FTC’s Attempt to Axe Noncompete Agreements and the Implications for M&A

JOSH YAGUR—On January 5, 2023, the Federal Trade Commission (“FTC”) proposed a new rule that would prohibit employers from entering into noncompetes with their employees. A noncompete clause or agreement prevents an employee from working for a rival company or starting a competing business within a specified geographic area for a certain period after the employee’s employment ends. The FTC’s proposed rule, if it were to be finalized and upheld by courts in its current form, would constitute a blanket ban on noncompetes and would apply to all current and future agreements, which would bring significant adverse consequences to businesses and dealmakers.

Approximately 30 million American workers are subject to noncompete agreements. Noncompete agreements are typically used to protect confidential information including trade secrets and investments made in the business that employees are privy and have contributed too. They have been used across a wide-array of industries and pay-scales. While such agreements are most common among senior employees and top executives, overtime entry level employees and blue-collar workers have been required to execute non-competes with their employers as well. In its proposal, the FTC has argued that the use of noncompetes is an anticompetitive, exploitive practice by employers with superior bargaining power that suppresses wages, hampers innovation, and limits entrepreneurial endeavors. The FTC estimates that the proposed rule to ban noncompetes could increase wages by nearly $300 billion per year and expand career prospects for workers.

Noncompete agreements have played a significant role in mergers & acquisitions (“M&A”). In M&A transactions, noncompete agreements are typically entered into amongst Buyer and Seller to prohibit executives and employees of the target company from working for a competitor or setting up a competiting entity if they quit. The proposed FTC rule only contains a limited exception for M&A, and therefore, would likely cause significant adverse consequences to many businesses and transactions. The proposed FTC rule allows the Seller of a business to enter into a noncompete agreement with the Buyer provided that the party restricted is an “owner, member or partner holding at least a 25% ownership interest in a business entity.” Therefore, this narrow limitation only permits noncompetes with respect to “substantial owners.” Other executives, key employees, and minority shareholders would be left free without any noncompete limitations. As such, the proposed rule would cause a major shift in the structuring dynamics regarding executives and employees’ compensation, and dealmakers will need to reconsider closing conditions, executive compensation, purchase price payments and earnouts, valuation, and other various structuring considerations. Additionally, deal teams and corporate executives would have to tactfully handle the effects with respect to existing non-competes in relation to completed transactions that the FTC rule would now retroactively prohibit.

The FTC’s proposed rule has received significant criticism. Noncompetes are regulated at the state level and many states limit or forbid employers from utilizing such agreements. Some states have limited noncompetes for people earning under a stipulated wage threshold or working in a particular industry. In proposing its new rule, the FTC preempted state law by claiming authority under Section 5 of FTC Act. The standard for an agency or commission to preempt state law is significantly higher than Congress’s and the agency must do so via a clear congressional grant as proscribed in the 2022 Supreme Court Case, West Virginia v. Environmental Protection Agency. Accordingly, there is immense scrutiny around the FTC’s proposed rule and questions arise as to whether the FTC has actual constitutional authority to enact the rule pursuant to Section 5 of the Federal Trade Act’s standard of unfair methods of competition. This challenge could be a death blow to the FTC’s rule, especially since U.S. antitrust jurisprudence has generally permitted noncompetes for decades.

Nonetheless, there is also significant support for the FTC’s rule, including from the Biden Administration. The administration has argued to limit noncompetes in some manner because negative externalities have resulted from noncompetes, especially in relation to lower-wage workers. As a result, some believe that the FTC may narrow its rule, and for example, allow noncompetes for highly compensated workers or certain industries. More specifically, the potential alternatives under FTC consideration include a rebuttable presumption of unlawfulness instead of a categorical ban, and different rules applied to different categories of workers or transactions. 

In the coming months, the progress of the FTC’s proposed rule should be monitored because the rule, as it stands, has substantial potential impacts on businesses throughout the country. The comment period is open until March 10, 2023 and the FTC may alter the rule in response to comments as it and other regulators further evaluate the initial proposal.