The FTC’s Noncompete Rule Is in Serious Jeopardy

A Texas federal district court recently concluded that the Federal Trade Commission (FTC) lacks the requisite statutory authority from Congress to enact a controversial rule that would prevent employers from entering into noncompete clauses and, beyond that, bar them from enforcing most existing noncompete clauses.

The FTC’s Noncompete Clause Rule is scheduled to take effect on September 4. However, U.S. District Judge Ada Brown from the Northern District of Texas granted certain challengers’ motion to stay the effective date of the rule and entered a preliminary injunction that prohibits the FTC from implementing and enforcing the rule until the court can resolve the ultimate merits of the challengers’ claims, which the Texas judge intends to do by August 30, 2024.

.

The Groundwork for the Rule 

In the summer of 2021, President Biden issued Executive Order 14036, titled “Promoting Competition in the American Economy.” The executive order called upon numerous federal agencies to take action to promote robust competition. Biden took aim at “federal government inaction” leading to consolidated industry, weakened competition, and increased power remaining with corporate employers.

The executive order encouraged federal agency heads to use their authority to further the administration’s policies, including to influence their regulations and competition. With respect to noncompete clauses, the executive order urged the chair of the FTC to “exercise the FTC’s statutory rulemaking authority under the Federal Trade Commission Act to curtail the unfair use of noncompete clauses and other clauses or agreements that may unfairly limit worker mobility.” 

The same day that Biden issued the executive order, a divided majority of the FTC issued a statement announcing the withdrawal of its bipartisan principles related to its enforcement of unfair methods of competition. The 2015 enforcement principles applied a “rule of reason” framework that focused on actions which cause, or are likely to cause, harm to competition. In withdrawing its statement of enforcement principles, the majority believed the rule of reason statement abrogated the FTC’s “duty to use its expertise to identify and combat unfair methods of competition even if they do not violate a separate antitrust statute.” Two of the five commissioners issued a dissenting statement opposing the majority’s withdrawal of the 2015 enforcement principles.

In the fall of 2022, the FTC issued a policy statement regarding the scope of unfair methods of competition under Section 5 of the FTC Act, which prohibits unfair methods of competition in or affecting commerce. The 2022 statement purported to supersede “all prior FTC policy statements and advisory guidance” on the scope and meaning of an unfair method of competition under the act. The FTC stated that an unfair method of competition need not show current anticompetitive harm or intent. An unfair method of competition must go beyond competition on the merits, which can be conduct that is coercive, exploitative, collusive, abusive, or deceptive.

The 2022 statement made clear that the FTC would not use the “rule of reason” inquiries but, instead, would focus on stopping unfair methods of competition “based on their tendency to harm competition conditions.” Similar to the FTC’s statement regarding its withdrawal of the 2015 enforcement principles, the 2022 statement drew a dissenting statement from one of the commissioners. 

.

The Final Rule Nullifying Existing Noncompete Clauses and Banning Future Ones

In early 2023, less than two months after the FTC altered its interpretation of unfair methods of competition, the agency issued a notice of proposed rulemaking and announced its first iteration of the Noncompete Clause Rule. A majority of FTC commissioners concluded that noncompete clauses are unfair methods of competition and dictated that employers could not maintain, enter into, or attempt to enter into noncompete clauses with workers.

The same commissioner who dissented from the FTC’s prior actions also dissented from the proposed rulemaking, finding it to be a “radical departure from hundreds of years of legal precedent.” The dissenting commissioner—Christine S. Wilson—also outlined several legal challenges that she anticipated the proposed rule would face. One of the challenges Wilson identified in her dissent was the FTC’s lack of authority to engage in rulemaking for unfair methods of competition. When Wilson resigned shortly thereafter, she heaped criticism upon the current chair of the FTC. The FTC’s proposed rule received tens of thousands of comments from the public.

Earlier this year, the FTC issued its final rule outlawing most noncompete clauses. The FTC has determined that noncompete clauses with nearly all workers are exploitative and coercive and, therefore, amount to unfair methods of competition. While the FTC did not find noncompete clauses with senior executives to be exploitative and coercive, the FTC nevertheless found that they are unfair methods of competition because noncompetes are restrictive, exclusionary, and tend to negatively affect competition conditions.

If the rule takes effect, it will prohibit a person from  (i) entering into, or attempting to enter into, a noncompete clause;  (ii) enforcing or attempting to enforce a noncompete clause, even an existing one; and  (iii) representing that a worker is subject to a noncompete clause.

The rule extends to current and former workers, regardless of their title or status, such as an independent contractor. The rule defines a noncompete clause broadly as a term or condition that either prohibits, penalizes, or functions to prohibit or penalize a worker from seeking or accepting work with a different person that would begin after the worker’s current employment, or operating a business after the worker’s current employment. A term or condition of employment can include a formal contractual term, a workplace policy, or a handbook provision, whether written or oral.

The rule would nullify nearly all existing noncompete clauses—affecting 30 million workers, according to the FTC—and prevent employers from entering into prospective noncompete clauses with any workers, including senior executives. The rule contains a narrow carve-out for existing noncompete clauses with senior executives. A senior executive is one who earned more than $151,164 in the prior year and who is in a “policymaking position,” a term the rule defines narrowly. Existing noncompete clauses with senior executives are not invalidated by the rule. However, the FTC estimates this carve-out would apply to only 0.75 percent of workers.

Before the rule’s effective date of September 4, 2024, employers must provide clear and conspicuous notice to workers that existing noncompete clauses will not be, and cannot legally be, enforced against the workers. The rule provides model notice language that employers can use. The notice must be in writing and can be delivered by hand, mail, email, or text message. The rule’s notice provision extends to providing notice to former workers too. The FTC rejected a commenter’s proposal that notice to former workers be limited to workers who left the company two years or less before the effective date, unless the noncompete has already lapsed. 

The rule does not prohibit noncompete clauses when a person enters into a bona fide sale of  (i) a business entity,  (ii) the person’s ownership interest in a business entity, or  (iii) all or substantially all of a business entity’s operating assets. And the rule would not reach employers who fall outside of the FTC’s jurisdiction, such as banks, entities that are subject to the Packers and Stockyards Act, and entities that are not organized to carry on business for their own profit or that of their members.

However, the FTC anticipates that its rule will lead to the creation of more than 8,000 new businesses. Over 10 years, the FTC estimates, employers will need to pay increased wages of more than $400 billion, and physician services spending will decrease by between $74 and $194 billion. 

.

Expected Legal Challenges Show Promise 

On the same day the FTC issued its final rule, tax services and software provider Ryan LLC filed suit in the Northern District of Texas to challenge the FTC’s authority to issue the rule. The next day, the Chamber of Commerce of the United States of America, Business Roundtable, Texas Association of Business, and Longview Chamber of Commerce filed a similar challenge to the rule in the Eastern District of Texas. The day after that, a tree service company filed a similar challenge in Pennsylvania. The challengers in the second-filed Texas lawsuit joined Ryan’s first-filed lawsuit, and Ryan and the business groups filed a motion for preliminary injunction that sought to stay the effective date of the rule and to enjoin the FTC from implementing and enforcing the rule. 

On July 3, Brown sided with Ryan and the business groups and granted their request for a preliminary injunction. A preliminary injunction is not a decision on the ultimate merits of the challengers’ claims. Instead, a preliminary injunction is an order that usually remains in effect until the court has sufficient time to address the merits of the claims. However, to obtain this form of relief, the court must find that, among other things, the challengers are likely to succeed on the merits of their claims. 

In the Ryan case, Brown addressed two of the challengers’ arguments. First, Brown concluded that the text, structure, and history of the FTC Act did not grant the FTC substantive rulemaking authority with respect to unfair methods of competition under Section 6(g) of the act. As a result, Brown found that the FTC exceeded its statutory authority by promulgating the rule and the challengers are likely to succeed on the merits of their claim. 

The FTC relies on Section 6(g) of the FTC Act, which gives the agency the power to “classify corporations and … to make rules and regulations for the purposes of carrying out the provisions of this subchapter.” But Brown found the provision to be a housekeeping statute that allows the creation of “rules of agency organization procedure or practice” and not “substantive rules.” 

Second, Brown determined that the challengers are likely to succeed on the merits on their claim that the FTC’s rulemaking process is arbitrary and capricious. The Administrative Procedures Act requires agency action to be reasonable and reasonably explained. In siding with the challengers, Brown found the rule to be unreasonably overbroad without a reasonable explanation. She concluded, “It imposes a one-size-fits-all approach with no end date, which fails to establish a ‘rational connection between the facts found and the choice made.’” Brown opined that the FTC based its rule on “inconsistent and flawed empirical evidence, fails to consider the positive benefits of noncompete agreements, and disregards the substantial body of evidence supporting these agreements.” If that were not enough, Brown also concluded that the FTC did not sufficiently address reasonable alternatives to the rule.  

Brown did not go so far as to issue a nationwide injunction to enjoin the FTC from implementing or enforcing the rule against interested observers outside of this particular litigation. Nevertheless, Brown indicated she will issue a final decision on the merits of the challengers’ claims—which could permanently block the FTC’s rule—by August 30, just a few days before the rule is set to take effect. In the meantime, the Pennsylvania judge who is overseeing the challenge filed by the tree service company is expected to rule on its challenges to the rule by July 23. 

When the FTC made its final tweaks to the rule between its proposed rule in 2023 and the final rule published in 2024, the FTC accelerated the deadline by which employers must provide the notice required by the rule. The proposed rule had given employers 45 days after the rule’s compliance date to provide notice, but the final rule requires notice to be given no later than the rule’s effective date. This means employers should pay close attention to these ongoing legal developments because, barring a nationwide injunction, employers may have a very short period of time to provide the notice required under the rule.

Kellen Scott is a shareholder in Chamberlain Hrdlicka’s Houston office, where he maintains a general civil litigation practice in state and federal courts, with particular emphasis on employment law, governmental defense, and civil rights. His practice includes the defense of employers and businesses in state and federal courts and in matters before state and federal administrative agencies, including the Texas Workforce Commission and the Equal Employment Opportunity Commission.

From: Texas Lawyer