Author: James Reda
The Federal Trade Commission (FTC) has proposed a new rule designed to support the ability of workers to change jobs for better wages and to start new businesses, among other rationale. Moreover, state legislatures are formulating new laws that will ban the use of non-compete provisions for almost all employees. This change, which some observers anticipate in spring 2024, may disrupt selling businesses and hiring for key leadership positions.1 The proposed FTC rule attempts to balance the rights of employees with those of owners and investors.
The FTC Proposed Ban on Non-Compete Agreements2 may create significant consequences for companies that use non-competition agreements for employment agreements, incentive plan designs, merger considerations and taxation. This rule may impede the flow of capital and the selling of businesses based on intellectual capital and relationships. Specifically, the buyer may not have assurance that the departure of key people won't erode the value of the business. This change could render certain businesses economically nonviable and therefore unsellable.
Background on the FTC non-compete proposal
A non-compete agreement — also called a "post-employment restriction" or a "non-competition clause" — establishes a contract between an employer and employee wherein the employee agrees to one or more of the following restrictions to working:
- For their employer's competitors
- Within a certain geographical region in the same industry
- For a designated amount of time after they leave employment
At their core, non-compete agreements comprise a contract whereby an employee agrees to a post-employment restriction limiting career prospects compared with what they would have enjoyed otherwise. In return, the employee receives something in exchange — wages, training or severance protection.
Approximately 85% of US states recognize and enforce various forms of non-compete agreements.3 Most observers consider a non-competition clause reasonable when it
- Is necessary to protect the employer's legitimate business interests
- Doesn't impose an undue hardship on the employee
- Doesn't harm the public
- Is reasonable in time period and geographical scope
In recent years, the legal landscape for non-compete agreements has shifted. Increasingly, courts and state legislatures are pushing back against what they perceive to be an overuse or abuse of restrictive covenants with employees who don't pose a credible competitive risk. Each state maintains its own laws and rules about whether, when and to what extent a non-compete agreement is enforceable.
States such as California, Minnesota, Montana, North Dakota and Oklahoma, as well as the District of Columbia, ban or severely restrict the use of non-compete agreements. New York State soon may join these states. Both houses of the New York State Legislature have passed the identical bill that would prohibit all non-compete restrictions on employees and certain other service providers and allow them to recover civil damages from their employers who impermissibly impose such restrictions.4 If not vetoed by the governor within 30 days, the bill becomes law and will apply to all non-compete agreements entered into or modified on or after the effective date.
In his 2021 executive order on promoting competition in the American economy, President Joe Biden encouraged the FTC to engage in rulemaking to "curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility."5 In response, on January 5, 2023, the FTC proposed a new rule that effectively would prohibit non-compete agreements other than in very limited circumstances.
If adopted, the proposed rule will require all employers that use any agreement with a non-compete clause, or with a clause that could be deemed as non-compete under the expansive definition in the proposed rule, to rescind the non-compete clause.
While the proposed rule contains a sale-of-business exception, that exception is limited to individuals with at least a 25% ownership stake in the business. The same proposed rules will apply to all employee levels.
The process to implement a new rule can take quite a while, and in some cases, rule makers may never adopt the rule. The public comment period for the proposed rule closed on April 19, 2023. During this consultation period, the FTC received more than 26,000 comments on the proposed changes. Leading themes included:
- The adverse impact on the protection of intellectual property (IP) and the absence of any IP exception to the proposed non-compete ban
- The proposed rule's tendency to discourage investments in worker training
- Concerns that the proposed rule gives nonprofit healthcare providers an unfair advantage because they're exempt
Potential impact on executive compensation
In light of these potential rules, companies must consider three key areas with regard to executive compensation:
Many executive compensation arrangements, including employment agreements, severance plans, equity plans and award agreements, contain provisions that would qualify as non-compete clauses under the proposed rule. For example, where otherwise permissible under applicable state law, employment or severance agreements often provide that an executive will receive severance payments for a specified period of time following a qualifying termination of employment if, among other things, the executive doesn't compete with the company or violate any other applicable restrictive covenants during the severance period.
Even in instances where the severance is paid in a lump sum immediately upon a qualifying termination of employment, the severance is often provided at least partially in consideration of the applicable restrictive covenants.
Sale of business
Buyers and sellers in mergers and acquisitions (M&A) and in investment transactions routinely use non-compete clauses. Companies design these clauses to protect the interests of the relevant businesses and buyer; the individual agreeing to the non-compete clause receives separate and valuable consideration.
The application of the proposed rule to non-compete clauses in connection with M&A and investment transactions currently is unclear. Further, the proposed rule would invalidate non-compete clauses into which parties enter in connection with completed transactions.
Internal Revenue Code Section 280G
A key exemption in the Internal Revenue Code (IRC) Section 280G regulations concerns the term "parachute payment." The rule doesn't include any payment shown to be reasonable compensation for personal services rendered on or after the change in control date. However, if the final FTC rule broadly prohibits non-compete clauses for executives, the rule may result in the imposition of a 20% excise tax as well as a loss of corporate deduction for executives who aren't named executive officers (NEOs).
This potential imposition of excise tax may deliver unintended consequences as companies adjust remuneration programs to be 280G efficient. Programs with a higher percentage of time-based awards, for example, could be more 280G efficient but less optimal for performance philosophies.
Gallagher can help
Gallagher's Executive Compensation Consulting team can help guide your organization through the changing landscape of non-compete rules. We have the data and expertise to help drive smart compensation decisions so your company can face the future with confidence.