State of Confusion: The Complex Present and Uncertain Future of Employee Non-Compete Agreements

Labor & Employment

It seems like a simple question: Is the covenant not to compete in my employment agreement enforceable?  The answer is much more complex and uncertain than you might think.

Under current law, the enforceability of a covenant not to compete will be decided under state law.  Most contracts containing a non-compete will explicitly set out the state’s law that governs the agreement.  Courts will generally honor the choice of law provision in a contract unless 1) the parties have no substantial relationship with the chosen state, or 2) the application of the law of the chosen state would be contrary to a fundamental policy of a state that has a materially greater interest in enforcing its law.  If there is no choice of law provision in the contract, the laws of the state that has the most substantial relationship to the contract will govern.  However, in some states, such as California, Colorado and Massachusetts, the parties’ agreement in a non-compete agreement to the choice of a state’s law other than the state of the employee’s residence is void and unenforceable.

Currently, state laws on covenants not to compete are a patchwork of inconsistent policies.  A few states, California, North Dakota, Oklahoma and Minnesota, ban employee non-competes altogether. A growing number of other states, such as Colorado, Illinois, Maine, Maryland, New Hampshire, Oregon, Rhode Island, Virginia and Washington, as well as the District of Columbia, impose salary thresholds, prohibiting non-competes for lower wage earners.  Each of these jurisdictions, however, have differing definitions of what constitutes a lower wage earner in this context.  Massachusetts prohibits non-competes for employees who are non-exempt from overtime pay under the Fair Labor Standards Act, and it requires employers to provide garden leave benefits (essentially severance) to employees who can be bound by non-competes.  Nevada prohibits non-competes for hourly employees.

Against this backdrop, on January 5, 2023, the Federal Trade Commission (“FTC”) published a Notice of Proposed Rulemaking for a proposed new rule that would ban employers from imposing covenants not to compete on all of their workers, including both employees and independent contractors. The proposed rule comes in response to President Biden’s Executive Order 14036 which directed the FTC to “curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.”  President Biden mentioned the proposed regulation during his March 2023 State of the Union address, signaling that the issue was a priority for his administration.

If the FTC’s proposed rule becomes final, it will preempt any state statute or regulation that is inconsistent with the provisions of the final rule, unless the state law provides greater protections for workers.  Unlike the state variations of non-competition law discussed above, the FTC’s proposed rule does not have any salary thresholds – in short, it would prohibit non-competes for not only lower wage workers, but also for highly compensated employees.

Under the proposed rule, a “non-compete clause” is defined 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 basis for proposed rule is that, according to the FTC, an employee covenant not to compete is an unfair method of competition that violates Section 5 of the Federal Trade Commission Act, a law that prohibits antitrust and other anti-competitive conduct by businesses. 

The new proposed rule would invalidate all employee covenants not to compete, and applies retroactively to invalidate existing covenants.  Under the proposed rule, employers would be required to rescind all existing non-competes and provide a written notice to employees and former employees advising them that their non-competes are no longer valid.  A model notice is provided in the proposed rule.  Employers would have 180 days after the rule is made final in which to comply.  For employers who fail to comply, the FTC can seek civil penalties, restitution, damages, injunctive relief, orders of recission, or reformation of contracts on behalf of damaged workers.  The FTC can also refer criminal matters to the U.S. Department of Justice for prosecution in appropriate cases.

The proposed rule does not affect non-solicitation or non‑disclosure clauses unless they are so broad that they function as “de facto” covenants not to compete.  The proposed rule also does not affect non-compete covenants entered into in connection with the sale of a business, provided that such non‑competes are limited to individuals who own at least a 25% ownership interest in the selling business.

In accordance with the rulemaking process, stakeholders had a period of time in which to provide comments to the proposed rule, through April 19, 2023.  After receipt of almost 27,000 comments, the FTC is now in the process of reviewing those comments and considering whether to make changes to the proposed rule.  The FTC is expected to vote on a final rule this month, April 2024.  Any final rule would take effect 180 days after its publication.  Following the FTC’s Notice of Proposed Rulemaking, Sen. Chris Murphy (D-Conn.) reintroduced the Workforce Mobility Act (the “WMA”), which had been introduced to Congress in 2018, 2019 and 2021, but stalled each time. Like the proposed rule, the WMA seeks to ban all non-competes between US employers and their workers. Unlike the proposed rule, the WMA would apply only prospectively, not retroactively.  However, given the current gridlock in Congress, the WMA is unlikely to become law in the current legislative session.

So, what is the future of covenants not to compete?  First of all, it is not clear whether the proposed rule will become final as originally proposed—although it is unlikely given the volume of comments and the opposition from such stakeholders as the US Chamber of Commerce, the American Bankers’ Association, the American Hospital Association, the National Association of Manufacturers, the National Automobile Dealers Association and many others– or whether changes will be made to the proposed rule before the FTC votes.  It is quite possible that the FTC will limit the rule based on compensation thresholds modeled after the state laws outlined above.  Second, the rule is likely to face challenges in the courts, based upon arguments that the FTC has exceeded its rulemaking authority by imposing the final rule.  Finally, 2024 is an election year, and it is too early to predict what that might mean for rules passed under the current administration. 

Stay tuned.