Summary
What’s next for employers who want to protect their businesses from competition from departing employees, including the loss of customers, employees, and confidential information? With a federal court injunction against the Federal Trade Commission’s (FTC) Final Rule banning noncompetes, the door is open for employers to continue using them. But companies now have time to reflect on the increasing hostility of courts and legislatures towards overly broad restrictive covenants, update their existing agreements, assess which employees ought to be subject to post-employment covenants, and determine how to best protect their trade secrets and confidential information.
Attorneys in Ballard Spahr’s Labor and Employment Group review the current state of federal law, note the growing number of states regulating noncompete agreements, and provide strategic considerations for employers.
Nationwide Injunction
Just two weeks before the effective date of the FTC noncompete Final Rule and the deadline to send notices to current and former employees about the invalidity of noncompete covenants, a federal court enjoined the Rule nationally. As we previously reported, on August 20, 2024, Judge Ada Brown of the U.S. District Court for the Northern District of Texas granted a nationwide permanent injunction against the FTC’s Final Rule. The Rule would have banned the use of nearly all noncompete agreements in the U.S. as of September 4, 2024. Specifically, the Rule sought to invalidate all existing noncompetes except for those of “senior executives,” and ban employers from entering into future noncompetes with any employees, including senior executives. The FTC has until October 19, 2024, to appeal the injunction to the Court of Appeals for the Fifth Circuit, and could potentially seek an emergency stay pending the appeal. Should the FTC choose to appeal, it faces an uphill battle—the Fifth Circuit has recently vacated two other federal agency rules: (1) the U.S. Department of Labor’s tip credit rule under the Administrative Procedure Act on the grounds that the rule is arbitrary and capricious, and (2) the private fund adviser rules from the Securities and Exchange Commission (SEC) on the grounds that the SEC exceeded its statutory authority. Similar lawsuits playing out in Pennsylvania and Florida district courts also increase the likelihood that the validity of the Rule may eventually be decided by the U.S. Supreme Court. On September 24, 2024, the FTC gave notice of its plans to appeal the U.S. District Court for the Middle District of Florida’s preliminary injunction, which temporarily blocked the Rule from applying to a local real estate firm, to the Court of Appeals for the 11th Circuit.
Notably, the National Labor Relations Board (NLRB) also attacked noncompetes last year with NLRB General Counsel Jennifer A. Abruzzo’s May 30, 2023, memorandum stating noncompetes violate Section 8(a)(1) of the National Labor Relations Act (NLRA), and instructing regional offices to begin litigating cases under this theory. On June 13, 2024, NLRB Administrative Law Judge Sarah Karpinen followed suit and ordered an employer to rescind a noncompete clause. Employers can expect to see further challenges to noncompetes under the NLRA.
State Restrictions
A growing number of states have enacted, or are in the process of enacting, legislation that bans or restricts the use of noncompete agreements. In fact, there are only a handful of states left that do not currently have any statute governing noncompetes, and which leave enforceability entirely up to the courts.
Noncompetes have long been banned in California, North Dakota, and Oklahoma. Minnesota joined these states in 2023 when it enacted a blanket ban on noncompetes. Washington, Oregon, Colorado, Illinois, Virginia, Maryland, Rhode Island, New Hampshire, and Maine have all placed income restrictions on noncompetes, meaning they are only enforceable against employees who earn above a certain amount per year. Massachusetts only permits noncompete agreements that include a garden leave payment of at least 50 percent of the employee’s salary during the restricted period or “other mutually agreed upon consideration.” Many states have placed various other restrictions on noncompetes, such as:
- Making them unenforceable against certain types of employees or industries (such as, hourly employees, news broadcasters, health care practitioners);
- Limiting their duration (such as six months or less presumed reasonable, two years or greater presumed unreasonable);
- Limiting their geographic scope (such as noncompete must specify by name that it applies only to the areas in which the employer conducts business).
Over the last several years, there has been increased activity in state legislatures to further ban or restrict the use of noncompetes and other restrictive covenants, including non-solicitation provisions.
Judicial Hostility
In addition to state statutes chipping away at noncompetes, courts have become increasingly hostile to employers’ attempts to enforce them. This is likely fueled by the FTC’s recent efforts to eradicate the use of noncompetes, and the media attention and public commentary viewing them as an unfair method of competition and unreasonably oppressive to employees.
Overall, it seems clear that courts are now applying heightened scrutiny and more stringent reasonableness standards when assessing noncompetes. In addition, courts are now more often invalidating entirely overly broad restrictive covenants, refusing to “blue pencil” them to a more reasonable scope as had been done in the past.
For example, in Ohio, a state where noncompetes are legal and currently unregulated by statute, a trial court recently declined to modify a noncompete it found to be overly broad, instead finding the entire covenant to be unenforceable and granting summary judgment in favor of the employee. On appeal, the First District Court of Appeals for Hamilton County affirmed, holding that the decision to modify an invalid noncompete is within the trial court’s discretion. Kross Acquisition Co., LLC v. Groundworks Ohio LLC, 2024-Ohio-592, ¶ 1, 236 N.E.3d 453, 455 (Ct. App.). In that case, the noncompete at issue prohibited its former salesperson from directly or indirectly working for competitors throughout Ohio and Kentucky for a period of two years.
The appellate court found that the geographic scope exceeded the employer’s service area, and further exceeded the areas where the employee had actually serviced clients; the temporal scope exceeded that necessary to protect the employer’s legitimate business interests; and the prohibition against working “directly or indirectly” for a competitor in virtually any role “did not bear a sufficiently direct relationship” to the employer’s legitimate interests. The court concluded that, with so many deficiencies, the trial court did not abuse its discretion in refusing to rewrite it to an enforceable agreement. This decision is a significant departure from Ohio courts’ tradition of blue penciling noncompetes that fail to meet its reasonableness standard, and an example of the nationwide judicial trend of generally disfavoring them.
Even non-solicitation agreements are subject to growing scrutiny, with some courts analyzing them under the same reasonableness standards as noncompetes. For example, some courts have upheld non-solicitation covenants only to the extent that they prohibit the solicitation of customers or employees with whom the former employee had direct contact during their employment.
The various tests of reasonableness used by state courts continue to shift and become more unpredictable, leaving employers with uncertainty as to how long their agreements will remain enforceable. Further, the “patchwork” of state legislation and the shifting judicial temperament governing the enforceability of noncompetes have made it increasingly difficult for multi-state employers to adopt uniform agreements.
Strategic Considerations for Employers
So, when employees leave, how can employers best protect their good will and confidential information from being used to advance their competitors’ businesses?
The first step is to re-evaluate which employees can and should be asked to sign a restrictive covenant. The use of “top to bottom” noncompetes, whereby virtually all employees in the organization are required to sign one, has a tendency to water down the importance of the restrictions. Focusing on the categories of employees where unfair competition is truly at issue, and being more selective about who is required to sign a noncompete, will enhance the argument that the covenants are necessary and reasonable. For example, executives with access to the most sensitive information, or sales employees who have nurtured customer relationships, may be prime candidates for noncompete agreements.
In addition, noncompetes may not be “one-size fits all.” Employers should consider the design of the covenants and whether some employee categories justify a greater restriction than others – in time, scope, and/or geography. The same analysis should be done in terms of the specific nature of the covenants each employee category is asked to sign – noncompete, non-solicitation, confidentiality, non-disclosure, and/or specific protections for intellectual property.
These agreements should then be assessed for compliance with the state law where the employees work. Employers doing business in multiple states should particularly be aware of the nuances among jurisdictions and adjust their agreements accordingly. Because legislation and judicial decision-making are not static, covenants should be reviewed periodically. Agreements that are stale and have not been updated to reflect the trends in drafting, court decisions, and business realities, can be very difficult to enforce.
In states where noncompetes are banned altogether, consider alternative approaches to covenants, such as non-solicitation, confidentiality, non-disclosure, and intellectual property covenants. In states where noncompetes are still permitted, but regulated, there are ways to make them more palatable to the courts, such as with garden leave provisions, narrowing the duration and geographic scope, ensuring adequate consideration, and adding step-down provisions.
Read our other coverage of the FTC’s Rule here and here.
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