The Federal Trade Commission recently announced it is proposing to ban non-compete agreements between employers and workers. We are of the opinion that much of the conversation about the FTC’s proposed rule, both in terms of its substance and its ability to promulgate, are muddled between differing concepts. Our takeaway is that there is no justification for non-compete agreements once one sets aside Trade Secret protection—a matter already protected by existing law. We also argue that arguments about why the FTC should avoid challenges to its authority are overbroad: Essentially, the argument that the FTC should shy away from rulemaking because of the “major questions doctrine” and the “non-delegation doctrine” suggest that no agency should ever attempt to do anything. Moreover, the FTC has the better argument on these issues.
No Legitimate Business Justification
For present purposes, we set aside non-competes that are part of the sale of a business, as well as trade-secret provisions. We focus solely on clauses that restrict post-employment labor market activities. We refer to these contract terms as post-employment non-compete agreements or non-compete agreements. In the case of a trade secret (not protected by a non-compete agreement but a trade-secret protection clause), a business may have a protectable intellectual property interest. To bring a misappropriation of a trade-secret case, the employer must come forward and identify the trade secret, show that (a) it has competitive significance, (b) the employer took reasonable steps to protect the secret, and (c) the employee misappropriated the secret. In such cases, the claimed business justification is put to the test.
That’s not the case with post-employment non-competes. One of the authors has practiced law in Utah for more than three decades, a state that vigorously enforces non-compete agreements. In nearly every case, the central issue is: What exactly is the legitimate business interest being protected? In our experience, there is no credible business interest that justifies a non-compete agreement. While many corporate lawyers and business litigators will fight to enforce a client’s non-compete, and we have done this as well, there is rarely if ever a credible case. Ironically, the attorneys themselves never agree to their own non-compete agreements, and the American Bar Association’s Model Rule 5.6 (“Restrictions on Right to Practice”) makes non-competes among attorneys and law firms unethical. Is it the case that law firms are somehow different and have no legitimate interests to be protected like other businesses?
States that enforce non-competes usually adopt some version of the Restatement (Second) of Contracts Section 188. Under the rule, the post-employment non-compete restraint cannot be greater than needed to protect the legitimate business interest. Our main point is that there is no legitimate business interest in an employment non-compete agreement. Any effort to define the geographic scope or the duration of the restraint is pure fiction. Lawyers who draft these agreements don’t define relevant markets or estimate the time it takes to depreciate some alleged goodwill. They simply draft the broadest language they believe they may get away with either because litigation is unlikely, or the local precedent provides a good faith argument. This is because, again, there is almost never a credible business interest to be protected in the first place.
So what possible reason could a business have for preventing former employees from working where they choose, independent of trade secret issues such as secret technology or client lists? The classic answer appears in the lead Utah case where a clerk at a pharmacy through his hard work gains the trust of local patrons. The company claimed ownership in that goodwill.
How many situations are like this in today’s economy? According to a study by the Economic Policy Institute, roughly half of all businesses in the United States use non-compete agreements. It is not reasonable to believe workers at half the nations’ firms have acquired company-related customer goodwill sufficient to injure the company. American companies themselves do not seem to think so. Companies must report goodwill on their financial statements. Yet you will not find the list of their employees with non-competes reported as material sources of company goodwill. Indeed, if an employee does increase its employer’s goodwill with the public by their own efforts, why remove their bargaining power to increase their wages? The employee should be compensated for these achievements. Allowing the firm to appropriate the fruits of such efforts is the essence of “exploitation.”
One argument some businesses make is that the non-compete agreements are necessary to protect their investment in employee training. We find this argument particularly untenable. Non-compete incidence is rising among holders of professional degrees. A Ph.D. with a science background comes to a firm with significant human capital acquired over years at their own expense. The same is true of lawyers, accountants, and physicians. Often additional training occurs through professional organizations. For example, an accountant may receive training in valuation from the American Institute of Certified Public Accountants, or a lawyer may learn how to take a deposition at a National Institute for Trial Advocacy seminar. There are often continuing education requirements. The internal investments by firms in training are trivial in comparison, and what little there is to protect can be protected through trade-secret contract agreements. Such training may also not be valuable to other firms and may not lead to competitive injury. This seems particularly true at the lower end of the labor market. Learning the McDonald’s process may not be particularly useful at Burger King.
Moreover, investment in training takes place without non-compete agreements. It is unlikely that firms in California train less than other states. Law firms invest heavily in training without non-competes. There is no need to give employers the equivalent of an equitable stake in an employee’s human capital to induce training. We don’t allow banks to do this with student loans, and the same public policy should prohibit non-compete agreements as an incentive for training. In both cases, student loans and training will occur without the draconian “exploitation.”
Workers Generally Do Not Negotiate for Non-Competes
Even if there were a legitimate business interest in preventing former employee labor mobility, the Restatement further avers that such an interest can be outweighed by the hardship to the worker or the public. The FTC’s Supplementary Information accompanying its Notice of Proposed Rulemaking comprehensively reviews the economic literature relevant to these two points. The weight of the evidence from the economic studies show that non-compete agreements (a) lower wages, (b) increase racial and gender wage gaps, (c) harm entry and business formation because they impede labor mobility (one can speculate what would have happened if Shockley Semiconductor had non competes with the future Fairchild and Intel founders), (d) increase medical costs, and (e) may reduce innovation.
One of the most frustrating situations for an employee who becomes a party in a non-compete agreement enforcement action is to face a judge who views a post-employment non-compete as purely a contract issue. Early Chicago School law and economics encouraged this simplified thinking. The logic is that since there is a valid contract, and the employee voluntarily chose to execute it, it should be enforced (sometimes this is called the employee choice rule). This logic would only hold under conditions of perfect competition—that is, full information on both sides, equal bargaining power, and no issue of externalities impacting markets and the public. Most judges know this kind of thinking is pure ideology simply based on their knowledge of the common law. The common law itself recognizes that perfect competition is a fiction. The contract defenses of mutual mistake and frustration of purpose are because of asymmetric information. The defenses of unconscionability, duress, and necessity result from unequal bargaining power, and of course, restraints of trade are because of externalities.
To simply enforce a non-compete because it is in a contract, a judge must put on his or her ideological blinders and ignore the real-world factual record. In our litigation experience, employees learn about the non-compete for the first time after the job negotiations are completed and it is time to sign the paperwork. This often occurs after the employee has started the job. The non-compete is often in fine print and written in legal jargon. The contract terms are often presented as a nonnegotiable firm policy. If the worker wishes to negotiate, they are placed in a position where they must risk starting a major confrontation on their first day of work. And to adequately understand their rights will result in a long work delay. Thus, even if the employee might have not agreed ex ante to the non-compete agreement, by the time of the contract (or when they get around to reading the employee handbook), they agree ex post. According to the EPI survey, the vast majority of non-compete agreements are executed without any negotiation.
Answering Commissioner Wilson’s Dissent
This brings us to FTC Commissioner Christine Wilson’s dissent. True to form, she is most concerned that a rule against employee non-competes might harm “the business justification that prompted its adoption.” Of course, she never identifies or defends that business justification, Nonetheless, she knows that there must be something to be defended, and “unelected bureaucrats” shouldn’t interfere. Interestingly, elected officials seem to differ with Commissioner Wilson. Indeed, as noted by the FTC, three states already have rendered employee non-competes unenforceable, and many other states have limited their application. There is no identifiable trend in the other direction. The FTC proposed rule advances a sound policy that will promote economic development and the interests of consumers, workers, and new business formation.
Commissioner Wilson’s jurisdictional objection is that the FTC may not have the power to promulgate a rule against non-compete clauses. This is also the point recently made by Chicago law professor Randy Picker. They both imply that if legal challenges could occur, the Commission should censor itself in advance and give up on policies that improve welfare. For them, the potential protection the rule could afford workers (and ultimately consumers) is not worth the risk of a courtroom loss. We disagree both on the philosophy and on the merits. In connection with the merits, what cannot be disputed is that Section 5 of the FTC act covers non-competes. Binding precedent allows the FTC to bring cases under Section 5 that are covered by the Sherman Act. The Sherman Act prohibits contracts in restraint of trade. A non-compete agreement is a contract, and there is no doubt that the Sherman Act was meant to apply to common law restraints of trade.
The classic example of a restraint of trade is a non-compete agreement (and is where the name “restraint of TRADE” derives). Indeed, Justice White in the Standard Oil Case, which introduced the rule of reason, traces the common law of restraints of trade from Mitchel v. Reynolds, a covenant not to compete case. Because, in our view, post-employment covenants have no legitimate procompetitive purpose, they should be considered per se illegal. This was the view of the district court in Newberger, Loeb & Co. v. Gross, 563 F. 2d 1057, 1083 (1977) (“Restraint on postemployment competition that serve no legitimate purpose at the time they are adopted would be per se invalid”).
But courts in several cases have found that non-competes can protect interests in trade secrets and customer good will. For example, Aydin Corp. v. Loral Corp, 718 F 2d 897, 900 (1983). Therefore, at present the rule of reason is the norm. In our view, these courts have made an unjustified melding of trade secrets and post-employment non-compete agreements. Although a trade secret can be a legitimate interest, it is best handled by a separate contract clause, while the post-employment non-compete agreement is without any legitimate merit. Because of this confusion, post-employment covenants are analyzed under the rule of reason, and under this standard they inevitably fail. This is because it is virtually impossible to demonstrate a market effect emanating from a single or limited number of non-compete agreements, particularly where contracts include arbitration and/or non-class action clauses. In this legal context, Section 5 of the FTC Act can play a critical role. As the Supreme Court stated in FTC v. Brown Shoe Co, Section 5 “is particularly well established with regard to trade practices which conflict with the basic policies of the Sherman and Clayton Acts even though such practices may not actually violate these laws.” 384 US 316, 321 (1966).
On the FTC’s Legal Authority
The remaining issue is whether the FTC is authorized to promulgate a rule against employment non-compete contracts. There is great back-and-forth about whether the language of 6(g) of the FTC Act allows for unfair methods of competition rulemaking. The pre-Chevron doctrine D.C. Circuit decision in Nat’l Petroleum Ref’rs Ass’n v. FTC, 482 F.2d 672 (D.C. Cir. 1973), found such rulemaking authority.
In a nod perhaps to Justice O’Connor’s FDA v. Brown & Williamson decision, Commissioner Wilson notes that the Magnusson Moss Act (establishing Sisyphean barriers to Unfair Trade Practices Rulemaking) expressly carved out unfair methods of competition rulemaking. Commissioner Wilson suggests the reason is reliance on statements by FTC Commissioners and Chairs past disclaiming such authority.
Her argument faces two logical hurdles. The first is that the plain language of the FTC Act, which implies that that the agency has such authority: “From time to time classify corporations and (except as provided in section 57a(a)(2) of this title) to make rules and regulations for the purpose of carrying out the provisions of this subchapter.” To the extent we are all textualists now, it is surprising to see conservative flight to legislative history and former FTC Commissioner statements.
The second logical hurdle is that Chevron Doctrine is dead. Chevron in essence states that where a statutory provision is ambiguous, the Agency’s interpretation shall be given deference so long as that interpretation is reasonable. There is no discussion in Commissioner Wilson’s dissent of Chevron. One can only assume she believes the FTC deserves no deference.
Those are not the only precedents that appear to be ignored. Commissioner Wilson and others argue that it is improvident for the FTC to engage in rulemaking on this issue rather than adjudication. However, the Supreme Court has spoken on this issue as well. In “Chenery II,” Justice Murphy wrote (emphasis ours):
Problems may arise in a case which the administrative agency could not reasonably foresee, problems which must be solved despite the absence of a relevant general rule. Or the agency may not have had sufficient experience with a particular problem to warrant rigidifying its tentative judgment into a hard and fast rule. Or the problem may be so specialized and varying in nature as to be impossible of capture within the boundaries of a general rule. In those situations, the agency must retain power to deal with the problems on a case-to-case basis if the administrative process is to be effective. There is thus a very definite place for the case-by-case evolution of statutory standards. And the choice made between proceeding by general rule or by individual, ad hoc litigation is one that lies primarily in the informed discretion of the administrative agency.
It is entirely possible the Court will ignore its own precedent, but the FTC should not be so quick to do so like antitrust practitioners did with Philadelphia National Bank and other pre-consumer welfare decisions. The FTC should stick to protecting the public and not give deference to the Chicago School over controlling precedent.
The Constitutional Issues
Commissioner Wilson invokes Constitutional issues in apparent eagerness to eliminate her own agency’s authority. In doing so, she assumes that in any “major questions doctrine” (MQD) challenge to the FTC’s rulemaking the Supreme Court will rule against the agency. This is not an unreasonable assumption, given the MQD appears based on Judicial Activism to hijack Congressional intent and Agency autonomy and transfer power to the Supreme Court. Quite simply, according to the Supreme Court, the doctrine suggests that
there are extraordinary cases in which the history and the breadth of the authority that [the agency] has asserted, and the economic and political significance of that assertion, provide a reason to hesitate before concluding that Congress meant to confer such authority… Under this body of law, known as the major questions doctrine, given both separation of powers principles and a practical understanding of legislative intent, the agency must point to clear congressional authorization for the authority it claims.
But are all administrative rulemaking cases a major question? Are all rulemakings “extraordinary?” Is every rulemaking that benefits society destined to end in a MQD challenge? If that’s the case, then no agency rulemaking is safe, and the argument that the FTC should not promulgate this rule should really be that no agency should promulgate any rule, despite decades of precedent to the contrary. And perhaps that is the end goal that her comments imply she would favor.
Finally, it could be the case that the Supreme Court will just end the administrative state altogether. Certainly Justice Thomas has signaled that way. The “non-Delegation doctrine,” as some would have it, would kill independent administrative agencies, and perhaps the administrative state altogether.
These issues are shared by all administrative agencies, not just the FTC. So to claim that such rulemaking might bring the downfall of the administrative state understates the argument: Any rulemaking might do so, if five justices decide to again ignore precedent to gain power to halt changes that protect the public.
Conclusion
It is telling that a notice of proposed rulemaking has created such ire. Firms rely on non-compete agreements to “unfairly exploit and coerce” workers by minimizing worker leverage, depress their wages, and protect non-existent interests. Trade Secret law already protects any relevant employer interests. But firms favor less competition in the labor market and in the output markets in which they operate.
And Commissioner Wilson is happy to help them. The Notice itself is keenly aware of the history Wilson lays out (and the administrative law she ignores). Warning an agency to do nothing because it will bring backlash by the Supreme Court is a well-established antitrust philosophy. It is one that needs to change.
Mark Glick is a professor of economics at the University of Utah. Darren Bush is a professor of law at the University of Houston Law Center. The views express here are those of the authors only, and do not represent the views of their respective institutions.