On January 5, 2023, the Federal Trade Commission (FTC) proposed a sweeping new rule which, if enacted in its draft form, would ban virtually all non-competition agreements (non-competes), including those already in effect. The Proposed Rule can be found here. The FTC also included an overview fact sheet describing the Proposed Rule.

The FTC’s action comes in response to President Biden’s July 2021 Executive Order, which recommended that the FTC issue rules limiting non-competes “and other clauses or agreements that may unfairly limit worker mobility.” See Biden Administration Announces Plans to Curtail Non-compete Agreements for Workers (July 12, 2021).

The Proposed Rule is very broad with two notable exceptions: it will not ban restrictive covenants entered into in connection with the sale of a business or a franchise agreement. This Client Advisory discusses the Proposed Rule’s limited exception for certain mergers and acquisitions. We note that the Proposed Rule has the potential to reach beyond non-competes to the restriction of non-disclosure, non-solicitation, non-recruiting, and other conventional restrictive clauses.

The Proposed Rule is open for public comment for 60 days. Interested companies may submit comments throughout that period. After the comment period, the FTC will finalize the Rule, and, 180 days after the final version is published, the Proposed Rule will become effective.

Limited Exception for Mergers and Acquisitions

The Proposed Rule contains a narrow exception for non-compete agreements in connection with the sale of a business. Under the exception, the seller of a business may enter a non-compete agreement with a buyer that restricts owners with at least a 25% ownership stake in the seller’s business from competing with the buyer’s business.

The FTC states that this “sale-of-a-business” exception would apply both to sales of all assets of a company and to the sales of only a single division or subsidiary. See, Fed. Trade Comm’n, 16 C.F.R. Part 910, Non-Compete Clause Rule Notice of Proposed Rulemaking, https://www.ftc.gov/system/fil... at 107, 129-32.

How Do Non-Competes Between a Seller and a Buyer Differ from Those Arising Solely Out of Employment?

The FTC states in the Proposed Rule that “non-compete clauses between the seller and buyer of a business may be distinct from non-compete clauses that arise solely out of employment because they may help protect the value of the business acquired by the buyer.” It further notes that restricting such non-compete agreements “could potentially affect business acquisitions, including the incentives of various market actors to start, sell, or buy businesses.”

The Proposed Rule would not apply to a non-compete entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership in a business entity. The Proposed Rule also would not apply to a person who is selling all or substantially all of a business entity’s operating assets, when the person restricted by the non-compete clause is a substantial owner of, or substantial member or substantial partner in, the business entity at the time the person enters into the non-compete clause.

A “substantial owner, substantial member, and substantial partner” is defined as an owner, member or partner holding at least a 25% ownership interest in a partnership, corporation, association, limited liability company or other legal entity, or a division or subsidiary thereof, regardless of the consideration paid.
Non-compete clauses covered by the exception would remain subject to federal antitrust law as well as all other applicable law.

In the Preamble to the proposed rule, the FTC recognizes that the proposed rule would not apply to entities that are not subject to the FTC Act, which includes certain banks, savings and loan institutions, federal credit unions, common carriers, air carriers and foreign air carriers, and persons subject to the Packers and Stockyards Act of 1921, as well as entities not “organized to carry on business for its own profit or that of its members.” In addition, The Proposed Rule does not apply to a non-compete clause entered into by a franchisee in the context of a franchisee-franchisor relationship.

The Proposed Rule claims to preempt any state statute, regulation, order or interpretation to the extent that such statute, regulation, order or interpretation is inconsistent with the Rule.

Proposed Rule Departs From Long-standing Precedent and Is Likely To Face Legal Challenges

We believe that challenges to the Proposed Rule will focus on whether the FTC has the authority to adopt a nationwide ban on non-compete clauses. On the same day the FTC issued the proposed rule, Commissioner Wilson issued a dissenting statement that outlined potential legal challenges to the rule on the basis that:

the FTC lacks authority to engage in this type of rulemaking based on the history of Section 6(g) of the FTC Act and ambiguity as to whether rulemaking authority extends to substantive competition rules,
the rule is barred by the “major questions doctrine” recently addressed by the Supreme Court in West Virginia v. EPA, which found that a “clear statement” from Congress is needed to support assertions of broad authority that have great political or economic significance, and
even if the FTC has the authority to engage in this rulemaking, it is an impermissible delegation of legislative authority under the non-delegation doctrine.

The Proposed Rule seeks to change a lengthy history of case law recognizing the legitimacy of non-compete clauses that are determined to be reasonable, including well-settled federal appeals court precedent recognizing that non-competes “are legal [under Section 5 of the FTC Act] unless they are unreasonable as to time or geographic scope.”

The Implications for M&A Transactions

Buyers and sellers in M&A and investment transactions routinely use non-competes to protect the interests of the relevant businesses (and buyer) and for which separate and valuable consideration is received by the individual agreeing to the non-compete clause.

Many corporate acquisitions, particularly in the small-cap and mid-market space, are as much about acquired talent as they are about acquired brands or products. Sometimes that means software engineers, but it also applies to deals like rollups of financial advisories or professional services practices. In such cases, non-compete agreements are the current industry standard. If the FTC proposal becomes law, acquirers would need to employ different retention tools. That could mean some sort of golden handcuffs, or perhaps including installment payouts for the acquisition itself (although these could be subject to scrutiny as “functional“ non-competes under the proposal).

The Proposed Rule also covers non-disclosure, non-solicitation, non-recruiting agreements, and similar restrictions if they effectively prevent employees from taking jobs with competitors. If the Proposed Rule takes effect, all restrictive covenants (including customer and employee non-solicitation agreements and non-disclosure prohibitions) must be carefully reviewed and tailored to avoid classification as de facto non-competes.

We believe the “sale-of-business” exception in the Proposed Rule is very narrow in scope and would not allow transaction participants to use non-compete clauses in the same manner going forward, which could have a material impact on how parties structure transaction consideration and other terms.

In addition, buyers in transactions often seek to enter into non-competes with key employees who might not be selling shareholders, but the proposed rule would prohibit that practice unless the employee owns 25% or more of the target.

Finally, the proposed rule would invalidate non-compete clauses entered into in connection with completed transactions.

How Would the Proposed Rule Apply to Executive Compensation Arrangements

The removal of non-compete clauses would represent a fundamental shift in the negotiation of new executive compensation arrangements in many jurisdictions in a transaction context. 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.

It is not clear from the text of the Proposed Rule how or whether it would apply to non-competes in certain sophisticated incentive compensation or profits-sharing plans, including carried interest plans, in which the carry vehicle entity (typically an LLC or partnership) is not the employer and the individual is a member of or partner in the carry vehicle entity, not an employee or independent contractor.

The inclusion of a non-compete clause, and the duration of the non-compete clause following an executive’s termination of employment, is often subject to significant negotiations as part of the executive compensation arrangements. 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 does not 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. Similarly, many equity awards are made at least partially in consideration of the applicable restrictive covenants included in the equity award agreement.

The bottom line is that FTC’s Proposed Rule could have wide-ranging consequences, including for legal issues not identified in the FTC’s Proposed Rule.

Conclusion

The application of the Proposed Rule to non-compete clauses entered into with individuals who are workers and/or equity owners in connection with M&A and investment transactions is currently unclear. On its face, the Proposed Rule could have a material impact on how parties approach the use of non-compete clauses. Companies may wish to begin evaluating with counsel the business justification, necessity, and scope of their non-compete clauses and similar covenants both in the contexts of employment agreements generally and M&A activity, to determine if they would be better served with limiting their reliance on such clauses and covenants or eliminating them entirely.

We will continue to monitor and provide updates on issues in this area. In the meantime, as questions arise related to how to treat non-competes in ordinary course contracts and in M&A-related agreements, please contact your Kelley Drye team.

The FTC Proposes Ban on Non-Competes: The Implications for M&A Transactions