Protecting Your innovation When the Lights Go Out on Noncompetes

A recent Texas federal court ruling blocked the Federal Trade Commission’s (FTC) proposed ban on noncompete agreements, halting the rule’s nationwide implementation. This decision highlights the ongoing legal tug-of-war over noncompetes, which are facing increasing scrutiny both at the federal and state levels. Although the lights may never go out completely on the use of noncompetes, the overarching trend has seen their use diminished in recent years. With the legal landscape in flux, startups should reconsider their strategies for safeguarding sensitive information.

The FTC’s Proposed Ban on Noncompetes

In January 2023, the FTC proposed a rule that would effectively ban noncompete agreements in most employment contracts. The rule not only prohibits new noncompete agreements but also requires employers to rescind existing noncompetes and notify employees that these agreements are no longer in effect. The FTC argues that noncompetes restrict workers’ freedom to change jobs, which can depress wages and hinder innovation. According to the FTC, eliminating noncompetes could increase wages by nearly $300 billion annually and expand career opportunities for approximately 30 million Americans. The rule was expected to take effect on September 4, 2024.

Key Aspects of the Proposed Rule:

• Scope: The rule applies broadly to all workers, including employees, independent contractors, interns, and volunteers, effectively banning noncompetes across the board.
• Enforceability: Employers would be prohibited from enforcing, threatening to enforce, or attempting to enter into noncompete agreements. Employers must also provide notice to workers that existing noncompete agreements have been rescinded.
• Penalties: Employers who violate the rule could face significant penalties, including FTC enforcement actions. The FTC can seek both civil penalties and injunctive relief, potentially leading to substantial financial liabilities for noncompliant employers.

The Texas Ruling

In the recent case of Texas v. Federal Trade Commission, a federal judge in Texas blocked the FTC’s proposed nationwide ban on noncompete agreements. The case was brought by a coalition of business groups and employers who argued that the FTC exceeded its statutory authority in attempting to enforce such a broad prohibition. U.S. District Judge Matthew J. Kacsmaryk ruled that the FTC’s action was unconstitutional, particularly in light of the Supreme Court’s recent decision in Loper Bright Enterprises v. Raimondo, which overturned the broad deference that had been granted to agency rulemaking since the 1984 decisions in Chevron v. Natural Resources Defense Counsel. The court found that the FTC lacked clear congressional authorization to regulate noncompetes, aligning with the Supreme Court’s reasoning that agencies cannot assume regulatory powers that Congress has not explicitly granted.

The FTC may attempt to revive the noncompete rule by appealing the recent court decision. They could also seek an emergency order from the appellate court to enforce the rule as scheduled. However, any appeal would go to the 5th Circuit Court of Appeals, which is known for its business-friendly rulings, making it unlikely the rule will be reinstated. If unsuccessful there, the case might go to the Supreme Court, which has recently been critical of regulatory overreach, posing another significant challenge for the FTC.

The Changing Landscape of Noncompetes

Startups have long used noncompete agreements to protect intellectual property, prevent talent loss to competitors, and secure investor confidence. However, even before the FTC’s threat to ban noncompetes nationwide, many states have already enacted laws to limit or outright ban their use. For example:

• California, North Dakota, and Oklahoma: These states already prohibit noncompetes except in very limited circumstances.
• Washington, Oregon, Illinois, and Massachusetts: These states have implemented laws restricting the use of noncompetes, particularly for low-wage workers or by imposing limitations on duration and geographic scope.
• New York and New Jersey: Both are considering legislation that could severely restrict noncompetes.

This patchwork of regulations is leading to a national trend where noncompetes are becoming less favored, with businesses needing to navigate a complex legal environment to enforce them.

Continued Use of Noncompetes

While, for the time being, employers can breathe a sigh of relief while the FTC rule is blocked, it is still a good time to review your use of noncompetes and other restrictive covenants. Noncompetes will, for now, continue to be regulated by a patchwork of state laws here in the United States. This can create some complexity depending on how geographically diverse your workforce is.

Do you have employees in two different states with drastically different laws on noncompetes? Chances are, if you have employees in more than one state, the answer is yes. It may or may not be possible to draft a noncompete that will survive challenges in all of the relevant states. Companies should work with legal counsel to ensure that agreements and policies are updated regularly.

Employers should consider compiling an inventory of all restrictive covenants, including those with former employees, to prepare for any potential legal changes. This inventory will also aid in compliance and tracking, regardless of the rule’s future.

And if, even in the face of this uncertainty, you decide to continue using noncompetes with key employees, there are some general best practices:

• Don’t be the bad actor: These cases often involve a bit of the court trying to ascertain who was being fair and protecting a legitimate business interest and who was being a bad actor. The courts seem to often find a way to penalize whoever is perceived as being the bad actor.
• Don’t Use a “One-Size-Fits-All” Approach: There’s no universal approach to using noncompetes. Each business is different, and what would be considered reasonable in one industry or region might not be in another. The same holds true for employees, not all employees will warrant the same noncompete (or any noncompete at all). The purpose of a non-compete agreement is to protect business interests. As such, the agreement you create should be sufficient to accomplish that — no more or less.
• Reasonable Time and Place Limitations: The key aspects of your noncompete will include the who, what, when, and where. Check with legal counsel about the applicable legal precedents in your state, but don’t be overzealous about time or geographic restrictions.

Trade Secrets as an Alternative

Given the uncertain future of noncompetes, startups should explore alternative strategies, such as leveraging trade secrets. Trade secrets offer a form of protection that doesn’t rely on restricting an employee’s future employment. By safeguarding proprietary information through confidentiality agreements, controlled access, and robust security measures, startups can create a de facto noncompete environment without the legal risks associated with traditional noncompete agreements.

Although not universally adopted, the doctrine of inevitable disclosure provides an additional layer of protection in certain states that can function as an effective noncompete. This legal doctrine allows courts to prevent former employees from working for competitors if it’s deemed inevitable that they would disclose trade secrets. While not universally accepted, it is recognized in states like Illinois, New York, and Delaware, providing an even greater avenue for startups to protect their interests even in the absence of a formal noncompete.

Best Practices for Trade Secret Protection:

• Confidentiality Agreements: Ensure all employees and contractors sign strong confidentiality agreements.
• Access Control: Limit access to sensitive information to essential personnel only.
• Employee Training: Regularly educate employees on the importance of protecting trade secrets.
• Document Security: Implement secure document management and disposal practices.

Conclusion

As the legal landscape around noncompetes evolves, startups must stay informed and adaptable. While the FTC’s proposed ban is currently blocked, it should be expected that noncompetes will continue to face increasing restrictions. By focusing on trade secrets and other protective measures, startups can safeguard their valuable assets while navigating the uncertain regulatory environment.