Cutting the Gordian Covenant: A Case for the FTC New Proposed Rule on Non-Competes (Mostly)
By Spencer Thompson and Patricia Washienko
Introduction
Non-competes hit individuals hard. The collective damage, however, is even greater. If one were to apply the traditional common law balancing test for non-competes, which looks to weigh the burden of their restriction against the legitimate need for them, on a macro- rather than micro-level, the legitimate interests of companies would be outweighed not just by the harm to individuals, but by the burden on our local and national economies. As research shows, companies’ legitimate interests in protecting confidential information, most pronounced at the highest level of corporate organization (and the relatively few executives at such levels), are outweighed by the economic costs borne by the millions of people subject to non-competes who do not possess confidential information which could pose a significant risk to their employers, but nevertheless suffer from depressed wages and limited economic mobility.
Recently, the Federal Trade Commission proposed a new rule seeking to ban non-competes across the country.[1] This rule would both prohibit the use of non-competes and their functional equivalents and mandate the recission of existing non-competes.[2] The agency estimates, echoing a growing number of government reports expressing concern with the macroeconomic externalities of non-competes (which cover approximately 18% of all workers), that increased employee mobility will help increase Americans’ wages by “nearly $300 billion per year and expand career opportunities for about 30 million Americans.”[3] The agency also estimates that this will help reduce racial and gender wage gaps by 3.6 to 9.1% — substantial progress toward promoting equity in the workplace.[4]
Nevertheless, the proposed rule has been criticized, with opponents often claiming it will increase the risk of confidentiality breaches.[5] While a reasonable concern, we argue that risk is outweighed by the benefits of a (largely) categorical ban which would serve to eliminate workers’ uncertainty about non-competes more effectively than piecemeal approaches by providing an administrable solution at a national scale. Moreover, companies’ legitimate interest in protecting confidential information can be protected through other means, without the economic costs that the present laws create. With increasing research showing the harm of these covenants, now is the time to enact a nationwide, blanket ban – at least on non-competes below the executive level.
A (Brief) History of Non-Compete Law
The “covenant not to compete” or “non-compete” has a storied history. Courts have alternated between disapproval and acceptance of non-compete agreements, largely in response to economic policy concerns. Under early English common law, the non-compete was barred as an unlawful restraint on a worker’s right to practice his trade.[6] The courts made no secret of their disfavor of such clauses; when one 15th century court was asked to enforce an early non-compete, it replied, “the obligation is void because the condition is against the Common Law, and by God, if the plaintiff were present he should rot in gaeol [jail] till he paid a fine to the King.”[7]
Over time, however, the law, in both England and America, evolved to accommodate the emerging interests of businesses as the modern economy began to take shape.[8] The common test that emerged, and persists today in common law, is one that looks to see first if the non-compete protects a legitimate business interest and then, if it does, examines if the restraint is reasonable in geographical scope and time.[9] In Massachusetts, by the early 20th century, courts settled on three core interests which they recognized may be protected as legitimate business interests: (1) trade secrets, (2) goodwill, and (3) confidential information beyond trade secrets, the disclosure of which could cause harm to a company.[10]
State Laws (Including Massachusetts’) Are Not Sufficient
In 2018, after Massachusetts legislators became increasingly concerned with non-competes’ potential negative economic effects, especially with respect to the competitiveness of Bay State start-ups in the national marketplace,[11] the state enacted a new non-compete law, the “Massachusetts Noncompetition Agreement Act” (Mass. Gen. L. c. 149, § 24L). It requires new non-compete agreements to either provide a period of “garden leave,” where the former employee receives at least 50% of their salary in exchange for sitting out for up to 12 months (i.e., tending their garden) or “other mutually-agreed upon consideration.”
However, no state law, including Massachusetts’, resolves the national patchwork of often inconsistent state non-compete laws (relevant to a highly mobile national workforce). Moreover, Massachusetts’ law is not even sufficient intrastate, for a number of reasons. It does not include a minimum salary, unlike the non-compete laws of several other states, which likely disparately impacts lower income workers less able to afford legal representation.[12] Because it does not apply retroactively, the law results in disparate treatment between longer-term (often older) workers and more recent (often younger) hires in the same workplace. In addition, the lack of any guidance in the law as to what constitutes “other agreed upon consideration” sufficient to render a non-compete enforceable gives no clarity to workers considering changing jobs.[13]
These intra- and inter-state complexities create a difficult situation for workers. Indeed, scholarship indicates that even in states that do not enforce non-competes, employees (up to 40%) frequently cite them as reasons not to change positions.[14] This arises from the fear that they may be enforceable, or even when they know they are likely not enforceable, that they will have to spend significant economic resources defending against a potential lawsuit and suffer reputational harm as well.[15]
Balancing the Ban
The effects of a non-compete ban on corporate interests are likely not as dire as many non-compete proponents claim. Even if non-competes are banned, companies have many other ways to protect their confidential information. For example, companies can still enforce non-disclosure clauses and rely on the robust protections provided by state and federal laws (like the Defend Trade Secrets Act of 2016 and various state Uniform Trade Secrets Act laws) and the common law. In addition, there are many practical steps – like requiring the execution of confidentiality agreements, restricting access to trade secret and confidential information to those with a business need-to-know, conducting audits, and implementing training programs and employee departure policies – that companies can (and should) take to protect their trade secrets and other confidential information, whether or not the FTC bars non-compete agreements. There are also creative solutions; for instance, economic modeling suggests that equity-sharing programs are likely to encourage employee loyalty and reduce the risk of the spread of confidential information.[16]
Conclusion
The FTC’s new proposed rule provides an administrable solution which functions, at its core, to eliminate the negative externalities associated with the diffusion of non-competes below the executive level. It cuts through the ambiguity, fear, and uncertainty associated with them, which all serve to limit employees’ mobility, and instead provides clarity and definiteness allowing for decision-making based on the most rational economic opportunities available to employees. And after all, if the sky has not fallen in California – where non-competes have been banned for over 150 years but which nevertheless is poised to overtake Germany as the world’s fourth largest economy[17] – it seems doubtful the sky will fall in the other 49 states.
Spencer M. Thompson is a rising first year associate at Washienko Law Group, LLC. He earned his J.D., cum laude, from Boston College and his B.A. degree, High Honors, from Michigan State University. He sat for the bar exam in July 2023.
Patricia A. Washienko is the founding principal of Washienko Law Group, LLC. She earned her A.B., cum laude, from Harvard University and her J.D. with honors from Boston University School of Law. She is admitted to practice law in Massachusetts, the United States District Court for the District of Massachusetts, and the First Circuit Court of Appeals.
[1] Federal Trade Commission, Non-Compete Clause Rulemaking, FTC.gov (Jan. 5, 2023), https://www.ftc.gov/legal-library/browse/federal-register-notices/non-compete-clause-rulemaking.
[2] See id. In determining whether a contractual provision is a functional equivalent to a non-compete, the FTC has proposed a test which will examine if the provision “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.”
[3] See Federal Trade Commission, FTC Proposes Rule to Ban Noncompete Clauses, Which Hurt Workers and Harm Competition, FTC.gov (Jan. 5, 2023), https://www.ftc.gov/news-events/news/press-releases/2023/01/ftc-proposes-rule-ban-noncompete-clauses-which-hurt-workers-harm-competition ; see also Fact Sheet: Executive Order on Promoting Competition in the American Economy, Whitehouse.gov (July 9, 2021), https://www.whitehouse.gov/briefing-room/statements-releases/2021/07/09/fact-sheet-executive-order-on-promoting-competition-in-the-american-economy/.
[4] See Federal Trade Commission, supra note 3. Additionally, it appears that the American public largely approves of this proposed ban, with 61% of Americans surveyed by Ipsos reporting approval of the FTC’s proposed rule. Ipsos, Most Americans Support Banning Non-Compete Agreements for Workers, IPSOS.COM (Jan. 6., 2023), https://www.ipsos.com/en-us/news-polls/most-americans-support-banning-noncompete-agreements.
[5] See, e.g., Ani Huang, FTC’s Blanket Non-Compete Ban is Solving the Wrong Problem, TheHill.com (Jan. 29, 2023), https://thehill.com/opinion/congress-blog/3835378-ftcs-blanket-non-compete-ban-is-solving-the-wrong-problem/.
[6] See generally Hess v. Gebhard & Co., 570 Pa. 148 (2002) for a judicial exploration of the history of non-compete law.
[7] Cited by Hess, supra note 6, at 158.
[8] See Hess, supra note 6, at 158-59; see also Cristin T. Kist, Blocked Airwaves: Using Legislation to Make Non-Compete Clauses Unenforceable in the Broadcast Industry and the Potential Effects of Proposed Legislation in Pennsylvania, 13 Jeffrey S. Moorad Sports L.J. 391, 395-96 (2006) (discussing the history of non-compete law).
[9] See Hess, supra note 6, at 158-59; Boulanger v. Dunkin’ Donuts, Inc., 442 Mass. 635, 639 (2004).
[10] See Club Aluminum Co. v. Young, 263 Mass. 223, 226, 160 N.E. 804, 806 (1928), discussing Edgecomb v. Edmonston, 257 Mass. 12 (1926), Bos. & Suburban Laundry Co. v. O’Reilly, 253 Mass. 94 (1925), Farrell v. Chandler, Gardner & Williams, 252 Mass. 347 (1925), Chandler, Gardner & Williams v. Reynolds, 250 Mass. 309 (1924) (“In all these cases there was not only the element of using for the benefit of another employer information confidentially acquired as to details of business, but also the element of protection to the good will of an established business . . . [t]he use of trade or business secrets gained through employment may properly be made the subject of restrictive agreements.”); see also Meredith Gramann, “Garden” Against Competition: Codification of Garden Leave and Non-Compete Reform, 36 A.B.A. J. Lab. & Emp. L. 147, 152 (2022) (writing that the legitimate interest balancing test was settled law in Massachusetts by 1940).
[11] See Meredith Gramann, “Garden” Against Competition: Codification of Garden Leave and Non-Compete Reform, 36 A.B.A. J. Lab. & Emp. L. 147, 148-50 (2022).
[12] Washington’s law, for example, provides that non-competes are void unless the employee’s annual earnings exceed $100,000, adjusted annually for inflation. Wash. Rev. Code § 49.62.020. Illinois, Maine, Maryland, New Hampshire, New York, and Rhode Island also have enacted laws banning competes for workers falling below certain income thresholds. See Andrew Boling, William Dugan and Colton Long, “The Delicate Nuances in New State Compete Laws,” Baker McKenzie, Law360, December 2019.
[13] See M.G.L. c.149, § 24L.
[14] Evan Starr, JJ Prescott, Norman Bishara, The Behavioral Effects of (Unenforceable) Contracts, 36 J. L. Econ. & Org. 633, 666 (2020) (“In turn, the offer response analysis demonstrates that—in both enforcing and nonenforcing states—approximately 40% of employees with noncompete identify their noncompete as a factor in turning down job offers from competitors.”).
[15] See id.
[16] See Yifat Aran, Beyond Covenants Not to Compete: Equilibrium in High-Tech Startup Labor Markets, 70 Stan. L. Rev. 1235, 1267-72 (2018) (laying out a series of four scenarios gauging the likelihood of retention based on the intersection of human capital and the appreciation of company stock). Retention, under this model, will occur if human capital has appreciated, that is an employee’s skills and support systems have developed, and their stock values have appreciated as well, or to a lesser extent, if their human capital has not appreciated but their stock options have, as the employee will have an economic incentive to remain with the employer in order to realize their stock options.
[17] See Matthew Winkler, California Poised to Overtake Germany as World’s No. 4 Economy, Bloomberg (Oct. 25, 2022), https://www.bloomberg.com/opinion/articles/2022-10-24/california-poised-to-overtake-germany-as-world-s-no-4-economy.
Against the FTC’s Proposed Rule on Non-Competes
By Russell Beck and Sarah Tishler
The Federal Trade Commission (FTC) has proposed a rule that, if passed, would ban virtually all non-compete clauses (“non-competes”) throughout its jurisdiction (the “Proposed Rule”). The FTC states admirable goals of increasing worker mobility and earnings. In reality, the Proposed Rule would apply a mallet to an intricate area of the law where a scalpel is far more appropriate. We argue that the Proposed Rule goes too far, with potential unintended consequences that would eclipse any benefits. Instead, we recommend that the FTC leave policy-making on non-competes to the states, where more nuanced and localized approaches to non-competes can develop.
The Proposed Rule: Overbroad and Unclear
We begin by reviewing what the Proposed Rule entails. The text of the Proposed Rule is as follows:
It is an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker; maintain with a worker a non-compete clause; or represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe that the worker is subject to an enforceable non-compete clause.
The breadth of the Proposed Rule is plain on its face. It goes so far as to eliminate even existing non-compete clauses, even though companies may have already provided substantial consideration for that non-compete clause, perhaps in the form of additional wages, a bonus, stock, options, or a promotion.
After the text quoted above, the Proposed Rule sets forth a proposed “functional test” for defining what qualifies as a non-compete. That test would consider a contractual term to be
“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.”
This test is so broad that virtually any restrictive covenant could satisfy it. The FTC itself concedes that broad nondisclosure agreements may fail this test. Nonsolicitation agreements (no soliciting former customers) and no-service agreements (no working for former customers) for workers who are expected to bring a book of business with them also could fall under the “de facto” rule.
While the Proposed Rule contains a narrow carveout for non-competes in connection with the sale of a business or ownership interest in a business, it applies only if the person to be bound owns at least 25 percent of the business. And finally, the Proposed Rule would completely displace state law on this subject, unless state law affords the employee greater protection than the Proposed Rule.
Unintended and Detrimental Consequences of the Proposed Rule
There is no question that the FTC’s twin goals of increasing worker mobility and supporting worker earnings are commendable. But the academic research on which the FTC relies is flawed and inconsistent, and could result in precisely the opposite result for many workers as well as consumers. Further, the Proposed Rule would result in several unintended and detrimental consequences.
First, as businesses and workers have already seen in California (which banned non-compete clauses in 1872 under what is now California Business and Professions Code § 16600), outright bans of non-compete clauses result in more trade secret litigation. Indeed, trade secret litigation in California outpaces any other state, which many practitioners attribute to the lack of non-compete clauses as a straightforward tool for protecting trade secrets in the first place.[1]
Second, the functional test will call into question other restrictive covenants (e.g., nonsolicitation agreements, no-service agreements, nondisclosure agreements) and spur additional litigation over whether those fall under the Proposed Rule.
Third, some academic studies reveal that non-competes actually aid innovation because companies are more willing to invest in training and research when they have safeguards against their investments being used to further a competitor’s efforts. Similarly, though studies vary on whether non-competes result in fewer or more startups, the literature suggests that non-competes promote better startups, i.e., startups more likely to survive and thrive.[2]
Fourth, the narrow exception for the sale of businesses would harm the small-business merger and acquisition environment. Instead of buying, potential acquirers would be able to simply hire away key personnel and directly compete.
Finally, while the FTC relies on several academic studies for its proposition that banning non-competes will benefit consumers, the research on this subject is actually quite mixed. There are several studies that suggest the opposite. To take just one example, some research suggests that consumers were more likely to be harmed when non-competes were not enforced in the mutual fund industry, as fund managers were more inclined to engage in behavior that increased risks to clients.[3] Conversely, when non-competes were enforced at higher rates, fund managers’ investments were found to be more secure and predictable.
Allow the States to Continue Tinkering with the Right Fit
Above all, the Proposed Rule would bring to a screeching halt the state-level activity on non-competes, depriving the states of their function as the laboratories of democracy (to paraphrase Justice Brandeis). In the last decade alone, nearly two-thirds of U.S. states have made changes to their laws on non-competes. State legislatures are able to tinker with the specific policies that work best for their unique economic environments; a policy that may work well in Boston may not be the right fit for Bangor. Examples of this tailored approach abound: some states have established varying wage thresholds. Some states have exempted certain professions. And some states have limited the duration of non-competes by statute. These are just a few different policy choices that states can make to fit the needs of their particular economies, taking into account their workforce, major industries, and demand for services. As states learn from the experience of others, more nuanced and creative policy measures will appear in state legislatures.
The approach taken by the Massachusetts legislature in 2018 in the Massachusetts Noncompetition Agreement Act (MNAA) (Mass. Gen. L. c. 149, § 24L), reflects a decade-long process that ultimately rejected the bludgeon of a ban in favor of a localized scalpel approach. The MNAA explicitly only applies to non-compete agreements, and specific categories of workers are exempted (including undergraduate or graduate interns, employees 18 years old or younger, and employees classified as nonexempt under the Fair Labor Standards Act). The MNAA requires appropriate protections so that employees are informed about what they are signing. It requires that non-competes must be supported by garden leave or other mutually agreed upon consideration. It creates a 12-month cap on non-competes with a possible one-year extension. It does not have retroactive effect. And since its passage in 2018, a handful of opinions from state and federal courts in Massachusetts have provided additional guidance to interpret its terms, providing even more clarity and certainty for businesses, workers, and practitioners alike.[4]
Conclusion
The MNAA is exactly the type of legislation that would be completely displaced by the Proposed Rule. Such an intrusion into the states’ localized regulation is not only unnecessary, but it is entirely unjustified in light of the severe unintended consequences of the Proposed Rule. The Proposed Rule would not achieve the FTC’s stated goals, it would divest the states of their ability to fashion tailored laws that are best suited for their economies, and it would stifle the creative and nuanced lawmaking happening around the country in this area. For all of these reasons, we believe the Proposed Rule should be rejected.
Russell Beck, founding partner of Beck Reed Riden LLP, is nationally recognized for his trade secret and noncompete experience. He drafted most of the language in the Massachusetts Noncompetition Agreement Act, assisted the White House with noncompete policy, wrote the book, Negotiating, Drafting, and Enforcing Noncompetition Agreements and Related Restrictive Covenants (6th ed., MCLE, Inc. 2021), and teaches Trade Secrets and Restrictive Covenants at Boston University School of Law.
Sarah Tishler is senior counsel at Beck Reed Riden LLP, a nationally-recognized boutique litigation firm based in Boston, Massachusetts. Sarah’s practice is concentrated on trade secret and restrictive covenant advising and litigation, employee mobility, and commercial litigation. Sarah has won successful outcomes for clients on both sides of these disputes in all stages of litigation, including the preliminary injunction stage, jury trials, and mediation. Sarah has also counseled clients on the identification and protection of trade secrets, and the enforceability of noncompetes and other restrictive covenants. Sarah was named by the Legal 500 as a Rising Star for 2023 in the area of Trade Secrets.
[1] See California Trade Secrets Litigation Supplants Noncompete Litigation, available at https://www.faircompetitionlaw.com/2017/06/25/california-trade-secrets-litigation-supplants-noncompete-litigation/.
[2] Though many have pointed to California’s ban on non-competes and Silicon Valley’s success as proof of the opposite, there are flaws with that analysis. For example, as a threshold matter, research shows that workers in California are nonetheless subject to non-competes at the same rate as workers outside California (suggesting that the impacts of a ban are not as clear-cut as they may appear superficially). Further, companies in California have historically used intercompany no-poach agreements as an alternative, with a similar effect, further raising questions about what the actual impact of the ban really is. There are many other flaws. See Non-Compete Clause Rule, 88 Fed. Reg. at 3485 (NPRM at 16); see also Correlation Does Not Imply Causation: The False Comparison of Silicon Valley and Boston’s Route 128, available at https://faircompetitionlaw.com/2019/07/09/correlation-does-not-imply-causation-the-false-comparison-of-silicon-valley-and-bostons-route-128/.
[3] Gjergji Cici, Mario Hendriock, & Alexander Kempf, The impact of Labor Mobility Restrictions on Managerial Actions: Evidence from the mutual fund industry (University of Cologne) at 2, 5 (March 28, 2018) (“Our first set of results shows unambiguously that increased enforceability of NCCs [i.e., non-competes] leads to better fund performance. . . . Our empirical results show that fund managers increase effort even more in large fund families after NCC enforceability becomes stricter.”), available at https://www.econstor.eu/bitstream/10419/177385/1/1017934355.pdf.
[4] See, e.g., Cynosure LLC v. Reveal Lasers LLC, No. CV 22-11176-PBS, 2022 WL 18033055, at *8-10 (D. Mass. Nov. 9, 2022) (interpreting the MNAA’s right to consult with an attorney requirement); KPM Analytics N. Am. Corp. v. Blue Sun Sci., LLC, No. 4:21-CV-10572-TSH, 2021 WL 2982866, at *32 (D. Mass. July 15, 2021) (same, and also interpreting the consideration/garden leave requirement); Carroll v. Mitsubishi Chem. Am., No. CV 21-11801-JCB, 2022 WL 16573974, at *3 (D. Mass. May 19, 2022) (same, and also interpreting the sale exception); Vicarious Surgical Inc. v. Tragakis, No. 2284CV02321-BLS2, 2023 WL 3304305, at *1-2 (Mass. Super. Apr. 27, 2023) (affirming the MNAA does not apply retroactively); Genzyme Corp. v. Melvin, No. 2384CV00664-BLS2, 2023 WL 3173131, at *2 (Mass.Super. Apr. 04, 2023) (reforming a non-compete clause to make its geographic scope reasonable).
