Federal Trade Commission Proposes Rule Banning Non-compete Clauses

January 10, 2023

By: Stephen B. Stern

     The Federal Trade Commission (“FTC”) started 2023 by releasing a proposed rule that has the potential to affect a significant number of businesses varying in size and industry across the country.  On January 5, 2023, the FTC issued a proposed rule that would ban non-compete clauses, with limited exceptions.

     Under the proposed rule, employers will be barred from entering into or enforcing a “non-compete clause.”  The proposed rule defines “non-compete clause” as “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person, or operating a business, after the conclusion of the worker’s employment with the employer.”  The proposed rule goes even further by stating that a “functional equivalent test” will be applied to determining whether a contract provision constitutes a non-compete clause.  In this regard, the proposed rule states that “[t]he term non-compete clause includes a contractual term that is a de facto non-compete clause because it has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.”  Examples of a de facto non-compete clause provided in the proposed rule include:  (1) “[a] non-disclosure agreement between an employer and a worker that is written so broadly that it effectively precludes the worker from working in the same field after the conclusion of the worker’s employment with the employer” and (2) “[a] contractual term between an employer and a worker that requires the worker to pay the employer or a third-party entity for training costs if the worker’s employment terminates within a specified period of time, where the required payment is not reasonably related to the costs the employer incurred for training the worker.”

     The restrictions on non-compete clauses also are broad in terms of who qualifies as a “worker.”  Under the proposed rule, the term “worker” is defined to include “a natural person who works, whether paid or unpaid for an employer” and it specifically includes “an employee, independent contractor, extern, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer.”

     The proposed rule includes a limited exception related to business owners who sell their ownership interest.  In this regard, the proposed rule states that the restrictions “shall not apply to a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s 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 enters into the non-compete clause.”  The proposed rule defines “substantial owner, substantial member, and substantial partner” as “an owner, member, or partner holding at least a 25% ownership interest in a business entity.”

     The proposed rule also includes additional requirements for employers.  One additional requirement is that employers “must rescind [a] non-compete clause” that was entered into prior to the effective date of the rule and it must do so by what the rule calls the “compliance date.”  In addition, the proposed rule states that an employer “must provide notice to the worker that the worker’s non-compete clause is no longer in effect and may not be enforced against the worker.”  This notification must be sent in an “individualized communication” “on paper or in a digital format[,]” such as an email or text message, and it must be sent within 45 days of when the non-compete clause is rescinded.  The notification requirement is not limited to current employees; the proposed rule requires that notification be sent to former employees as well, as long as the employer has the “worker’s contact information readily available.”  The proposed rule includes sample notification language.

    Businesses and individuals can submit comments to the FTC about the proposed rule during the 60-day public comment period following the release of the proposed rule.
     This proposed rule is significant to businesses (and workers) with respect to the limitations it imposes.  First, the law governing non-compete agreements historically has been the domain of the states, both as a matter of statute and common law.  Implementing this rule or a variation of it will largely remove this area from the authority of the states.  If implemented, it is likely that lawsuits will be filed challenging the FTC’s authority to implement such a rule.  Second, non-compete agreements are an important tool that many businesses use when implementing trade secret protection programs and undertaking efforts to protect other confidential business information.  If this proposed rule or a variation of it is implemented, businesses will largely lose this tool and they will be hampered in their efforts to protect various intellectual and other intangible assets.  Businesses will not only be hindered by the substantially limited use of non-compete agreements, but also the potential elimination of the inevitable disclosure doctrine that has been recognized in several states.  The inevitable disclosure doctrine generally recognizes that, when it is virtually impossible for an employee to perform certain tasks for a new employer without utilizing the trade secrets and other confidential business information the employee learned from having worked for the former employer, the employee may be prohibited from obtaining certain employment with certain competitors of the former employer, even in the absence of a non-compete agreement.  The proposed regulation appears to overrule or otherwise eliminate the inevitable disclosure doctrine by applying the “functional equivalent test” for a non-compete clause.  

     If the proposed rule or a variation of it ultimately is implemented, while the restrictions on businesses will be significant, there still will be opportunities for businesses to implement measures to protect themselves.  For example, the proposed rule does not preclude the implementation of non-compete clauses during the term of employment.  While implementing non-compete agreements only during the term of employment is of limited utility, it may be helpful at least to some businesses to a limited extent even though the common law duty of loyalty generally prohibits competing against one’s current employer.  Also by way of example, the proposed rule does not preclude the use of non-disclosure clauses and they can be an important tool for businesses if they do not rely on them already (provided that they are not so overbroad as to be deemed the functional equivalent of a non-compete clause).  If implemented, the proposed rule also does not preclude the use of non-solicitation clauses, which can be an important tool for businesses to implement.  It would not be surprising to see legal challenges to the use of non-solicitation clauses as being the “functional equivalent” of a non-compete clause, even though the express terms of the rule do not include non-solicitation clauses.  Additionally, the proposed rule expressly permits the use of non-compete clauses in agreements where certain business owners are selling their businesses or the assets of their business.  As such, it is likely that non-complete clauses will continue to be used in such sale agreements.  Also, the definition of "worker" arguably is limited to individuals "who provide[] a service to a client or customer" and, based on this language, it would not be surprising if some businesses try to enter into non-compete clauses with individuals who are not in positions that "provide[] a service to a client or customer."  If that were to happen, this issue very likely will be resolved through litigation in the courts.

     Businesses varying in size and industry across the country should monitor developments related to this proposed rule, as its implementation or its withdrawal likely will have a significant impact on business strategy.