FTC’s Non-Compete Rule May Also Ban “Functional Non-Compete” Agreements – What are “Functional Non-Competes”?

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Co-Authored by: Erin Johnson (Law Clerk)

There has been substantial publicity surrounding the Federal Trade Commission’s April 23, 2024 final rule banning traditional employee-employer non-compete agreements. This ban, if it survives pending legal challenges, would essentially nullify typical non-compete agreements that prevent employees from competing with their former employers for a specific period of time within a specific geographic area. However, employers should be aware that the FTC’s ban may also affect other employee-employer agreements that do not appear to be traditional non-competes.

The FTC’s rule defines a “non-compete clause” as a term or condition of employment that either “prohibits” a worker from, “penalizes” a worker for, or “functions to prevent” a worker from seeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment that includes the term or condition.

While a traditional non-compete clause falls squarely in the “prohibits” category, the FTC also expressed concern regarding other agreements that may “function to prevent workers from seeking or accepting other work or starting a business after their employment ends.” As a result, employers should consider reviewing other employee agreements and prepare for the possibility that the FTC may attempt to bar those “functional non-compete” agreements in the future.

For example, many employers reimburse employees’ tuition fees or training costs to encourage employees to seek further work-related education or training. In such cases, the employees are often required to remain employed for a certain period of time after they receive reimbursement. If they leave before that time period ends, employers reserve the right to deduct the cost or a percentage of the cost from the employee’s final paycheck.  In its commentary on the non-compete rule, the FTC found that some “training repayment agreement provisions,” or “TRAPs,” can be concerning. The rule states, “[W]hen TRAPs function to prevent a worker from seeking or accepting other work or starting a business after the employment associated with the TRAP, they are non-competes under [the final rule].”

While the FTC rule would not categorically prohibit TRAPs, such agreements may be scrutinized more closely in the future. Therefore, employers should ensure the training or education involved is truly valuable by considering the employee’s job title, the type of training program attended, and the actual cost of training. Employers should consider creating a detailed agreement defining the curriculum and obligations for both parties and require the employee to sign the agreement before starting the training program. Additionally, employers should consider if the period of time the employee is required to remain employed is actually necessary or excessive given the reimbursement amount.

Another type of agreement that according to the FTC may be considered a “functional non-compete” is a nondisclosure agreement (“NDA” or “confidentiality agreement”). NDAs are not automatically disfavored since they specifically impact employee restrictions on information, rather than an employee’s ability to move and work. However, the FTC appears to be targeting NDAs that effectively “prevent someone from seeking work.”  The South Carolina Supreme Court, for example, has established a reasonableness standard for NDAs utilizing the following two-step framework:

• The restraint must be reasonable in that it is no greater than necessary to protect the employer’s legitimate business interest, and
• the restraint must be reasonable in that it is not unduly harsh in limiting the individual’s ability to earn a livelihood.

Milliken & Co. v. Morin, 399 S.C. 23, 33, 731 S.E.2d 288, 293 (2012). If the NDA is narrowly tailored to protect a legitimate business interest of the employer and does not unduly limit the individual’s ability to find future employment, the NDA would likely be enforceable under the FTC’s final rule. Employers are encouraged to review their NDAs to ensure they are reasonable.

The FTC also commented that other agreements which “penalize” workers for seeking or accepting other work after leaving their current jobs are generally considered prohibited non-compete agreements. For example, a “liquidated damages clause” may provide that for two years after the worker’s employment ends, the worker may not engage in any business within a certain geographic area that competes with the employer unless the worker pays the employer liquidated damages of $50,000. This type of “penalty” may no longer be enforceable under the FTC’s final rule.

As explicitly confirmed by the FTC, restrictive employment agreements other than non-competes—such as TRAPs, non-solicitation agreements, and NDAs—do not necessarily prevent a worker from seeking or accepting work after leaving their employment. Ultimately, whether a given restrictive covenant rises to the level of being a “functional non-compete” will turn on the facts and circumstances of the particular agreement and must be analyzed on a case-by-case basis.

Employers with questions or concerns about the FTC’s final rule and how it may impact agreements with employees can contact any member of the Maynard Nexsen Employment and Labor Law team.