Employers Beware: FTC Announces Final Rule Banning Worker Non-Competes

The purpose of this alert is to provide preliminary high-level guidance on the Final Rule. Further guidance will follow in the coming days as Pillsbury continues to review and analyze this Final Rule.

Gaining Definition
The FTC has revised several definitions to cement the broad scope of the Final Rule.

Non-Compete Clause
The FTC revised the definition of a non-compete clause that it had initially proposed when it published a Notice of Proposed Rulemaking on January 23, 2023. The Final Rule now defines a non-compete clause as a term or condition of employment that either “prohibits” a worker from, “penalizes” a worker for, or “functions to prevent” a worker from “(i) 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 (ii) operating a business in the United States after the conclusion of the employment that includes the term or condition.”

The Final Rule makes clear that the non-compete ban will apply to any terms or conditions that require a worker to pay a penalty for engaging in competition, including liquidated damages, forfeiture-for-competition clauses, and severance agreements that condition payment of severance on compliance with a non-compete.

Notably, however, the Final Rule also explains that non-competes during a period of garden leave, in which the worker is still employed and receiving the same total annual compensation and benefits on a pro rata basis, are not prohibited because such an agreement is not a post-employment restriction.

Workers
After considering the extensive comments, the FTC revised the definition of “worker” to clarify that all current and former workers are covered, regardless of which entity hired or contracted with them to work, and regardless of a worker’s title or status under any other applicable law.

The Final Rule defines “worker” as “a natural person who works or who previously worked, whether paid or unpaid, without regard to the worker’s title or the worker’s status under any other State or Federal laws, including, but not limited to, whether the worker is an employee, independent contractor, extern, intern, volunteer, apprentice, or a sole proprietor who provides a service to a person. The term worker includes a natural person who works for a franchisee or franchisor, but does not include a franchisee in the context of a franchisee-franchisor relationship.”

The FTC specifically declined to specify in the Final Rule whether a “‘worker’ includes an “owner who provides services to or for the benefit of their business” because “the definition already encompasses the same.” Employers, particularly startup companies who rely upon their owners and a host of outside advisors for assistance, must therefore understand that, if the Final Rule takes effect, they will no longer be permitted to enter into non-competes with any individual rendering any services to the company, whether with or without compensation (equity or otherwise).

Limits to the Ban
The ban does not apply to other restrictive covenants so long as they do not function as non-competes.

In the Final Rule, the FTC clarifies that the Final Rule does not cover agreements other than non-competes, such as nondisclosure agreements (NDAs) and non-solicitation agreements, that do not by their terms or necessarily in their effect prevent a worker from seeking or accepting work with a person or operating a business after the worker leaves their job. The FTC explains that, for example, a garden-variety NDA, in which the worker agrees not to disclose certain confidential information to a competitor, would not prevent a worker from seeking work with a competitor or from accepting such work after the worker leaves their job, and, therefore, is still lawful.

However, NDAs will be viewed as unlawful non-competes if they cover such a large scope of information that they function to prevent workers from seeking or accepting other work or starting a business after they leave their job. For example, an NDA that bars a worker from disclosing, in a future job, any information that is “usable in” or “relates to” the industry in which they work would not be permissible.

The Final Rule discusses training repayment provisions, described with the acronym “TRAPs.” These provisions require workers to repay the value of training before or after departing a job. The Final Rule does not categorically ban their use but requires that they do not functionally prevent a worker from seeking or accepting work or starting a business after departing the job, such as when they impose penalties that are disproportionate to the value of training workers received.

Similarly, non-solicitation agreements will be impermissible non-competes where they function to prevent a worker from seeking or accepting other work or starting a business after their employment ends.

Exceptions
The Final Rule contains four express exceptions.

Existing Non-Competes with Senior Executives (But Senior Executives Cannot be Required to Enter into New Non-Competes)
The Final Rule specifically creates an exemption for senior executives with existing non-competes. The FTC explains it created this exception based on “the practical impacts of extinguishing existing non-competes for senior executives.” In addition, the FTC considered the fact that valuations of senior executive non-competes are routinely conducted during many M&A transactions, with acquisition prices reflecting the value of those non-competes to ensure the buyer retains certain talent.

The definition of a “senior executive” includes both an earnings test and a job duties test: The executive must have received total annual compensation in the preceding year of at least $151,164 and be in a “policy-making position.” Total annual compensation may include salary, commissions, nondiscretionary bonuses and other nondiscretionary compensation earned during that preceding 52-week period.

The Final Rule defines “policy-making position” as “a business entity’s president, chief executive officer 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.” The definition of “policy-making authority,” in turn, means “final authority to make policy decisions that control significant aspects of a business entity or a common enterprise.” The definition further states that policy-making authority “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 of or affiliate of a common enterprise.”

To be clear, the exception covers only existing non-competes. If the Final Rule takes effect, employers may not enter into new non-competes with senior executives after the Effective Date.

Non-Competes Entered Into in the Sale of Business Context
In the Notice of Proposed Rulemaking, the FTC proposed an exception for certain non-competes between the seller and the buyer of a business that would have applied only to a substantial owner, member or partner, defined as an owner, member or partner with at least 25% ownership interest in the business entity being sold.

In a bit of good news for those in the M&A world, the FTC has revised this exception and adopted an exception for the bona fide sale of a business without requiring any specific level of ownership interest. The Final Rule does require that such sales are “bona fide” and conducted at arms’ length with the opportunity for the seller to negotiate the terms of the sale, a qualification described as addressing the possibility of repurchase rights for equity granted to employees, or other examples of possible “sham” transactions that could circumvent the Final Rule.

Causes of Action Accruing Before the Effective Date
The Final Rule does not render existing non-competes unenforceable or invalid. Instead, the Final Rule makes it an unfair method of competition to enforce certain non-competes beginning on the Effective Date. Accordingly, actions taken before the Effective Date—for example, enforcing an existing non-compete or making representations related to an existing non-compete—are not unfair methods of competition under the Final Rule.

Good Faith
The Final Rule’s “good faith” exception states: “It is not an unfair method of competition to enforce or attempt to enforce a non-compete clause or to make representations about a noncompete clause where a person has a good-faith basis to believe that this part 910 is inapplicable.”

Application to Nonprofit Organizations
The FTC has stated that the Rule “applies to the full scope of the Commission’s jurisdiction” and will apply to nonprofit, tax-exempt organizations, if they are “organized to carry on business for their own profit or the profit of their members.” Citing both FTC precedent and court decisions, the FTC has stated that it will look to both “the source of the income, i.e., to whether the corporation is organized for and actually engaged in business for only charitable purposes, and to the destination of the income, i.e., to whether either the corporation or its members derive a profit.” Unfortunately for most nonprofit associations, there are not clear bright-line checklists on which they can rely. The preamble to the Final Rule notes that “The Commission cannot predict precisely how many entities claiming nonprofit tax-exempt status may be subject to the Final Rule. The Commission finds that the benefits of the Final Rule justify implementing it no matter how many nonprofit entities claiming tax-exempt status it ultimately reaches—including under the unlikely assumption that it does not reach any of them.” Nonprofit organizations wishing to incorporate noncompete provisions in future employment contracts would be prudent to consult counsel for advice on the application of the Final Rule to them.

Interaction with State Law
State laws that restrict non-competes and do not conflict with the Final Rule are not preempted. The Final Rule makes clear that states may continue to enforce in parallel laws that restrict non-competes and do not conflict with the Final Rule, even if the scope of the state restrictions is narrower than that of the Final Rule. Similarly, states that have broader scope restrictions—such as California’s prohibition on non-solicitation clauses—may continue to enforce those restrictions. State laws, however, cannot authorize non-competes that are prohibited under the Final Rule.

No Rescission, But Required Notice
The Final Rule does not require rescission of existing non-competes, but it does prohibit enforcement of existing non-competes after the Effective Date, other than with respect to senior executives or as subject to other exceptions in the Final Rule. The Final Rule requires the employer or person who entered into the non-compete with the worker to provide clear and conspicuous notice to the worker, by the Effective Date, that the worker’s non-compete will not be, and cannot legally be, enforced against the worker.

This notice must identify the employer or person who entered into the non-compete with the worker and must be delivered by hand to the worker, or by mail at the worker’s last known personal street address, or by email at an email address belonging to the worker, including the worker’s current work email address or last known personal email address, or by text message at a mobile telephone number belonging to the worker. There is an exception if the employer does not have any contact information for the worker.

The Final Rule includes a model notice that may be used by employers.

The Final Rule’s Fate Is Far from Certain
It is not at all certain when, or even if, the Final Rule will take effect, as this Final Rule will trigger numerous legal challenges. Indeed, two lawsuits have already been filed in Texas—one by Ryan LLC, in the U.S. District Court for the Northern District of Texas, and the other by the U.S. Chamber of Commerce in the U.S. District Court for the Eastern District of Texas.

As noted, Pillsbury is continuing its review and analysis of the Final Rule and will be issuing additional guidance regarding this important legal development.