FTC Bans Most Post-Termination Worker Non-Competes

This article is not legal advice. No attorney-client relationship is formed by this article.

Executive Summary: On April 23, 2024, the Federal Trade Commission (FTC) adopted a final rule to ban many post-termination non-competes. It does not ban all non-competes. Non-solicitation, confidentiality and other provisions may be impacted. Non-competes between buyer and seller in the sale of a business are not banned, and some non-competes between co-owners of a business will survive.

Unless overturned in court, the rule will go into effect 120 days after the rule is published in the Federal Register (not 120 days from approval of the rule). The legality of the rule has already been challenged in court.

Below are key points about the rule and its impact, and suggested action items for business owners and deal parties. We have included several observations about open questions or unclear aspects of the rule in italics below.

What is a non-compete clause under the rule?

• Any written or oral term or condition (which could be in a contract or policy) that prevents a worker from (i) seeking or accepting work in the US for any other person after the conclusion of employment or engagement, (ii) operating a business in the US after the conclusion of employment.
• The language is broad enough that it will likely cause some non-solicitation and confidentiality provisions (and other provisions, perhaps) to be invalidated or modified by courts.

 Who is a worker?

• Anyone who works (an employee, independent contractor, extern, intern, volunteer, apprentice, or sole proprietor) Franchisees are not considered workers.

 What is banned?

• Entering into any post-termination non-compete with a worker (independent contractor or employee).
• Enforcing or attempting to enforce a post-termination non-compete with a worker.
• Representing to a worker that they are subject to a post-termination non-compete clause unless an exception applies.
• The rule says that a non-compete that prohibits “operating a business” post-termination is banned, but did not include language that a non-compete prohibiting “owning” a business post-termination is banned.

 What notice must be provided to workers?

• By the effective date of the rule, businesses must notify applicable workers in writing that the worker’s non-compete clause will not be, and cannot legally be, enforced against the worker.
• The notice must identify the party that entered into the non-compete clause with the worker, and must be provided by mail, email, or text message to an address, email address, or phone number belonging to the worker.

Should the model notice language provide by the rule be used?

• The model language seems to be defective in a number of places. It exceeds the scope of the rule, and fails to specify that non-competes during the term of employment/engagement may still apply, and also implies that no other terms of employment will be modified, which is not required by the rule, and may cause other problems, and prevent other modifications that should be considered in light of the loss of the non-compete.
• If the legal status of the rule is unclear when it goes into effect (e.g., pending litigation), providing the model notice as written may create legal and practical issues if the rule is ultimately overturned.   

 What are the exceptions?

• Existing post-termination non-competes for senior executives.
  • It is not clear whether an amendment to extend the duration of an existing agreement, or an auto-renew period in a contract would qualify as an “existing” agreement.

• Senior executives.
  • A president, CEO or any other officer who holds or held policy-making authority and earned total annual compensation of at least $151,164 in the preceding year (as pro-rated for any partial year.
  • A policy-making position is any position with the final authority to make policy decisions that control significant aspects of the business or common enterprise. This will likely include the president, chief executive officer or equivalent, and others. Input or influence on policy is not enough.
  • The rule is unclear whether officers in a common enterprise must have policy-making authority over the entire common enterprise (or just certain entities within the enterprise) to be considered a senior officer. The implication seems to be that it should require policy making control over the common enterprise, but the drafters chose to use “may” instead of “will,” creating the confusion.

• Calculating senior executive total annual compensation.
  • The total compensation is the worker’s earnings over the preceding year, and may include salary, non-discretionary bonuses, and other non-discretionary compensation.
  • Life insurance, medical insurance, retirement contributions or other similar fringe benefits are not included.
  • Discretionary compensation of any kind does not seem to be included. This will result in some officers who have total compensation greater than $151,164 not qualifying as senior executives.

• Selecting the “preceding year” for purposes of determining senior executive compensation.
  • At the business’ choice, the most recent 52-week year, calendar year, fiscal year, or anniversary-of-hire year, during the worker’s employment or engagement.
  • The rule is not completely clear on whether the worker or business selects the year, but this is the most sensible interpretation.

• Bona fide sale of a business.
  • Non-competes entered pursuant to “a bona fide sale of a business entity, the person’s ownership interest in a business entity, or of all or substantially all of the entity’s operating assets.”
  • This language is likely to create problems. It is unclear from the drafting whether the ownership interest sale relates to the worker’s ownership interest in the business entity, or the employer’s ownership interest in an entity.  It is also unclear whether a sale of some or all of the interest must be sold. The language never makes specific reference to the non-compete being with the seller, creating ambiguity around whether non-seller workers could also agree to post-termination non-competes pursuant to a bona fide sale. The FTC’s small business guide provides clearer language that it is intended to refer to sellers only, but this guide is not binding law.

• Existing causes of action.
  • Legal claims for breach of non-competes that arose before the rule takes effect

• Enforcement in good faith.
  • Attempts to enforce a non-compete if the business has a good-faith belief that the non-compete is exempt from the rule.

What happens to compensation with invalidation of non-compete?

• It is unclear. When compensation was agreed to in part in consideration of a post-termination non-compete, it is unclear what impact that could that have on compensation a worker is entitled to, or perhaps even compensation that was previously paid for a post-termination non-compete that the business will now no longer receive.

 

What is the impact on M&A?

• No impact on buyer and seller ability to enter into non-competes.
• Post-termination non-competes in retention agreements and employee agreements won’t be enforceable unless the senior executive exception applies, or the worker is a seller.
• The invalidation of existing post-termination non-competes could be considered a material adverse change.
• The invalidation of post-termination non-competes could be considered a breach of representations and warranties and could give rise to an indemnity claim or termination right.
• On deals in process, the change will impact due-diligence and will probably impact deal terms at least in the near term.
• Senior executive non-compete agreements may not be assignable to a buyer in an asset deal, which may impact structuring, as new post-termination non-competes with senior executives will be banned after the rule takes effect.

What actions should M&A deal parties consider taking?

• Before Signing/Closing.
  • Diligence:
    • Consider adding non-compete compliance to the due-diligence process.
    • Review the current/proposed notices to employees.
    • Evaluate worker confidentiality and non-solicitation provisions for compliance issues
  • Structuring/Terms:
    • Determine whether the loss of value from invalidated non-competes is significant enough to consider renegotiation of any deal term.
    • Identify alternatives to using non-competes in retention and key employee agreements.
    • Add the preservation or loss of senior executive non-competes to the list of pros and cons in asset deals and stock deals (the non-compete agreements may not be assignable in an asset deal).
    • Determine if the effective date of the rule should impact timing for closing on the deal (particularly with respect to senior executive non-competes).
    • Consider including contingent language in deal documents that contemplates the possibility that the rule is overturned.
    • Determine how the structure of the deal will impact integration/transition particularly if non-competes will not survive the closing.
  • Documents:
    • Consider adding a representation and warranty relating to compliance and disclosure schedules of senior executives with existing post-termination non-compete agreements.
    • Consider modifying indemnity provisions to address the impact of non-compete invalidation or the effect of worker competition if the rule goes into effect.
  • Business/Culture/Integration:
    • Consider impact on company culture from ongoing uncertainty while the law is being challenged, and possible re-implementation of non-competes if the rule is invalidated.
    • Evaluate relational exposure/competitive risks/flight risks from the loss of post-termination non-competes.
  • Post-Signing:
    • Determine if the invalidation could be considered a breach of representations and warranties.
    • Determine if the invalidation of non-competes could form the basis of an indemnity claim, or the basis for termination of the agreement.

• Post-Closing.
  • Determine if the invalidation of non-competes could result in a breach of representations and warranties.
  • Determine if the invalidation of non-competes could form the basis of an indemnity claim.
  • Evaluate the likely impact that added flight risks may have on indemnity escrows, earnouts, and other post-closing consideration.
  • An interesting question is whether there could be an argument that part of the purchase price should be returned if worker non-competes that the buyer bargained for in connection with the deal are invalidated – that argument may be stronger in a stock purchase than an asset purchase where new agreements are entered with workers.
  • It would also be interesting to determine whether retention agreements which include compensation for a non-compete, if invalidated, could entitle the party that paid the bonus to a return of some or all of the bonus paid to the worker.

 

What actions should business owners consider taking?

• Gather information:
  • Make a list of all non-expired current and former worker non-competes.
  • Identify all current and former senior executives.
• Update agreements and documents:
  • Prepare new agreements for workers who will begin after the effective date of the rule.
  • Update relevant policies and handbooks.
• Compensation arrangements:
  • Consider whether any compensation arrangements should be modified to address added risks.
  • Consider modifying discretionary compensation for certain employees in order to qualify them as senior executives.
• Notice requirements:
  • Prepare a compliant notice, and gather relevant contact information (mailing addresses, email addresses, and phone numbers must belong to the employee).
  • Make sure that a plan is in place to timely provide the notices and retain documentation that notices were provided.
• Manage risk:
  • Review the list of non-competes that will become invalid and consider any proactive measures to mitigate risks to the business and relationships.
• Culture:
  • Keep taking great care of your team and investing in your culture.
  • Consider working with a business coach or consultant to address workplace culture issues that may arise out of this issue.

 

Please discuss this important legal topic with your attorney and other key members of your team. This article is not legal advice and does not create an attorney client relationship.