FTC Rule Barring Non-Compete Agreements Likely Will Fail

In a significant move, the Federal Trade Commission issued a final rule on April 23 by a 3-2 vote, banning most non-compete clauses in employer-employee contracts as an “unfair method of competition.”

Little changed from a proposed version of the rule released in January 2023. (An FTC fact sheet provides an overview of the final rule.) The final rule would preempt state laws that currently govern non-competes, and it will surely face judicial challenges for exceeding the FTC’s legal authority. Indeed, in voting against it, new FTC Commissioners Melissa Holyoak and Andrew Ferguson stated that the rule is defective on statutory and constitutional grounds. The rule also raises substantial economic questions.

The rule will be subject to legal challenges as soon as it is published in the Federal Register. If struck down in federal court, which is likely, non-compete legal oversight would revert to state law and the FTC would have to go back to the drawing board. A more limited rule informing workers of non-compete requirements before signing employment contracts could make economic sense and be far more likely to pass legal muster.

Non-Compete Policy – A Federal Or State Matter?

FTC Chair Lina Khan asserts that non-competes harm innovation and competition by blocking workers from freely switching jobs, depriving them of higher wages and better working conditions, and depriving businesses of talent pools to build and expand.

In January and March 2023, the FTC obtained litigation settlements with four firms who agreed to drop their non-compete restrictions, alleging that the settling parties had used “unfair methods of competition” in violation of Section 5 of the FTC Act. The settlements, however, applied only to the matters at hand and did not create binding legal precedents.

Non-competes historically have been evaluated case-by-case through state law adjudication. As Mercatus Center Labor Economist Liya Palagashvili and I pointed out last year, “many states have restricted non-competes to prevent abuses, to define the circumstances in which they will or will not enforce non-competes, and to ensure procedural protections.” A few states ban non-competes, and the policy experimentation allows alternative approaches to be compared and thus helps welfare-enhancing best practices to emerge. Individual states can tweak their approaches in reaction to new information.

In contrast, as economist Brian Albrecht points out, “the FTC’s total ban of non-competes replaces the decision making of businesses and workers, as well as the oversight of state governments, with a one-size-fits-all approach.” Such an approach prevents legal policy from taking into account new information.

The Non-Compete Rule In A Nutshell

The new rule is very broad. As the FTC’s original press release announcing the proposed rule explains, it bars employers from:

· entering into or attempting to enter into a non-compete with a worker

· maintaining a non-compete with a worker

· representing to a worker, under certain circumstances, that the worker is subject to a noncompete

It would require employers to rescind existing non-competes and actively inform workers that these agreements are no longer in effect. (The final rule allows businesses to retain existing non-competes with senior executives, while barring future such arrangements.) Other types of employment restrictions could be subject to the rule if FTC enforcers decided they are so broad in scope that they function as non-competes.

The rule does not apply to entities outside the FTC’s statutory jurisdiction, including financial institutions, air carriers, and certain non-profits.

It would take effect 60 days after publication in the Federal Register. Firms must fully comply 180 days after publication, but enforcement likely will be delayed by the legal challenges.

Economic Policy Problems Posed By The Rule

The FTC made no convincing economic showing supporting the rule. There is also compelling evidence, not addressed by the FTC, that suggests the rule could harm innovation.

In an April 2023 public interest comment, Mercatus Center labor economist Liya Palagashvili and I evaluated the economic research relied upon by the FTC. We noted that two prominent labor economists the agency cited extensively, Norman Bishara and Evan Starr, were “concerned” that bans on non-competes “are being made without the proper empirical foundation.”

The proposed rule also failed to cite FTC staff economist John McAdams, who had demonstrated that there is no research consensus on whether non-competes positively or adversely impact training, wages, information sharing, firm entry, and innovation.

Furthermore, we document work by multiple economists ignored by the FTC indicating that a ban would reduce innovation by reducing human capital investments (training of high-skilled workers) and the necessary R&D.

In addition, the economic costs of a non-compete ban could have negative national security implications, according to a June 2023 Center for Strategic and International Studies paper coauthored by former Undersecretary of Commerce for Intellectual Property Andrei Iancu. This research concludes that non-competes “stem the transfer of valuable IP from U.S. firms to foreign competitors … This strengthens the U.S. innovation system and enhances the United States’ economic growth, global competitiveness, and national security.”

Legal Obstacles Confronting the Rule

The non-compete rule will face major legal obstacles, as detailed in a 2021 article I wrote with Andrew Mercado and a 2023 dissent by then-FTC Commissioner Christine Wilson. (New FTC Commissioners Holyoak and Ferguson share Commissioner Wilson’s concerns, a fact that reviewing courts are sure to note.)

First, the statutory provision the FTC relies upon, Section 6(g) of the FTC Act, makes only a passing reference to the authority to issue rules embedded in a list of investigative powers. This fact, combined with the FTC Act’s failure to provide sanctions for Section 6(g) rule violations, strongly suggests that Congress did not intend to authorize substantive agency rulemaking.

Second, judicial deference to the FTC’s claimed rulemaking authority appears unlikely. The Supreme Court’s 2021 decision in AMG Capital Management v. FTC took a narrow view of FTC power in denying it the ability to obtain monetary relief as part of an injunction under Section 13(b). A similarly narrow reading here would doom the non-compete rule.

Third, according to former Commissioner Wilson, the FTC lacks the authority to issue a non-compete rule. She argues that the rule runs afoul of the Supreme Court’s holdings that reserve “major questions” to Congress and would involve an unconstitutional delegation of legislative authority.

An Alternative Rule That’s Both Legal and Beneficial

As Mercado and I explained, a narrower FTC rule requiring businesses to proffer their non-compete agreement before a contract is signed would stand a good chance of being upheld. It would allow employers to continue to preserve the benefits of non-compete agreements and enable employees to more fully consider the ramifications when deciding whether to accept an employment offer.

The rule could be issued under Section 19 of the FTC Act, which (unlike Section 6(g)) authorizes the FTC to enact substantive rules to combat unfair or deceptive acts or practices. The mutual benefits to employers and employees could allow the FTC to demonstrate that these exceed the costs, as required by Section 19.

The Road Forward

Businesses may, of course, choose to eliminate their non-competes immediately to avoid rising future confrontations with the FTC. Others may choose watchful waiting. After all, there is a high probability that the rule will eventually be struck down.

In any event, some time will pass before we see legal resolution of the non-compete issue. It’s also possible that, if administrations change, future FTC leadership withdraws the rule.