Recommended actions

As we recommended in our previous client alert, although the final rule is being challenged, employers should be prepared to comply with the rule. In the event the final rule goes into effect (whether on the proposed date or later), employers should develop a compliance strategy.

1. Companies should review and inventory all contracts that include employee noncompete clauses. Employers should also review all human resource (HR) documents, including offer letters, internal policies, employment contracts, compensation-related agreements, and any other employment-related documentation. Companies should identify and be prepared to modify and/or remove any noncompete clauses that may be prohibited if the final rule takes effect.¹
2. Companies should be prepared to notify their affected employees. Should the rule become effective, employers would be required to provide their employees with pertinent information regarding their noncompete clauses. Specifically, the rule requires that employees be informed that their noncompetes are no longer enforceable as of the rule's effective date.²
3. Companies should understand the final rule in detail, how this rule will impact their business, including what is prohibited and any exemptions that may exist under the final rule.³

Key takeaways

This decision represents a setback for the FTC in its efforts to target noncompete agreements and broaden its enforcement authority under Section 5 of the FTC Act. Although the judge found that the plaintiffs are likely to succeed on the merits of their case, the judge did not grant a nationwide injunction, and the FTC may decide to appeal any adverse ruling on the merits.

Court ruled the FTC does not have substantive rulemaking authority. The court based its determination on an analysis of the text, history, structure, and subsequent amendments to the FTC Act, which the court determined only granted the FTC the ability to issue substantive rules under its consumer protection authority (not its competition authority). It also explained that the FTC previously disclaimed that it possessed substantive rulemaking authority for much of its history and had not issued a single substantive rule defining unfair methods of competition in over four decades.

Court held the final rule likely fails under the "arbitrary and capricious" standard. The court found that the rule is likely to constitute an abuse of discretion under the "arbitrary and capricious" standard of review applicable to the Administrative Procedures Act (APA). Despite noting its review under this standard is "limited and deferential," the court highlighted several key problems with the FTC's approach. Specifically, the court highlighted that the final rule was "based on inconsistent and flawed empirical evidence, fail[ed] to consider the positive benefits of non-competes, and disregard[ed] the substantial body of evidence supporting these agreements." The court also found the FTC failed to consider alternative courses of action or did not explain why exceptions to instituting a categorical ban on noncompetes would be insufficient.

Rulemakings represent a challenging avenue for pursuing broad reforms that depart from existing practice. Taken together with the points outlined above, the decision is a reminder that courts continue to provide an independent source of review when reviewing agency actions and are less inclined (particularly following the Supreme Court's recent decision in Loper Bright Enterprises v. Raimondo, No. 22-1219, 2024 WL 3208360, at *14 (US June 28, 2024)) to defer to administrative agencies (like the FTC) in determining the scope of their legal authority. And, particularly in the competition context, courts are likely to continue scrutinizing citations to empirical economic evidence when evaluating the agencies' decisions.

Background

As detailed in our previous alert, issued in April, the FTC issued a final rule instituting a nationwide ban on nearly all noncompete clauses. The rule was scheduled to take effect on September 4, 2024. Shortly after the vote on the final rule, three lawsuits were filed challenging the legality of the rule. The first two cases were filed in Texas, and the third case was filed a day later in the Eastern District of Pennsylvania. 

Each of the plaintiffs sought to delay the effective date of the rule pending a final ruling on the merits of their challenge. The lawsuits shared similar arguments–they each alleged the following: (i) the FTC lacks authority under the FTC Act to issue substantive rules under Section 6(g); more specifically, the FTC lacks authority to ban noncompetes as an unfair method of competition under Section 5 of the FTC Act, (ii) the rule is unconstitutional, (iii) the noncompete rule is "arbitrary and capricious" and violates the APA, and (iv) the FTC does not have authority to issue rules having retroactive force, which the final rule purports to have.

1 Please note that the FTC's final rule includes certain noncompete exceptions. For example, the rule does not apply to noncompetes entered into as part of a "bona fide" sale of a business—including a sale the ownership interests in a business entity, or of all or substantially all of a business entity's operating assets. See, Still going strong - M&A noncompetes and the FTC final rule on noncompetes. 

2 The FTC provides model notices (in several languages) on its Noncompete Rule webpage. Notice can be delivered by email, text message, or a paper notice by hand or mail. If the employer has no contact information for the former worker, no notice is required.

3 FTC Noncompete Fact Sheet.