment practice. In a July 2021 executive order, President Biden recommended the FTC take action to limit or ban non-competes using its authority under Section 5 of the FTC Act, which prohibits unfair competition. The day before the proposed rule was announced, the FTC did just that—using Section 5 for the first time to find that three companies and two individuals imposed violative non-compete agreements on their employees. Considering these recent efforts, the FTC’s proposed rule is not a surprise to many.

The FTC’s press release on the proposed ban proffers that the use of non-compete agreements “suppresses wages, hampers innovation, and blocks entrepreneurs from starting new businesses.” As non-compete usage transcends industries and pay grades, the proposal could potentially affect thirty million workers. The FTC will accept public comment on the proposed ban for 60 days and issue a final version after reviewing the comments. The final version will take effect 180 days after it is published.

In light of the potential widespread impact and the FTC’s new reliance on Section 5, it is likely that any final rule will face legal challenges, potentially providing employers and businesses additional time to determine their desired next steps to best safeguard their protectable interests.

Nevertheless, employers should consider auditing their employment contracts for non-compete and possible de facto non-compete provisions and then assess the respective scope of each. Do the restrictions only apply to executives? Are they of uniform duration? Are they tailored based on location? Employers should then consider assessing the purpose of that non-compete in the context of their business structure and strategy. Is it to protect confidential information or intellectual property? Is it to preserve customers’ goodwill? It is to protect an investment in employee development? Even in the absence of the FTC’s proposed rule, these are questions that employers should consider even in jurisdictions that permit non-compete agreements.

With a firm grasp on their business needs, employers should consider their plan to adjust accordingly. Whether it is drafting new non-disclosure covenants to protect confidential information, reviewing hiring criteria and compensation packages, or consulting with legal counsel to understand how it can protect their business interests within the constraints of state and federal law.