In brief
On Tuesday this week, the Federal Trade Commission (FTC) issued its highly anticipated final rule on noncompetes, imposing a near-total ban on worker noncompetes in the United States. Barring injunctive relief from legal challenges (which have already started), the rule will take effect 120 days from publication in the federal register.
Interestingly, the rule exempts noncompete covenants entered into pursuant to a bona fide sale of a business. While “bona fide” is not defined in the final rule, the Supplementary Information for the rule explains that the FTC considered but rejected percentage and dollar minimum thresholds for the sale of business exception to weed out “exploitative and coercive” noncompetes and clarified that excepted noncompetes must be given “pursuant to a bona fide sale.” The Supplementary Information further explains that the FTC considers a bona fide sale to be one that is made between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale.
Contents
- What type of noncompetes are impacted?
- Do state laws still apply?
- New Ideas
- What about nonsolicitation agreements? Are they banned?
- What should companies do now?
- US State noncompete laws: Trending toward restrictive
In contrast, the FTC specifically calls out as problematic “springing noncompetes,” which apply to employees in the event of a sale and mandatory stock redemption or repurchase programs because the employee has no goodwill to exchange in the sale for the noncompete and no meaningful opportunity to negotiate at the time of contracting.
Nevertheless, the bona fide sale exception is broad and preserves the status quo by allowing buyers in M&A transactions to obtain noncompetes from individual sellers in circumstances where such noncompetes are otherwise permitted currently. While the pending and anticipated legal challenges to the rule are significant and place the entire rule in jeopardy, the sale of business exception is not likely to be narrowed because of these challenges.
So, what does this new regime mean for M&A?
What type of noncompetes are impacted?
The Supplementary Information confirms that the new rule does not apply to B2B noncompetes or nonsolicits. Instead, the focus of the rule is noncompetes with workers that limit their ability to work for others. So the rule does not impact current B2B agreements.
Second, the FTC repeatedly makes the point that noncompetes must meet existing state and federal law restrictions (e.g., reasonable in scope and duration; limited to the goodwill to be acquired, etc.) to be enforceable, even if they otherwise fall within the sale of business exception in the new rule. This is the case because the FTC rule creates a new floor for noncompetes by preempting more lax state rules, but it does not preempt more stringent state laws or federal antitrust restrictions.
Do state laws still apply?
Signed Deals. The good news is that, while the FTC rule applies retroactively, prior noncompetes entered into with individual sellers remain valid if given as part of a bona fide sale of a business because the new rule only supersedes state law “to the extent that such laws would otherwise permit or authorize a person to engage in conduct” that is regulated by the final rule.
Thus, noncompetes obtained as part of a bona fide sale of a business remain valid if they otherwise already complied with state and existing federal antitrust laws. The final rule also makes clear that where a cause of action related to a noncompete clause arose prior to the effective date, the final rule does not apply. In other words, if a selling employee already has breached a sale of business noncompete, buyers can still sue.
New Deals. The same exemption analysis listed above applies. In any bona fide sale of business, the parties still must comply with state laws, which may be more restrictive than federal antitrust law. For example, in California, sale of business noncompetes are valid only when the sale is of a substantial interest in the corporation so that the shareholder, in transferring all his or her shares, can be said to transfer his or her interest in the corporation’s goodwill.
New Ideas
We expect to see an increase in partnership transactions and/or equity ownership offerings for the executives of target businesses to qualify such executives for sale of business noncompetes. Specifically, the removal of the significant ownership requirement under the sale of business exception opens the door to permissible noncompetes for option holders and lower-level employees, barring applicable state law restrictions.
What about nonsolicitation agreements? Are they banned?
The FTC’s final rule does not directly address nonsolicitation covenants. However, the Supplementary Information provides that, while the rule “does not categorically prohibit…NDAs, TRAPS (an agreement to repay training or educational expenses advanced by an employer), and nonsolicitation agreements,” an agreement “that is so broad or onerous that it has the same functional effect” as a noncompete would fall under the rule. More pointedly, under the FTC’s rule, “non-solicitation agreements can satisfy the definition of [a] noncompete clause…where they function to prevent a worker from seeking or accepting other work or starting a business after their employment end.” Note that this interpretation should not apply in the sale of business context-in a bona fide sale situation in which a noncompete is permissible under the rule, nonsolicitation covenants should be equally available (and subject to the same limitations on reasonableness as are noncompetes). But other than in the sale of a business context, the FTC’s position is that overly broad consumer nonsolicits could be challenged as functional noncompetes under the rule.
What should companies do now?
- Until litigation over the FTC rule is resolved, we recommend a close evaluation of state law applicable to each material person to be bound by a sale of business noncompete. Below is a brief explanation of how US state noncompete law is trending.
- Companies should ensure that noncompetes entered into with individual sellers meet the bona fide sale of business exception even before the rule takes effect and should aim to comply with applicable state law to position themselves for maximum enforceability regardless of the rule’s ultimate outcome.
- It is common practice to consider limiting noncompetes to 3 years or less in length for maximum enforceability (though longer periods may still be enforceable), tying restrictions to the actual operation of the acquired business, and using the tax residence of individual sellers to decide which state law applies to further bolster the validity and future enforcement of noncompetes.
US State noncompete laws: Trending toward restrictive
State law is increasingly restrictive towards M&A non-competes. For example, California generally prohibits non-competes, but allows them in the sale of business context as follows:
Any person who sells the goodwill of a business, or any owner of a business entity selling or otherwise disposing of all of his or her ownership interest in the business entity, or any owner of a business entity that sells (a) all or substantially all of its operating assets together with the goodwill of the business entity, (b) all or substantially all of the operating assets of a division or a subsidiary of the business entity together with the goodwill of that division or subsidiary, or (c) all of the ownership interest of any subsidiary, may agree with the buyer to refrain from carrying on a similar business within a specified geographic area in which the business so sold, or that of the business entity, division, or subsidiary has been carried on, so long as the buyer, or any person deriving title to the goodwill or ownership interest from the buyer, carries on a like business therein.
California courts have made clear that a person must sell a “substantial interest” in the business, meaning it is clear from the transaction that the person is transferring his interest in the goodwill of the acquired business, for this exception to apply.
We note that Delaware, Illinois and New York have reasonableness-based laws where such non-competes must be reasonably tailored to legitimate business interest. Even Texas, which is generally lenient with respect to employment agreements, requires tailoring of non-competes in the M&A context.
