FTC Ban on Non-Competes Would Have Major Impact on Closely Held Businesses

• The Federal Trade Commission is considering an administrative rule that would enact a broad ban on non-compete agreements that would prohibit contracts that restrict the employee from working for a competitor or starting a competing business.

• The rule would also apply to ‘de facto’ non-competes, such as non-solicitation agreements, that have the effect of limiting a worker’s activities after employment.

• The proposed rule will likely have a negative impact on the competitiveness and value of closely held businesses.  Non-competes in equity transactions would be prohibited unless the equity stake involved is at least 25 percent.

---

A proposed rule pending before the Federal Trade Commission would bar noncompete agreements across-the-board, and in a way that could bring some very profound changes to the business climate in this country.  If it is adopted in its present form, it likely will have a direct effect on the value of the investments of business owners in their own  businesses and make the smaller, privately held business less competitive.

This proposed rule is a big shift in resources from business owners to the employees.  It is something to watch and understand because of the effect it is likely to have if the proposed rule is adopted in its present form.  It’s controversial and has already run into opposition from the U.S. Chamber of Commerce.

The rule that the FTC is considering is very broad and it applies not only to the traditional non-compete but also to what the FTC describes as “de-facto” non-competes.  These are agreements like non-disclosure, confidentiality and non-solicitation agreements, that have the effect of limiting an employee from taking work with a competitor or starting a competing business.

The proposed rule would also apply to a new class of individuals as “workers” including independent contractors, sole proprietors that are contracted to work for a company, and even unpaid interns.

Owners of closely held businesses will experience a direct negative affect on the value and competitiveness of their closely held enterprise.  They will see the effect of the rule reflected in any transaction or sale of the equity in the business.  And, for many owners of closely held businesses that contemplate a sale of a business as their exit strategy, a broad ban on non-compete agreements will probably make it harder to retire.

And because a ban on non-compete agreements weakens the ecnomic moat around a business, it may be reflected in a host of other ways because the small entreprises, particularly service businesses, will be weaker.  It could discourage training some employees and employers may feel the need to restrict access to some of their most sensitive information.

Some background on the FTC and the rule-making process may be in order.  The FTC is a federal agency charged with protecting consumers and competition by regulating and prohibiting conduct that may deceptive, unfair or anti-competitive.  It regulates such industries as franchises, sweepstakes or games, some online activities and has, from time to time, gone after companies for what it saw as the over-reaching use of non-compete agreements.

The FTC’s extensive comments on the proposed rule articulates two over-riding reasons why it is proposing to ban non-compete agreements.  The first rationale is the group of cases that it has pursued in the past involving some high-profile over-reaching non-compete agreements that involved relatively low-wage employees without any real access to the kinds of information and influence that have been the rationale behind many non-compete laws.  These cases included such things as warehouse workers or security guards.  The contracts on their face screamed that they were devised by large companies to make rank-and-file workers less mobile and to avoid having to compete for talent based on wages.

The second rationale, and the one that the FTC staff really focuses on, is the negative effect that restrictive covenants have on the earnings of American workers and professionals.  The agency’s analysis of the proposed rule devotes much effort to a review of the way in which non-compete agreements result in lower wages across a broad spectrum of employees and professionals.  These studies, the commission says, reduce wages by reducing competition.

Because non-compete clauses prevent workers from leaving jobs and decrease competition for workers, they lower wages for both workers who are subject to them as well as workers who are not. Non-compete clauses also prevent new businesses from forming, stifling entrepreneurship, and prevent novel innovation that would otherwise occur when workers are able to broadly share their ideas.

The FTC estimates that its proposed rule banning non-compete would increase American workers buy $250 billion to $269 billion per year.  The commission cites various studies that as many as one-in-five or us work under some form of non-compete and that one-in-three have been subject to a non-compete at some point in the past.  Wages are depressed, according to these studies by 3 to 14 percent.

Is the FTC ban on non-competes part of an emerging trend in the US economy?  Certainly there have been a number of statutory limitations adopted by various states, as well as the fact that non-competes are subject to close judicial oversight.  But so far only California, North Dakota and Oklahoma have banned non-competes in the same way as the proposed rule.

Eleven states have banned non-competes with low-wage workers by placing an income requirement or have enacted other statutory restrictions.  These include, in some states, a prohibition on blue-penciling an agreement to make it reasonable.  Instead, when a non-compete does not meet a reasonableness threshold, in these states, it is unenforceable.

In all of the states where non-competes are still permitted, the restrictions on employment are subject to judicial review and the commonly adopted reasonableness standard.  There are three elements to this test: the non-compete must protect a legitimate interest of the employer – as opposed to limiting competition.  It must also be reasonable in its scope, usually geographic, and the time period in which it would be in force.

The proposed rule applies to any business entity such as a partnership, corporation, limited liability company or “other legal entity.”  Interestingly, it does not appear to apply to a sole proprietor.  It defines worker as “an employee, individual classified as an independent contractor, extern, intern, volunteer, apprentice, or sole proprietor who provides a service to a client or customer.”

The rule defines a non compete clause as “a contractual term between an employer and a worker that prevents the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment.”

The definition goes on to articulate a “functional” test for de-facto non-compete agreements, that is agreements that have the effect of being a non-compete though not identified as such.  A de facto non-compete “has the effect of prohibiting the worker from seeking or accepting employment …or operating a business after the conclusion of a worker’s employment”

The FTC’s proposed rule would make it an “unfair method of competition” for an employer to:

• Enter into or attempt to enter into a non-compete clause with a worker;
• Maintain with a worker a non-compete clause; or
• Represent to a worker that the worker is subject to a non-compete clause where the employer has no good faith basis to believe the worker is subject to an enforceable non-compete clause.

Finally, the rule would impose a limit on the restrictive covenants that are typically bargained for as part of the sale of a business or the purchase of an interest in a business.  It excludes from its application

a non-compete clause that is entered into by a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in the business entity, or by 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.”

The “substantial owner” presents a significant issue in the context of a closely held business because it is defined as someone holding a minimum 25 percent interest in the entity.

What does this mean for the smaller closely held business?  A great deal.  First, smaller companies are much more vulnerable to the resignations of key employees with competitive information or a competitive advantage gained through their former employer.  While the FTC’s commentary states that the rule would not bar confidentiality agreement, non-disclosure agreements and non-solicitation agreements, that commentary has to be measured against the “de facto” non-compete.

If the otherwise permitted agreement — a non-solicitation agreemen for example — would effectively bar an employee from subsequent employment with a competitor, it could function as an a de facto non-compete.

Unlike with much larger companies, the risk of the resignation of some key employee who now seeks to compete is proportionately larger.  Big, public companies are going to be far more likely to weather the financial consequences.

Private businesses also make proportionately bigger investments in key employees, expose them to more critical information about the business and are more likely to allow the influence of a single person to have a much greater impact on the business.

It’s hard to imagine, for example, that Amazon or Microsoft could be ruined by an employee defection to a competitor.  It’s not so hard to imagine the local real estate management company being put under by the defection of a key executive to a competitor.

In a similar way, the smaller the business, the more likely it is to rely on a limited customer base.  Large public entities may have millions of customers.  A closely held business may rely on a handful of key customers.  Here again, the relative harm to the business is disproportionately weighted against the closely held private business.

On the issue of value of the business, it is a recognized principle of business valuation that good will —the reputation of a company and its ability to generate new business from that reputation — does not belong to a company unless it has been transferred to the company.  The vehicle for the transfer of good will: a non-compete.

The recognized rule of law in dealing with the IRS and in many states is that good will belongs to the individual who generated the business unless there has been a transfer.  The result is that when applying traditional business valuation rules, the company that relies on good will — and that will include most service businesses — is likely to be worth nothing more than the value of its bank accounts and its hard assets like equipment and inventory.

This may not be a big deal for the manufacturing business, but for the consulting firm, the advertising agency and a host of other service businesses, it is a huge shifting of the resources of a business to its employees — a transfer that would occur without any compensation to the employer company.

In a similar vein the “substantial partner” definition restricts the ability of a company to provide a full array of incentive compensation, including equity shares.  What the rule means is that owners who leave, unless they are a 25 percent owner, cannot be limited in their employment.  This proposal is contrary to what has become a uniform presumption that good will that is sold as part of a transfer of equity can be protected with a non-compete agreement.

Businesses frequently have owners with less than 25 percent interests and it is generally accepted that restrictive covenants as part of a repurchase of an owner’s interests will be enforceable.

That could change drastically under the rule.  Consider for example, the owner of less than 25 percent who wants to retire.  Under this rule, the company or other owners that might buy his or her interest cannot require a non-compete as part of the transaction.  That risk of competition is going to be reflected in what the company is willing to pay for the retiree’s interest.  If the company cannot buy the retiring owner’s non-compete, the retiring owner cannot sell I either.

Or consider the relatively frequent case of the oppressed minority shareholder.  These cases are frequently resolved with a compelled or negotiated purchase of a minority share.  Those transaction under the proposed rule, whether bargained for or ordered by a court, could run  afoul of the FTC rule if the minority owns less than 25 percent.

The FTC is asking for comments on the rule.  I have attached a copy of the notice and request for comments here.  The rule making is likely to take quite a number of months.  Congress can also over-ride the rule and, ultimately, this is one adminiostrative rule that is likely to end up in the courts.