How The FTC's Proposed Rule Banning Non-Competes Affects You

The FTC recently proposed a sweeping rule that, if enacted, would effectively ban all non-compete agreements nationwide. Here's why they should do it, sort of.

No one reads contracts. I don’t just mean no one reads those “I hereby agree to abide by the terms and conditions” contracts. I mean no one reads those “sign on the dotted line to officially become a proud full-time employee of Applebee’s” contracts.

A recent study found that only about 16% of employees read their employment agreements in full. And, if that study is remotely accurate, then statistically you didn’t read anything more than the comp section of your employment contract either (even though we all like to think we’re above average).

If you did read your employment contract, though, chances are you might just find yourself bound by a non-compete provision—a contractual restriction on your ability to move to a competing employer, typically covering a specified period of time after you’ve quit or been fired.

About one in every five workers (roughly 30 million Americans) is currently subject to a non-compete provision, and nearly 40% of all workers have signed a non-compete at one point in their careers. These provisions are important and real for employees of all shapes, sizes and income brackets—not just senior executives. Roughly 15% of employees making less than $40,000 a year have non-competes in their contracts, which in some cases means they can’t work for a competing employer for six months, a year, or maybe more, even if they’ve been terminated without cause. Amazon is notoriously harsh when it comes to non-competes, and has reportedly even put non-competes in the contracts of temporary warehouse workers.

Source: Non-Compete Agreements: Analysis of the Usage, Potential Issues, and State Responses, May 2016

The classic argument over non-competes generally tends to be framed as one of pro-business vs. pro-employee (although the tradeoffs are a bit more nuanced in reality). The pro-business folks argue that non-competes incentivize companies to invest in workers by giving firms downside protection against the possibility that an employee will up and leave after a firm has spent time and money training them. (There’s also an argument about safeguarding certain proprietary info belonging to the company called “trade secrets,” but that sort of information can, and is, pretty easily safeguarded with a non-disclosure agreement, and it turns out a total of zero Applebee’s restaurant employees have ever been granted access to corporate trade secrets.) Meanwhile, the pro-employee folks argue that non-competes stifle competition and innovation and reduce employee bargaining power, ultimately leading to lower wages.

Enter the Federal Trade Commission (the “FTC"), whose new, youthful and outspoken leader, Lina Khan, is on a mission to expand the the FTC’s presence by wielding a brazenly liberal agenda. Earlier this month, the FTC voted 3-1 to propose a new rule that would not only make it illegal for any U.S. employer to enter into a non-compete with a worker, but would also invalidate all existing non-competes nationwide. Here is the 216-page Notice of Proposed Rulemaking (“NPRM”), if you’re into that sort of thing.

The NPRM is the first stage of the process, where the FTC puts out a proposed rule for “public comment.” The public comment stage is basically where lobbyists, special interest groups, academics and other idiosyncratic people who have an interest in this issue read the weighty tome that is this proposed rule and provide comments back to the FTC. After the FTC reviews the public comments, it crafts a final rule, which, as Commissioner Wilson (the sole dissenter to the proposed rule) noted, will surely be challenged in court.

The weird thing about antitrust and competition law, though, is that it falls somewhere in between law—a notoriously nebulous and conceptual field—and economics—an almost equally malleable social science. Not only is the issue of non-competes no exception to the murky world of antitrust law, it’s actually a topic that’s particularly understudied by academics. Worse, the FTC even acknowledges that what little evidence is out there on non-competes is “conflicting.” All that to say, regardless of your instincts or well-thought-out views on the issue of non-competes, the FTC is making a pretty big move based on a lot of theory, conjecture and dubious math.

For example, the FTC’s proposed rule is pretty radical in that it would ban all non-competes between employees and employers, with an exception only for mergers between companies. As a result, the rule would invalidate non-competes with “senior executives,” which the FTC suggests is worthwhile because (emphasis added):

[N]on-compete clauses for senior executives may harm competition in product markets . . . to the extent that senior executives may be likely to start competing businesses, be hired by potential entrants or competitors, or lead the development of innovative products and services. Non-compete clauses for senior executives may also block potential entrants, or raise their costs . . . As a result, prohibiting non-compete clauses for senior executives may have relatively greater benefits for consumers than prohibiting non-compete clauses for other workers.

That’s it. The FTC doesn’t really backup any of these claims, and the above excerpt is pretty much the extent of their reasoning as to why the ban should cover executive non-competes—a big decision regarding contracts that often deal with millions of dollars worth of compensation.

Another example of the FTC’s shaky reasoning is how it arrived at its headline figure: “By stopping [the] practice [of non-competes], the agency estimates that the new proposed rule could increase wages by nearly $300 billion per year.” Although it took some digging (163 pages of digging, to be exact), the FTC explains in the NPRM that it basically arrived at this number—a number it’s widely touted in connection with this proposed rule—by a quick back-of-the-napkin analysis. Basically, the FTC found one study that “estimates decreased non-compete clause enforceability would increase earnings by approximately 1%.” Then, after acknowledging that there’s really “no way to disentangle [the impact of non-competes] from state-specific effects,” they simply back out the 1% earnings estimate to each state and then multiply that by the total annual wages of each state to arrive at an overall annual earnings increase for the country of $295.9 billion. But hey, people love a round number so let’s go with “nearly $300 billion” and call it a day.

But here’s the thing: Despite the FTC’s lack of compelling evidence to support a ban on non-competes, the rule largely makes sense intuitively.

Although many of us are often critical of the government’s desire to intervene in conduct between private parties that would otherwise be more efficient if simply left alone, that’s not always the case. One specific instance where government intervention or oversight is welcomed is when there are asymmetries between the parties. For instance, most of us like when the government intervenes in the homebuying process by creating laws that require a homeowner to disclose all known defects to a potential buyer (correcting an information asymmetry that exists between the seller and buyer). We also typically like it when the government steps in to correct asymmetries of bargaining power (like most landlord/tenant laws, to continue with the theme of housing).

The FTC can try to make the issue of non-competes about hypothetical and theoretical “negative externalities” or “anticompetitive forces” or “wage suppression” but, at the end of the day, we really just want to address the issue of asymmetry. An employer/employee relationship is, in most circumstances, inherently one-sided—the employer has all the information and bargaining power. This is particularly true when the employer has an opening for a job that pays less than $40,000 a year and/or doesn’t require a college degree. Those are the cases where banning non-competes makes total sense. These employees have effectively no power to negotiate the terms of their contract, don’t gain access to proprietary trade secrets during the ordinary course of their job, and don’t have any material impact on their employer’s business if and when they leave to a competing firm.

What’s even worse is that the asymmetry continues even after the employee leaves or is terminated—there are countless examples of companies including unenforceable and illegal non-competes in employee contracts because (1) the sheer existence of those words in a contract scares the employee into not seeking out employment with a rival company and (2) the company has the resources to litigate the enforceability of the provision, whereas the employee usually doesn’t, even if the provision ultimately isn’t enforceable at all. There just really isn’t even a remotely strong case for keeping non-competes in place for your average, everyday worker.

All that said, the FTC’s proposed ban on non-competes with executives and other high-earning individuals is over-broad and honestly a tactical error on the part of Lina Khan and the other two commissioners who voted for this rule. All of the criticisms I laid out above are simply non-existent for executives: Asymmetries of information and bargaining power are typically not substantial (and sometimes even favor the high-earning employee), and even the concern about the high-level employee spilling trade secrets at a rival firm carries some water (it’s hard to tell a senior executive to simply not use or talk about confidential information she learned from her previous employer when she starts a new job with a competitor). Those non-competes should be carved out from the final rule, which could easily be done with a compensation threshold adjusted for each state.

People in the private sector love to tout, I think reasonably, that a cornerstone of American innovation is the ability to hire fast and fire fast (but I am most certainly not condoning “Moving Fast and Breaking Things”). Scaling quickly, pivoting quickly, and unfortunately sometimes cutting quickly are essential to a firm’s success. But firms can’t have their cake and eat it too (a saying I’ve never really understood, but whatever). In other words, if firms want to be nimble, it’s unreasonable to then force obscure contractual provisions upon rank and file employees that restrain where they go after they leave your firm. And if firms are so worried about the possibility that they’ll invest time and resources in their employee only for the employee to turn around and leave for a competitor, maybe try running your firm in a way that entices employees to stick around, rather than wielding the stick that is a non-compete provision in order to force them to stay. I hear people are quite fond of free kombucha in the office these days.