The Federal Trade Commission’s final rule banning noncompete provisions in contracts will have broad implications for employers and employees in the labor and employment context. It will also impact businesses and their owners entering into sale transactions and any other transactions involving noncompetes.
The final rule, released April 23, defines a “non-compete” as a term or condition of employment that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from seeking or accepting work in the US with a different person where such work would begin after conclusion of employment that includes the term or condition; or operating a business in the US after the conclusion of the employment that includes the term or condition.
A “worker” must be a natural person who works or previously worked, whether paid or unpaid. The final rule intentionally omits a definition for “employer” to ensure that it covers all workers regardless if they work for the same person who hired or contracted with them to work, and to avoid evasion of the final rule through complex employment relationships.
Notably for merger and acquisition transactions, the final rule adopts a sale of a business exception that permits entering into a noncompete with a person who is selling a business entity or otherwise disposing of all of the person’s ownership interest in a business entity in a “bona fide sale.”
The FTC requires a bona fide sale to be a sale “made in good faith as opposed to, for example, a transaction whose sole purpose is to evade the final rule,” and generally considers a bona fide sale to be a sale between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale.
The FTC declined to include the requirement contained in its earlier proposed rule that the restricted party be a substantial owner of the business holding at least a 25% ownership interest in a business entity, therefore, the exception applies to any person, regardless of ownership percentage.
The commentary to the final rules specifies that certain transactions won’t be considered a “bona fide sale,” including “springing” noncompetes that become effective upon the breach of a contractual obligation or duty, or noncompetes that arise out of repurchase rights and mandatory stock redemptions, including, for example, a noncompete that automatically becomes effective upon the redemption of a worker’s vested equity interest.
The rationale is that in these cases the worker that would be bound by the noncompete doesn’t have goodwill they are exchanging for the noncompete or sufficient bargaining power to negotiate the terms or conditions of the sale and the non-compete.
For example, workers with mandatory stock redemptions in connection with the sale of their employer couldn’t be bound by a noncompete in connection with the sale. Additionally, transactions between two wholly owned subsidiaries wouldn’t be considered bona fide sales since these transactions aren’t at arm’s length between two independent parties.
Parties to sale transactions that involve noncompetes should ensure transactions are structured as an arm’s length sale between two independent parties and that sellers subject to a post-sale noncompete are represented by counsel in connection with negotiation of the terms of the sale and the noncompete.
Additionally, given the FTC’s focus in the commentary to the final rules on the importance of goodwill in a bona fide sale, ideally a material portion of the consideration received in exchange for the interest of a party bound by a noncompete should be based on the goodwill in the business being sold by the restricted party.
There is significant uncertainty for investment funds regarding the applicability of the final rule to carried interest vehicles such as a partnership or LLC. While the final rule provides that it only applies to workers who are natural persons, it doesn’t specify whether it applies to noncompetes entered into in the context of individual partners or members of a partnership or LLC outside of an employer-employee relationship.
Parties that enter into such non-competes should be aware that they may face legal challenge and have uncertain enforceability, particularly in light of the decision by the FTC not to provide a definition for what qualifies as an “employer” in the final rule.
It is expected, however, that the final rule will permit noncompetes that apply to an entity general partner in a partnership, enabling, for example, private equity funds entering into noncompete agreements with their entity general partners. However, any such noncompetes couldn’t apply to a specific individual involved in the operation and management of a restricted general partner.
Businesses concerned about the effect of the final rule on the protection of confidential business information and other valuable intellectual property should consider and implement alternative means of protecting such information, including, for example, nondisclosure agreements, non-solicitation agreements, enforcement of intellectual property rights under trade secret and patent laws, invention assignment agreements, and taking measures to better retain employees.
The final rule is expected to take effect in late August, 120 days after publication in the Federal Register. Legal challenges, some already pending, could delay enforcement.
This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.
Author Information
Donald Hammett is partner in Alston & Bird’s investment funds group and co-leader of the firm’s REIT team.
Christina Heddesheimer is a senior associate in Alston & Bird’s investment funds group.
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