In the words of Joe Biden, the FTC’s proposed ban on employee non-competes is a big f***ing deal.
Bear in mind, it is only a proposed rule, and it is sure to face constitutional challenges.
I’m no con law scholar, but I have a hunch the conservative 6-3 majority on the Supreme Court is not going to be psyched about a Democratic administration sweeping aside state non-compete law with the stroke of an administrative pen.
But just for grins, let’s put aside the original public meaning of the Sherman Act and assume the FTC’s proposed rule is enacted and survives legal challenges. On its face, it would be a sweeping change to the law in the 47 states that currently allow employee non-competes to some degree.
Still, it’s not as sweeping as it sounds. You might even argue the proposed FTC rule just codifies what non-compete law already is, or at least what it’s supposed to be, in most states.
To explain why, I have to take a detour to give you some background on existing non-compete law. Stay with me.
In the states that allow employee non-competes, a non-compete already has to be reasonable in scope. I’ll use Texas as an example, because that’s where I practice.
The existing industry-wide exclusion rule
Under Texas law, the scope of activity restrained by a non-compete must be no greater than necessary to protect the employer’s goodwill or other business interest. “Other business interest” means, essentially, the employer’s confidential information.
That means the scope of activity restrained must be no broader than necessary to protect the employer’s goodwill and confidential information. That’s the general rule.
Texas has a corollary to this general rule called the “industry-wide exclusion” rule. It says a non-compete that completely prohibits the employee from working for a competitor in the same industry is too broad. For the typical sales person employee, the non-compete should be limited to preventing the employee from doing business with customers she developed relationships with—or learned confidential information about—while working for the employer.
I have previously summed up this general rule of Texas non-compete law in seven words: you can’t take your customers with you.
But other customers? They should be fair game.
The rationale for this corollary is that prohibiting the employee from doing business with other customers, i.e. customers the employee did not develop goodwill with while working for the employer, is more than what is reasonably necessary to protect the employer’s goodwill with customers.
This is the rule in Texas, and I’d wager most of the other 46 states that allow employee non-competes have some version of this rule.
Let me hasten to add that this industry-wide exclusion rule is widely misunderstood by both lawyers and judges. Believe me, I know. But that’s a topic for another post.
For now, let’s just assume that non-competes already have to be limited to protecting goodwill and confidential information tied to specific customers. Even in the states that allow non-competes, you can’t use a non-compete to completely remove a former employee from competing in the industry.
What a reasonable non-compete looks like under current law
Now let’s apply what we’ve learned and look at the kind of non-compete that current law generally allows.
Under Texas law—and again, I’d bet most of the other states—there are four types of restrictions that are generally allowed:
- A restriction on using the employer’s confidential information (a “confidentiality agreement” or “NDA”)
- A restriction on soliciting the employer’s customers (a “non-solicitation agreement”)
- A restriction on accepting business from the employer’s customers, regardless of solicitation (a “no-business agreement”)
- A restriction on hiring other employees of the employer (a “no-recruit agreement”)
Keep in mind, I say “generally” because the fundamental element of non-compete law is reasonableness. That’s a fuzzy standard, so there can always be exceptions.
But in most cases, these four types of restrictions are considered enforceable.
What is generally not allowed, as we’ve already seen, is a restriction on being employed by any competitor in the former employer’s industry. (Again, there are exceptions.) Let’s call that a “non-compete.”
Now, before we get too hung up on these categories, let’s keep in mind that non-solicitation agreements, no-business agreements, and no-recruit agreements are all a form of “non-compete” or “covenant not to compete,” because they restrain competition with the former employer to some degree.
So, for example, when people say a non-solicitation agreement is not a non-compete, that’s a misunderstanding. I explain this in Is a Non-Solicitation Agreement a Non-Compete.
But for simplicity and labeling purposes, let’s use “non-compete” to mean a general restriction on going to work for a competitor.
Putting it all together, we can say current law generally does not allow a “non-compete,” using the FTC’s terminology, but allows the other kinds of agreements described earlier.
Now we can look at how the proposed FTC law would affect this current law.
The proposed FTC rule on employee non-competes
The proposed FTC rule has an exception for non-competes in the sale of a business. That’s a logical and important exception, but I’m putting it aside for now. I’m focusing on the typical employer-employee non-compete.
The proposed rule would prohibit employee non-competes by declaring them unfair methods of competition: “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” or to “maintain with a worker a non-compete clause.” § 910.2(a).
Notably, the proposed rule would be retroactive. To comply with the rule against employee non-competes, “an employer that entered into a non-compete clause with a worker prior to the compliance date must rescind the non-compete clause no later than the compliance date.” § 910.2(b).
On its face, this is a broad, sweeping prohibition on an employer entering into a “non-compete clause” with an employee.
But it raises an obvious question: what is a “non-compete clause”?
Does a non-compete by another name smell as sweet?
The FTC’s proposed rule would define non-compete clause as follows: “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.” § 910.1(b)(1).
I’ll be honest. After all the hype over the sweeping proposed rule, I was a little surprised to find the definition this narrow. Any good lawyer can immediately think of ways to get around this rule.
Arguably, there are four kinds of restrictions that would not fall under this definition of a non-compete clause:
- A confidentiality agreement
- A non-solicitation agreement
- A no-business agreement
- A no-recruit agreement
If I’m representing the employer, I’m going to argue that none of these restrictions is a “non-compete clause,” as defined by the proposed rule.
The employee is free to accept employment with a competitor, or to start her own competing business, I would argue. She just can’t use the former employer’s confidential information, solicit the former employer’s customers, accept business from the former employer’s customers, or hire the former employer’s employees.
And do you notice something interesting about these four restrictions that the new rule would arguably allow?
Yes! Of course. These are the same kind of restrictions that existing non-compete already allows.
The drafters of the proposed FTC rule are well aware of these types of restrictions. “In addition to non-compete clauses,” they explain, “other types of contractual provisions restrict what a worker may do after they leave their job.” Those “other types” include confidentiality agreements, non-solicitation agreements, no-business agreements, and no-recruit agreements. Proposed Rule at pp. 9-10.
So there you have it. Perhaps the FTC’s proposed rule banning employee non-competes is much ado about nothing. You could argue that all it really does is codify—and perhaps sharpen—existing non-compete law.
Now, that would be no small thing. Remember, as I said there is a lot of confusion about existing law. The FTC’s proposed rule would clear up some of that confusion.
But the proposed rule really doesn’t change the law that much in the states that allow employee non-competes, because those states already require non-competes to be reasonable in scope.
Or at least you could argue that.
The truth, of course, is a little more complicated.
The complication: de facto non-competes
The complication is that an agreement that does not expressly prohibit competition can still function as a non-compete.
For example, consider an employee confidentiality agreement that says almost all of the company’s information is confidential, including things like customer names and contact information. (This is not purely hypothetical.)
Taken literally, an agreement like that could effectively prevent the employee from doing anything in the industry, because there’s no way for the employee to compete for customers without using that information. It would be a de facto non-compete.
Texas courts have recognized this very problem. See, e.g., Trilogy Software, Inc. v. Callidus Software, Inc., 143 S.W.3d 452, 466-67 (Tex. App.—Austin 2004, pet. denied) (“this does not mean that trade secret status automatically attaches to any information that a company acquires regarding its customers; if it did, it would amount to a de facto common law non-compete prohibition”).
Here’s another example. Suppose the agreement is limited to prohibiting the employee from leaving and accepting business from the employer’s clients. That would arguably be a “no-business” clause, not a “non-compete” clause, using the FTC’s terminology.
But what if the industry at issue has five big customers that everybody is trying to do business with, and the employer does business with all five? In that case, the “no-business” clause would have the same effect as a “non-compete” clause. It would be another de facto non-compete.
These examples of de facto non-competes suggest maybe the FTC’s definition of a “non-compete” clause is too narrow.
The FTC’s proposed rule addresses the de facto non-compete problem with a functional test
But this is not the FTC’s first rodeo. The folks who drafted the proposed rule are well aware of the de facto non-compete problem.
That’s why part 2 of the FTC’s proposed rule adopts a “functional” test for whether a contractual term is a non-compete clause: “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 conclusion of the worker’s employment with the employer.” § 910.1(b)(2).
The rule then provides examples of contractual terms that “may” be de facto non-compete clauses.
And guess what? Those examples include the four kinds of restrictions we looked at earlier: a confidentiality agreement, a non-solicitation agreement, a no-business agreement, and a no-recruit agreement.
So, when is one of those agreements a de facto non-compete?
If the FTC’s proposed rule is adopted, I expect that’s where the fight will be (even aside from the constitutional challenges).
And lawyers like me who do a lot of non-compete litigation will still have plenty of work.
Now that’s a BFD.
Zach Wolfe (firstname.lastname@example.org) is a Texas trial lawyer who handles non-compete and trade secret litigation at Zach Wolfe Law Firm (zachwolfelaw.com). Thomson Reuters named him a Texas “Super Lawyer”® for Business Litigation in 2020, 2021, and 2022.
These are his opinions, not the opinions of his firm or clients, so don’t cite part of this post against him in an actual case. Every case is different, so don’t rely on this post as legal advice for your case.