LEGAL CORNER: The Impact of FTC’s Proposed Rule Banning Non-Compete Clauses
John Dolgetta, Esq. | March 14, 2023
On Jan. 5, 2023, the Federal Trade Commission issued a proposed rule (see https://bit.ly/3T5ixuM] (“Notice of Proposed Rulemaking” or NPRM), that would ban employers from imposing non-compete clauses and agreements on employees. The public comment period for the NPRM ends on April 19, 2023. The rule’s genesis stems from an Executive Order issued by President Biden in July 2021, which focused on promoting competition in America. The FTC describes the use of non-compete provisions as a “widespread and often exploitative practice that suppresses wages, hampers innovation, and block entrepreneurs from starting new businesses.” Those who oppose the FTC’s view argue that non-compete provisions are vital, long-standing tools that protect an employer’s legitimate business interests and protect businesses from harm caused by departing employees.
Restrictive Covenants: Non-Compete and Other Restrictions
Black’s Law Dictionary defines “restrictive covenants” in the employment context as “clauses in contracts of partnership and employment which limit a contracting party after termination of the contract in performing similar work for a period of time and within a certain geographical area.” Restrictive covenants are utilized to address a variety of circumstances such as non-competition and non-solicitation arrangements, as well as restrictions relating to confidential information and trade secrets obtained by employee while working for the employer.
Normally, restrictive covenants are written agreements (or clauses included in agreements) entered into between employers and employees. In recent years, these restrictive covenants are being utilized in the real estate industry in independent contractor agreements between brokers and real estate agents and members of significant teams, as well as employment and severance agreements between brokers and high-ranking executives and employees employed by the employer.
Restrictive Covenants Are Permissible in New York
Although restrictive covenants are generally closely scrutinized by the courts in New York (and other states), these types of agreements and provisions are permissible under New York law. The FTC explains in its NPRM that “In the 47 states [including New York] where at least some non-compete clauses may be enforced, courts use a reasonableness inquiry to determine whether to enforce a non-compete clause, in addition to whatever statutory limits they are bound to apply.” [see https://bit.ly/3YwXUZK]. It is important to note that non-compete agreements and restrictive covenants are recognized in all but three states and have been long allowed under the law.
The Reasonableness Test
In BDO Seidman v. Hirshberg [see https://bit.ly/3kXhNM1], the New York Court of Appeals held that “The modern, prevailing common-law standard of reasonableness for employee agreements not to compete applies a three-pronged test. A restraint is reasonable only if it: (1) is no greater than is required for the protection of the legitimate interest of the employer, (2) does not impose undue hardship on the employee, and (3) is not injurious to the public. A violation of any prong renders the covenant invalid.” It is important that legal advice is sought before utilizing restrictive covenants in any employment or other agreement. If the non-compete provision or restrictive covenant is over-broad and does not meet the requirements of the tests laid out by the courts, it will be invalidated.
Interests Protected by Non-Compete Agreements in New York State
In New York, courts have issued a variety of decisions which outline “protectable interests” of an employer. In New York, the courts “have limited the employer interests which can justify the imposition of post-employment restraints to (1) protection of confidential customer information, (2) protection of trade secrets, (3) protection of an employer’s client base, and (4) protection against irreparable harm where an employee’s services are unique or extraordinary.” [See Summary of Covenants Not to Compete: A Global Perspective at https://bit.ly/3kXDcEN]. The courts have generally upheld restrictive covenants where trade secrets and confidential information are involved, as well as non-solicitation of existing customers and clients.
Courts have also held that a restrictive covenant is enforceable where an employee’s services are unique or extraordinary [see Shearshon Lehman Bros., Inc. v. Schmetzler at https://bit.ly/3ZZDCZQ]. In many cases, where an employee’s services are found to be unique, special and/or extraordinary, the courts have held that an employer would be entitled to injunctive relief. However, the courts have held that any such determination must be made on a case-by-case basis and will be scrutinized carefully [see Ticor Title Insurance Co. v. Cohen at https://bit.ly/3JvXgaC].
The FTC’s Newly Proposed Rule On Banning Non-Compete Clauses
The FTC explains that “The rule would provide that noncompete clauses are an unfair method of competition. As a result, the rule would ban employers from entering [into] noncompete clauses with their workers, including independent contractors.” [See NPRM at https://bit.ly/3ywY4G0]. This new rule simply makes illegal an invaluable tool that has been available to employers and brokers for many years.
‘Non-Compete Clause’ Defined And The FTC’s ‘Functionality Test’
Under Section 910.1(b)(1) 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.” Although the new rule seems to apply only to non-compete clauses, the rule also provides a “Functionality Test” to determine if other types of restrictive covenants or agreements, which may not, on their face, prevent an employee or worker from accepting or seeking employment, but by its terms has the same effect. [see Section 910.1(b)(2) at https://bit.ly/3ZE6BCJ].
The FTC’s Functionality Test [see Section 910.1(b)(2) at https://bit.ly/3ZE6BCJ] basically provides that “the 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.” According to the FTC’s new rule, if an agreement or restrictive covenant is entered into that effectively restricts the employee from going to a competitor firm or company, then that provision would be invalid. Additionally, if there are liquidated damages provisions or required payments included that may also be deemed to be a de facto non-compete clause prohibited by the FTC’s new rule.
Generally, NDAs, Non-Solicitation Agreements Permitted
The FTC does clarify in its NPRM that “…the definition of non-compete clause would generally not include other types of restrictive employment covenants—such as non-disclosure agreements (“NDAs”) and client or customer non-solicitation agreements—because these covenants generally do not prevent a worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer.” However, one must be careful that any NDA, non-solicitation agreement or other restrictive covenant is not “…so unusually broad in scope that they function [and] as such would be considered non-compete clauses….”, thereby failing the Functionality Test. [See https://bit.ly/3J8GyfZ].
Broad Definition of ‘Worker’
It is important to note that the new rule would not only apply to W-2 employees, but also to all individuals defined as “workers,” which “includes, without limitation, an employee, individual classified as an independent contractor, extern, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer.” The rule does exclude “a franchisee in the context of a franchisee-franchisor relationship,” which would remain subject to federal antitrust laws. [See https://bit.ly/3ZE6BCJ]. Therefore, any restrictions imposed by brokers on licensed real estate salespersons who are W-2 employees, as well as those engaged as independent contractors, would come squarely under the new rule.
A Non-Compete Clause is Now Deemed Unfair Competition
Under Section 910.2(a) of the new rule, “[i]t 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.” Any non-compete clause in an agreement with any worker, including an independent contractor, is now deemed illegal.
Employers Obligations Regarding Existing Non-Compete Clauses
Under Section 901.2(b)(1) an employer would be required to rescind any existing non-compete clauses entered into with any worker. This is a major issue. Normally, when a new law or rule is promulgated, any existing agreements would be “grandfathered”, meaning that they would be allowed to remain in effect, and that the inclusion of a non-compete provision going forward would be subject to the new rule and, therefore, banned. The FTC’s proposed rule would be retroactive and amount to an ex post facto regulation. In effect, thousands of non-compete agreements that have been negotiated and included in valid and binding agreements would be invalidated overnight.
An employer must rescind the non-compete provision by the compliance date, which is defined as 180 days after the publication of the final rule by the FTC. Section 910.4 also provides that the new rule would supersede any “State statute, regulations, order, or interpretation” unless they afford a worker greater protection than the new rule. Basically, the laws of 47 states would become null and void when it comes to non-compete provisions.
Rescission Notice Requirements of Employers
Under Section 901.2(b)(2), when an employer rescinds an existing non-compete clause, the 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.” The employer must provide the notice to each worker specifically and the notice can be provided by paper correspondence or by email or text. The new rule further provides that “[t]he employer must provide the notice to the worker within 45 days of rescinding the non-compete clause.” The notice provision also applies to any worker who previously worked for the employer and is subject to a non-compete provision, “provided that the employer has the worker’s contact information readily available.” The new rule provides model language for the required notice:
A new rule enforced by the Federal Trade Commission makes it unlawful for us to maintain a non-compete clause in your employment contract. As of [DATE 180 DAYS AFTER DATE OF PUBLICATION OF THE FINAL RULE], the non-compete clause in your contract is no longer in effect. This means that once you stop working for [EMPLOYER NAME]:
You may seek or accept a job with any company or any person—even if they compete with [EMPLOYER NAME].
You may run your own business—even if it competes with [EMPLOYER NAME].
You may compete with [EMPLOYER NAME] at any time following your employment with [EMPLOYER NAME].
The FTC’s new rule does not affect any other terms of your employment contract.
Exception Permitted with Sale of a Business
Section 910.3 provides an exception to this new rule and allows a non-compete to be entered into with a person or persons selling their business or is “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.” The person must be a “substantial owner” which is defined as an individual that owns or holds at least a 25% ownership interest in the selling business entity. The rule further makes clear that any non-compete provisions covered under this exception would still be subject to federal antitrust law, as well as all other applicable law.
Where Do We Go from Here?
There is no doubt that there will be lawsuits filed seeking to invalidate the FTC’s new rule. Non-compete provisions have been used and upheld for years and the courts have always been very careful when upholding or invalidating these types of provisions. Employers, including real estate brokers, have utilized these non-compete provisions when it comes to key individuals and their departure. Departing “workers” could cause irreparable harm to a business or brokerage firm and employers need mechanisms to limit the potential economic harm that could be caused by “workers” who move to competitors. If non-compete clauses are no longer valid, business owners need to ensure that effective and carefully drafted non-disclosure and non-solicitation agreements are entered into with workers and, provided they are not overbroad, these alternatives will afford employers the tools necessary to protect their legitimate business interests.