FTC Issues Final Rule Prohibiting Most Post-Employment Non-Compete Agreements

On April 23, 2024, the United States Federal Trade Commission (“FTC”) issued a Final Rule (the “Final Rule”) that would prohibit the use of non-compete clauses with most American workers. The Final Rule is scheduled to go into effect 120 days following its publication in the Federal Register (the “Effective Date”), which is expected soon; however, substantial legal challenges may result in delay or invalidation of the Final Rule before the Effective Date.

The Final Rule prohibits any business from entering into or attempting to enter into any post-employment non-compete clause with its workers, regardless of the worker’s title, authority, or salary, except for certain agreements in connection with sales of businesses. It also prohibits businesses from enforcing (or attempting to enforce) any non-compete clauses or representing that any worker is bound by a non-compete clause, other than agreements with senior executives in effect as of the Effective Date or continuing enforcement actions accruing prior to the Effective Date.

The Final Rule’s basic prohibitions largely track those included in the FTC’s January 5, 2023 Notice of Proposed Rulemaking (the “Proposed Rule”, summarized here); however, the Final Rule contains several significant departures from the Proposed Rule – particularly with respect to sale-of-business non-compete agreements (which are now fully exempt) and existing agreements with senior executives – and provides meaningful elaboration on the intended scope of its prohibitions.

The Final Rule faces multiple legal challenges. At least two lawsuits have already been filed seeking to invalidate the Final Rule, including one by the U.S. Chamber of Commerce. Those challenges will include requests for injunctive relief seeking to delay the effectiveness of the Final Rule while its validity is litigated, but it is too early to determine whether these challenges will be successful. In the meantime, here are answers to some of the most pressing questions employers may have about the Final Rule.

1. What are the key terms of the Final Rule?

The Final Rule reflects the FTC’s view that the following actions constitute unfair methods of competition within the meaning of Section 5 of the Federal Trade Commission Act (the “FTC Act”): (i) entering into or attempting to enter into a non-compete clause; (ii) enforcing or attempting to enforce a non-compete clause; and (iii) representing that a worker is subject to a non-compete clause. These prohibitions will apply to all non-compete clauses first executed after the Effective Date. The enforcement and representation bans will effectively invalidate all non-compete clauses in effect as of the Effective Date, other than those with workers who qualify as senior executives (discussed in more detail below).

The Final Rule also requires businesses to notify impacted workers that their existing non-compete clauses will not be, and legally cannot be, enforced against them. This notice is due to be issued to workers other than senior executives by the effective date of the Final Rule. The Final Rule includes model language for the notice.

2. Are there any exceptions to these prohibitions?

Other than the senior executive exception for existing non-compete clauses, the Final Rule identifies three exclusions: (i) non-compete clauses entered into in connection with a “bona fide sale” of a business entity, of an individual’s ownership interests, or of all or substantially all of a business’s operating assets; (ii) enforcing or attempting to enforce a non-compete clause where the cause of action accrued prior to the Effective Date; and (iii) enforcing or attempting to enforce a non-compete clause “where a person has a good-faith basis to believe” that the Final Rule does not apply to such non-compete clause.

3. Does the Final Rule apply only to agreements with employees?

No. Consistent with the breadth of the Proposed Rule, the Final Rule applies to non-compete clauses applicable to “workers,” which it defines to include expressly not only employees, but also independent contractors, interns, volunteers and other types of workers.

4. What is a non-compete clause for purposes of the Final Rule?

The Final Rule defines “non-compete clause” as a provision in a contract or an employment policy that “prohibits a worker from, penalizes a worker for, or functions to prevent a worker from” working (or seeking work) in the United States with a different person or from operating a business in the United States, in either case beginning after the worker’s employment or engagement ends.

The FTC’s comments accompanying the Final Rule elaborate on the various types of arrangements that could qualify as “non-compete clauses.” Agreements that “prohibit” a worker from competing are those explicitly prohibiting an employee from engaging in competitive activities following the end of employment. Agreements that “penalize” a worker for competing are those that require a worker to pay a penalty for seeking or accepting other work or starting a business after their employment ends, such as liquidated damages clauses (i.e., arrangements requiring a former employee to pay a specified sum if engaging in post-employment competition), forfeiture-for-competition clauses (i.e., arrangements requiring a former employee to forfeit certain rights or benefits if engaging in post-employment competition), and conditional severance clauses (i.e., arrangements conditioning receipt of severance upon a former employee refraining from post-employment competition). Agreements that “function[] to prevent” a worker from competing are those that “restrain such a large scope of activity that they function to prevent a worker” from competing. These could include non-disclosure and non-solicitation covenants if, in the particular circumstances, they are “so broad or onerous” as to prohibit or penalize a worker from seeking or accepting other employment or starting a business after employment ends.

5. Are “garden leave” provisions permissible under the Final Rule?

They can be, if they satisfy rigid standards. In a traditional “garden leave” scenario, a worker is relieved from work-related duties and obligations, but remains actively employed on the payroll and receiving compensation and employment benefits. The FTC noted in its commentary to the Final Rule that if an agreement provides that a worker remains employed and “receiv[es] the same total annual compensation and benefits on a pro rata basis,” that agreement would not be a prohibited non-compete clause. Since the worker would remain employed, the agreement would not be a post-employment restriction. On the other hand, a scenario in which a worker terminates employment and receives compensation from their former employer during the time they are subject to a post-employment non-compete clause – which is specifically authorized as a “garden leave clause” under Massachusetts law – is prohibited by the Final Rule.

6. Who are senior executives for purposes of the Final Rule?

The group of senior executives whose existing non-compete clauses will not be invalidated by the Final Rule appears to be quite small. To qualify, a worker must both earn annualized compensation of at least $151,164 and have been in “a policy-making position.” To be in “a policy-making position,” a worker must (i) be the chief executive officer or president (or the equivalent) of a business entity, or (ii) have “policy-making authority” with respect to the business entity. To have policy-making authority, a worker must have “final authority to make policy decisions that control significant aspects” of the business. That is not satisfied by having authority to advise or exert influence over business decisions, nor is it satisfied by having final authority that is limited to a subsidiary or affiliate of a common enterprise. Notably, other than chief executive officers and presidents, no officers are presumed to have policy-making authority. Nevertheless, in the commentary to the Final Rule, the FTC stated that “many executives in what is often called the ‘C-suite’ [as well as partners in a partnership] will likely be senior executives if they are making decisions that have a significant impact on the business.” Given the fact-intensive duties test, determinations of senior executive status seem ripe for litigation; regardless, not all highly-compensated employees will qualify.

7. How does the Final Rule impact non-compete clauses negotiated in the context of a sale of business or in other equity arrangements?

The Final Rule excludes from its coverage non-compete clauses entered into pursuant to a bona fide sale of a business entity, of a person’s ownership interest in a business entity, or of all or substantially all the operating assets of a business. Notably, the Final Rule does not include any sort of ownership percentage threshold or sale-proceeds threshold; this is a meaningful departure from the Proposed Rule, which would have limited sale-of-business non-compete clauses to those sellers owning at least 25% of a business. As such, non-compete clauses should remain available from any seller who is selling their company, their ownership interest in a business, or all of their company’s operating assets.

The FTC’s commentary to the Final Rule states that “a bona fide sale is one … that is made between two independent parties at arm’s length.” By way of contrast, the FTC commentary further states that “springing” non-competes and non-competes arising out of repurchase rights or mandatory stock redemption programs are not considered to be entered into pursuant to a bona fide sale under the theory that they are not negotiated at arms’ length and the worker does not have a reasonably opportunity to negotiate the terms of the sale. These comments call into question the continuing viability of non-compete clauses in operating agreements, equity incentive programs, or similar arrangements to the extent those apply beyond the end of an equityholders’ employment.

Finally, the Final Rule does not provide guidance with respect to the types of ownership interest the sale of which might qualify for this exception. For example, it is unclear whether a non-compete clause could be obtained from an employee who holds unexercised options, whether vested or unvested, and who receives a cash payment for the forfeiture of those options in connection with an M&A transaction. Similarly, it is unclear whether a non-compete clause could be obtained from profits interest unit holders, particularly those in transactions where the applicable participation hurdle is not achieved.

8. How will the Final Rule be enforced?

The Final Rule reflects that engaging in prohibited activities relating to non-compete clauses constitutes an “unfair method of competition” within the meaning of Section 5 of the FTC Act. Remedies for violations of Section 5 of the FTC Act are limited. Section 5 of the FTC Act does not grant a private right of action, nor does it authorize the FTC to recover civil penalties or other monetary relief from parties who engage in unfair methods of competition. Instead, the FTC may either pursue an adjudication under Section 5(b), which would involve the FTC’s own internal processes and could result in the issuance of a cease-and-desist order against an offending employer, or seek an injunction in federal court trying to stop a company from engaging in prohibited activities. The FTC cannot obtain civil penalties or other monetary relief against parties for using an unfair method of competition, although it can obtain civil penalties in court if a party is ordered to cease and desist from a violation and fails to do so.

9. How will the Final Rule interact with existing state law, including in states that permit non-compete clauses?

The Final Rule purports to supersede any inconsistent state statute, regulation, order, or interpretation, except that, if the protection that any such state law affords any worker is greater than the protection provided under the Final Rule, then the state law would continue to apply. For example, California’s law prohibiting non-compete clauses also prohibits customer non-solicitation clauses. That prohibition would not be superseded by the Final Rule.

10. What can businesses do now to prepare for the Final Rule?

If the Final Rule survives legal challenges and actually takes effect, businesses will need to be prepared to stop using non-compete clauses in their agreements with employees and other workers. If no injunction invalidating or delaying the Final Rule is issued in the near term, companies should begin identifying those current and former employees, independent contractors, and other covered workers who are not senior executives and who are currently bound by non-compete clauses, so that the required notice can be prepared and be ready to be issued by the effective date of the Final Rule. Businesses should review their form documents and restrictive covenants that are currently in effect to determine if there are restrictions beyond express prohibitions on post-employment competition, such as non-solicit clauses and confidentiality clauses, to assess whether they may also qualify as prohibited non-compete clauses. Businesses should also begin developing alternative approaches for ensuring protection of their trade secrets and other proprietary information.

The Final Rule could have profound effects on efforts that many employers make to protect confidential information and goodwill. The members of Goodwin’s Employment and Antitrust Practices are ready to work with clients to navigate the challenges that the Final Rule may pose.

This informational piece, which may be considered advertising under the ethical rules of certain jurisdictions, is provided on the understanding that it does not constitute the rendering of legal advice or other professional advice by Goodwin or its lawyers. Prior results do not guarantee a similar outcome.