This is the second in a multipart series on ML BeneBits discussing the implications and fallout from the Final Rule recently adopted by the Federal Trade Commission (FTC) banning the enforcement of almost all noncompete agreements with workers. In Part 1, we discussed the general parameters of the rule and several threshold questions that it raises. In Part 2, we discuss the types of arrangements that are prohibited by the Final Rule and the alternatives to noncompete clauses that likely remain available to companies following the effective date of the Final Rule.
The Final Rule is currently expected to be effective on September 4, 2024, unless earlier enjoined, delayed, or invalidated by a court or other government body.
Arrangements That Will Be Prohibited by the Final Rule
The Final Rule is broad in its definition of “noncompete clause,” which includes any term or condition, whether written or oral, that prohibits, penalizes, or functions to prevent a worker from “(i) seeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment that includes the term or condition; or (ii) operating a business in the United States after the conclusion of the employment that includes the term or condition.” There are two very limited exceptions built into the Final Rule, discussed in more detail in Part 1.
Straightforward noncompete clauses may be found in a variety of agreements and plans, including employment agreements, offer letters, severance agreements, and, on occasion, agreements with other service providers such as independent contractors. In addition, companies often include noncompete clauses in equity awards and equity plans, cash-based incentive plans, severance plans, and separation agreements. In the context of equity awards, for instance, this includes grants containing postemployment noncompetes that are tied to continued vesting.
If the Final Rule becomes effective, noncompete clauses can no longer be included in these agreements and plans, and companies should consider whether they want to retain accelerated or postemployment vesting in equity awards if such vesting can no longer be tied to noncompetes.
The Final Rule goes beyond prohibiting straightforward noncompete clauses. It also prohibits functional noncompetes, which are arrangements that serve to restrict, “penalize,” or “function to prevent” a worker from working after their current employment terminates. In the preamble to the Final Rule, the FTC indicates that inclusion of the term “penalize” is meant to prohibit clauses that “require a worker to pay a penalty for seeking or accepting other work or starting a business after their employment ends.”
The FTC provides examples of such penalties that include clauses that impose liquidated damages if the worker engages in specified business, clauses that relieve the employer of an otherwise existing obligation to provide promised compensation or benefits as a result of a worker seeking or accepting other work or starting a business postemployment, and forfeiture-for-competition clauses. Forfeiture-for-competition clauses have been commonly used in equity compensation arrangements. If the Final Rule becomes effective, companies should review equity compensation provisions related to repurchase (“call rights” or “call options”) and forfeiture, as well as other punitive pricing provisions, to ensure that they are not tied to competition.
Terms and conditions that “function to prevent” a worker from working after the termination of their current employment is perhaps the least-defined category of noncompete clauses under the Final Rule. The FTC indicates in the preamble to the Final Rule that this category may include certain nonsolicitation agreements, confidentiality agreements, nondisclosure agreements, training repayment agreement provisions (TRAPs), and other restrictive covenants that are so broad or onerous as to “function to prevent” or penalize workers from seeking or accepting other work or starting a business after their employment ends.
If the Final Rule becomes effective, companies should review any such provisions to make sure they are not “de facto” or “functional” noncompetes under the Final Rule and its guidance.
Arrangements That Are Likely Still Permissible Under the Final Rule
While the Final Rule bans a broad array of arrangements, there are still arrangements that are not prohibited and that should still largely be available following the effective date of the Final Rule, including the following nonexhaustive list:
- The Final Rule includes two important, but limited, exceptions that may be applicable: (1) existing noncompetes with “senior executives” and (2) certain noncompetes entered into in connection with a bona fide sale of a business. These exceptions are discussed in Part 1.
- The FTC clarifies in the preamble to the Final Rule that many “garden leave” arrangements are likely outside the reach of the Final Rule. As used in this context, a garden leave arrangement is one in which a worker remains actively employed and receives the same total annual compensation and benefits on a pro rata basis, even though their job duties or access to their colleagues or the workplace may be significantly or entirely curtailed. With respect to the “same total compensation” requirement, the preamble provides that where a worker does not meet the eligibility requirements to earn a component of their expected compensation, such as a condition to receive a bonus, this does not render the garden leave impermissible under the Final Rule, even if the employer does not pay the bonus or other anticipated compensation.
- While garden leave arrangements may be permissible under the Final Rule, they pose complications in other contexts. Garden leave arrangements are often less effective for a voluntary termination than an involuntary termination because it is generally difficult to enforce a requirement that an employee continue in employment during a garden leave period.
- Garden leave arrangements pose complications under Section 409A of the Internal Revenue Code for deferred compensation that is to be paid on a separation from service. Under Section 409A, a separation from service is triggered where the level of services that a service provider will perform after a specified date is reasonably anticipated to permanently decrease to no more than 20% of the average level of services (or up to 50% if specified in the applicable plan) they performed over the preceding 36-month period. While the ultimate determination as to whether a separation from service has occurred is a facts-and-circumstances analysis, where a worker on garden leave has been relieved of their work-related duties, it is likely that they have incurred a separation from service under Section 409A, and any deferred compensation plans should be administered accordingly.
- Garden leave arrangements may pose complications with respect to the employee benefit plans in which the worker participates. Such complications include, for example, issues relating to eligibility under the plans: if a company’s employee benefit plans tie eligibility to active service (based on hours worked), companies risk rendering workers ineligible to participate in their employee benefit plans during the garden leave period. While garden leave arrangements may be permissible under the Final Rule, companies should review arrangements on a case-specific basis to address issues that arise in the garden leave context.
- The FTC’s commentary on garden leave suggests that paid notice periods, where a worker or employer is required to provide advance notice of employment termination and the worker will continue to be employed and paid during the notice period, are also permitted under the Final Rule. Paid notice periods, such as garden leave periods, pose many of the same complications described above under Section 409A with respect to employee benefit plans and with enforcement in a voluntary termination context.
- The preamble to the Final Rule clarifies that certain retention and “stay” bonuses or clawback requirements (e.g., a bonus required to be repaid if the worker leaves before a certain period of time) that are in place during employment will likely remain enforceable so long as they are not tied to postemployment noncompetition. The preamble similarly describes provisions requiring the forfeiture of accrued sick leave upon termination of employment.
- Companies can look to states that currently restrict the use of noncompete clauses, such as California, and follow the lead of companies in those states for protecting valuable information without the use of noncompetes. For instance, in these states, employers have utilized fiduciary duty law, as well as appropriately tailored intellectual property and disclosure/misuse of trade secret and patent law provisions (in some instances, paired with more competitive compensation packages and working conditions) to protect the company.
Next Steps
Despite the uncertainty surrounding the Final Rule, including whether it will become effective, companies may take this as an opportunity to evaluate the arrangements they currently have in place with workers and consider potential alternatives to noncompete clauses that may be appropriate. For additional action items, please see Part 1 of this series as well as Morgan Lewis’s recent LawFlash and FAQ. If you have questions about the information in this post or other topics related to the FTC’s Final Rule, please contact the authors or your usual Morgan Lewis contacts.