On Jan. 5, 2023, the Federal Trade Commission (FTC) took a significant step towards banning noncompete agreements between companies and workers. The FTC proposed a broad rule that not only aims to ban the future use of noncompete agreements in the employment context, but also require employers to remove existing noncompete agreements. In addition, it would cover contractual terms written so broadly as to function as “de facto non-compete clauses,” including broad nondisclosure agreements.
A wide variety of small businesses – from professional service providers to tech start-ups – rely on noncompete agreements, one tool to protect trade secrets and intellectual property (IP) from misappropriation by a competitor. Noncompete agreements are contractual restrictions that prohibit an employee from working for a competing company or forming their own competing company. Under current law, noncompete agreements are permitted in 47 states, and there is no existing federal law specifically governing the provisions of employee noncompete agreements.
When leaving for a new job, an unscrupulous employee could take with them information from the former employer and use that information at the new company. Even without malicious intent, confidential information can inadvertently leak when an employee goes to a competitor. A new employee, eager to show value, might recall the memory of a particular strategy that was used at his or her former employer. Noncompete agreements give employers in most states a useful tool to protect against the loss of intellectual property this way.
If the FTC’s proposed ban on noncompete agreements goes into effect, then businesses of all sizes, but especially small businesses, will lose one of the critical tools to protect confidential information, IP, and trade secrets.
What Small Business Owners Can Expect If the FTC’s Rule Goes Into Effect
The FTC’s proposal is a step towards a potential promulgation of a final rule to regulate noncompete agreements across the country at the federal level and is a blanket ban on the use of noncompete agreements between employers and workers. What can companies expect in the near future?
- The proposed rule would ban companies from entering into new noncompete agreements with workers for almost any reason and so far does not distinguish between classes of workers, whether highly-paid executives or managers.
- The proposed rule would require employers to rescind existing noncompete agreements with workers. This means that previous existing noncompete agreements would be invalidated.
- The proposed rule would impose a “functional” test to determine whether contractual provisions are treated as “de facto” noncompete agreements. Nondisclosure or nonsolicitation provisions drafted so broadly as to functionally prevent an employee from competing with the employer would be treated as “de facto” noncompete agreements and therefore be banned.
- The proposed rule contains only one narrow exception for noncompete agreements entered into as part of a sale of a business, but only for owners of more than 25% of the seller’s equity.
The FTC is accepting comments on its proposed rule. After the comment period closes, the FTC may promulgate a final rule, which may or may not track the current proposal.
Any proposed rule is likely to face prolonged legal challenges. The FTC may lack legal authority to regulate noncompete agreements at all, and a sweeping ban that affects millions of contracts will surely face a challenge in court.
What Can Small Businesses Do Now In Response to the FTC’s Proposed Rule?
The inevitable court challenges will take some time to be resolved, but companies have confidential information to protect today. While the political debate over the FTC’s proposed rule continues to play out, small businesses should consider taking the following actions:
- Participate in the FTC Comment Period. Consider providing comments to the FTC, either individually or through an industry group. Well-informed comments from industry participants can influence the final FTC rule. Much of the academic literature relied upon by the FTC in its Notice of Proposed Rulemaking has a progressive angle, focused on employee mobility. The FTC cites various anecdotal overreaches regarding noncompete agreements. The perspective of the business community may be valuable in influencing the scope of any final rule from the FTC.
- Don’t Tear Up the Noncompetes Yet. For now, the FTC’s proposed rule is just a proposal. It is not legally binding unless and until the FTC adopts a final rule. Given the likelihood of legal challenges, the proposed rule could be delayed or blocked. In the meantime, noncompete agreements are enforceable in nearly every state. Given the significant protections that noncompete agreements provide, businesses should continue using noncompetes as a tool to protect its IP.
- Carefully Review Existing Nondisclosure Agreements. To protect proprietary information, be sure that any employee or business partner with access to the information is subject to a carefully-crafted nondisclosure agreement. The FTC’s proposed rule could limit the use of nondisclosure agreements if they are found to be so overly broad, such as limiting a worker’s ability to compete within the same industry, so avoid unnecessarily broad clauses in employment agreements that aim to capture more than what could be arguably described as specific material interest.
Review and Update Processes for Protecting Confidential Information
While it is not the law yet, the FTC’s proposed rule puts a bullseye on noncompete agreements. Whether or not noncompete agreements are ultimately banned, companies should ensure that their other processes for protection of confidential information are following best practices, including:
- Use Nondisclosure Agreements. Appropriately-drafted nondisclosure agreements are often the most important factor courts consider in determining whether a business took appropriate steps to secure its confidential information. Companies should carefully tailor those nondisclosure agreements to avoid a later claim that they are functioning as a de-facto noncompete agreement and that they comply with any applicable state law limitations on their use and enforcement.
- Limit Access to Sensitive Information. Courts frequently examine how widely information was disseminated in determining whether it should be protected. The tighter the “circle of trust,” the more likely a court will determine the information qualifies for protection. Modern file sharing systems allow for easy control of permissions for documents or workspaces. Management should ensure that document permissions are limited only to those with a need to review the information.
- Expand Training. Confidential information policies are only as good as the employees who implement them. Creating and maintaining a culture of respect for the company’s confidential information can be a powerful tool to prevent misappropriation. Implement regular training on the importance of maintaining confidentiality.
- Utilize IT Resources. Some vendors offer automated tools that report incidents of unusual or suspicious network activity in real time.
- Conduct Exit Interviews. Well-managed programs for protecting confidential information include routine exit interviews of departing employees. Exit interviews allow companies to review confidentiality obligations with departing workers, ensure employees have returned all company property, and obtain certifications from workers of their compliance.
- Impose Restrictions on Vendors and Partners. Trade secret owners often must share confidential information with third parties. Those partners should be subject to an NDA, and possibly be required to protect the information upon receipt.
The proposed FTC noncompete ban faces an uncertain future, but companies of all sizes should promptly consider the above actions. These simple prophylactic measures can help your business reduce the risk of IP and trade secret misappropriation from departing employees.
Gregory S. Bombard is a trial lawyer focusing on trade secret litigation, intellectual property disputes, and other complex commercial disputes. His trade secret practice spans high tech industries, including biotech, medical devices, software, robotics, fintech, and manufacturing. Greg is an author of the ABA’s Guide to Protecting and Litigating Trade Secrets, 2nd Ed. He can be reached at firstname.lastname@example.org.
Noncompete agreement stock image by Vitalii Vodolazskyi/Shutterstock