Seyfarth Synopsis: The federal district court for the Northern District of Texas has issued an order in the Ryan case staying the effective date on a nationwide basis the Federal Trade Commission (FTC) Rules banning noncompete agreements (the “Rule”), as well as enforcement of the Rule. However, legislatures and agencies at the federal and state level continue their efforts to ban or limit non-compete agreements. This blog post highlights actions employers may consider to reduce risks related to reliance on non-compete and non-solicitation arrangements in employment related contracts.
In Ryan LLC v. FTC, on August 20, 2024, a federal district court judge issued an order granting the plaintiffs’ motion for summary judgement and holding that the Rule is unlawful and “shall not be enforced or otherwise take effect on its effective date of September 4, 2024, or thereafter.” The court determined that the FTC lacked statutory authority to promulgate the Rule and that the Rule was arbitrary and capricious. For a more detailed discussion of the court’s reasoning, see here.
There are two additional court rulings regarding the Rule that were made in response to preliminary injunctions to stop enforcement of the Rule. In ATS Trees v. FTC, the Eastern District of Pennsylvania denied a preliminary injunction because it found that it was likely the FTC has authority to issue the Rule and that ATS Trees had not shown the requisite irreparable harm required to issue a preliminary injunction (see discussion here). In Properties of the Villages v. FTC, the Middle District Court of Florida issued a preliminary injunction holding that it was likely that the FTC did not have authority to promulgate the Rule and that the FTC violated the Major Questions doctrine (see discussion here).
We will see if the nationwide reach of the order in Ryan has any effect on the future rulings in the other two district courts. No appeal of the Ryan decision has been filed so far by the FTC to the U.S. Court of Appeals for the Fifth Circuit (the deadline is October 21). Until there is a contrary court decision, employers should have a reprieve from enforcement of the FTC’s prohibitions. The FTC has appealed the decision in Properties of the Villages to the Eleventh Circuit, but it is unclear how this appeal of a stay order and preliminary injunction could affect the Ryan court’s summary judgement order vacating the Rule nationwide.
Additional Sources Seeking to Limit Noncompete Arrangements
While employers have apparently obtained a reprieve from enforcement of the FTC’s Rule banning the use of noncompete arrangements, many federal and state legislatures and agencies are still busy seeking to restrict the use of non-compete arrangements. For example:
- The FTC can still seek orders against individual employers (such as its actions announced here) that the employer was prohibited from imposing, maintaining, enforcing or threatening to enforce non-competes against its employees.
- In line with the National Labor Relations Board memo from its General Counsel on May 2023, an administrative law judge for the NLRB recently issued a decision in J.O. Mory, Inc. requiring an employer to rescind certain restrictive covenants (including noncompete and nonsolicitation provisions) in its employment agreements (see our prior legal update here).
- The FTC and the Department of Justice signed a Memorandum of Understanding with respect to coordination of investigations into anti-competitive activities such as restrictive contract provisions utilizing noncompete and nondisclosure provisions (see memo here).
- Many state legislatures have been or are considering narrowing or out-right banning the use of noncompete arrangements. Minnesota recently adopted a ban on non-compete agreements and Washington state (see blog post here) and Colorado (see blog post here) passed legislation limiting the use of non-competes. In addition, governors in New York (here), Maine (here) and Rhode Island (here) vetoed legislation that would have banned non-compete agreements.
- The Federal Deposit Insurance Corporation issued a notice seeking public comment on a proposal to revise its current Statement of Policy on Bank Merger Transactions to prohibit non-compete restrictions in bank mergers where the selling entity must divest all or a portion of its business lines or branches (see prior post here).
Employer Options and Strategies to Reduce Risks
Employers can take proactive steps to reduce the risks of enforcement actions relating to, or new laws invalidating, noncompete and nonsolicitation provisions by restructuring how employers protect against departing employees damaging the valuable goodwill that the company owners have worked hard to create.
Restructuring Employment Agreements
- Garden Leave. Garden leave generally means that an employee is required to remain employed with an employer for a certain period of time after the employee or employer provides notice of its intent to terminate employment and the employer limits or restricts the employee’s duties and access to the Company’s employees or premises. For example, in the preamble to its release of the Rule, the FTC has acknowledged that this type of garden leave agreement is not a post-employment restriction and would generally not be treated as noncompete agreements when the employee is receiving the same total compensation and benefits on a pro rata basis. See 89 Fed. Reg. 38366 (May 7, 2024).
- Fixed-Term Employment Agreements. Similar to garden leave, a fixed-term employment agreement retains restrictions on competing against the company while still employed and would not be treated as a post-employment prohibition or restriction. To incorporate either garden leave or fixed terms into employment agreements, employers may need to sort through certain design considerations, such as the application of a “separation from service” under Section 409A of the Internal Revenue Code with respect to payments of deferred compensation and the individual’s continued treatment as an employee for purposes of certain employee benefit plans. However, currently, these types of “in-service” restrictions appear to be subject to less scrutiny. Thus, the benefit of having them warrant consideration by employers to restructure employment agreements to have garden leave or fixed terms instead of post-employment restrictive covenants such as noncompete and nonsolicitation provisions.
- Post-Termination Mitigation Requirement. Some severance or other post-termination payments can have mitigation clauses when the severance or other payment is intended to provide compensation to the employee while unemployed instead of a windfall or double dip if the employee immediately obtains new employment. This type of mitigation is usually not limited to compensation received from a company’s competitor, but any employer. Generally, this type of mitigation provision will provide for an offset to severance payments by compensation received by the former employee from another employer during the severance period.
Take Advantage of Restrictions under State Corporate Laws
Companies can look to restrictions based on state corporate laws, such as the duty of loyalty and fiduciary responsibilities of partnerships, member managed limited liability companies or shareholders of a closely held corporations. In many situations, these restrictions apply to owners or members, and continue after termination of employment.
- Closely Held Corporation. Closely held corporations are those with a limited number of shareholders. The maximum number of shareholders in a closely held corporation can vary between 10 and 35 depending on the state’s laws. The “majority view” followed by some states (e.g., MA, NY, IL and IN) is that all shareholders, even minority shareholders, of a closed corporation owe fiduciary duties to the other shareholders. In Delaware (the “minority view”), only controlling shareholders have fiduciary duties to the other shareholders. To be able to extend restrictions to key employees, a company might look to reincorporate or incorporate as a closely held holding company in a state following the majority rule and grant those key employees shares in this type of entity. Also, if the company purchases the employee’s shares upon a termination of employment, the transition may be treated as a sale of an interest in the company, which is a general exception under the Rule and several state rules that prohibit non-competes. As part of the stock repurchase agreement, the company could negotiate reasonable non-compete provisions. Even better, the company could provide the required non-compete provisions that will apply in the event the employee sells her interest in the company.
- Limited Liability Company (LLC). LLC members may or may not have fiduciary duties depending on the operating agreement and the design of the management of the LLC. For example, under California LLC statutory rules, a member of a member-managed LLC is statutorily prohibited from competing with the LLC unless the operating agreement provides otherwise.
Review Scope of Restrictive Covenants
It can be tempting to draft broad restrictive covenants because it may appear that “more is better” when designing these protections for the employer. However, if certain restrictive covenants are overly broad, they may be subject to legal restrictions or enforcement actions relating to the noncompete agreement. For example, in the preamble to the Rule, the commission noted that a reasonable NDA which would otherwise not be treated as a noncompete provision could be problematic if the NDA’s restrictions apply to workers’ general training, knowledge, skill or experience gained on the job. While the FTC ban has been struck down, it is important to note that the FTC still has authority to bring enforcement actions against employers for uncompetitive activities. The FTC also cited the case of Brown v. TGS Mgmt., 57 Cal. App. 5th at 316, 19, in which a California appellate court found that a company’s NDA was overly broad and functioned as a de facto noncompete agreement. Similarly, while customer or employee nonsolicitation agreements may not be expressly prohibited under a state’s laws, an overly broad provision may be treated as a noncompete restriction.
Therefore, employers should review their restrictive covenants in compensation documents to determine if the restrictive covenants might be treated as noncompetitive actions by the FTC or under the ever shifting landscape of state law restrictions. Overly restrictive covenants may be treated as invalid and unenforceable under state laws. Employers can reduce the risk of FTC enforcement action or changes to state law that may invalidate its restrictive covenants by narrowly drafting the restrictions to protect the company’s trade secrets and other protected information and to prohibit unfair competition under applicable state laws.
