Spencer Thompson
BC Law EIC Student
April 2023
Revolution, in its original astronomical definition, signifies a single orbit of one object around another or about an axis or center. It is a return to the origin. And non-compete law is on the precipice of completing exactly that as the Federal Trade Commission considers eliminating them nationwide. [1]
First: What Are Non-Competes and What is Happening?
The non-compete, or more formally a “covenant not to compete”, is a contractual provision which restricts an employee or independent contractor from working for a specified competitor for a period of time following his termination of employment with his current employer (or contractor). Historically, at English Common Law, the Non-Compete was barred as an unlawful restraint on a worker’s right to practice his trade. [2] The courts made no secret of their disfavor of such clauses. As one court from the 15th century stated in its decision, “The obligation is void because the condition is against the Common Law, and by God, if the plaintiff were present he should rot in gaeol [jail] till he paid a fine to the King.” [3]
Over time however, the industrial pressures which accompanied the rise of modern capitalism forced the King’s courts to change their tune, and courts eventually adopted a series of equitable restrictions which looked at the reasonableness of the contract’s restrictions, in an attempt to balance the interests in worker’s freedom with the growing pressure to restrict the flow of labor in order to protect businesses’ proprietary information. [4] As capitalism and the legal system developed, this evolved into the modern rule--Courts would generally allow non-competes if they were: (1) necessary to protect a legitimate business interest, (2) reasonably limited in time and space, and (3) consonant with the public interest. [5]
What this meant in practice however changed over time. At first, non-competes could be added at almost any time during the employment relationship, commensurate with the freedom of contract rationale that dominated late 19th century American jurisprudence. A non-compete would be valid both before employment or during employment if offered in return for the opportunity to work or continue working for the company. [6] Courts and legislatures naturally became concerned with the disparity in bargaining power between workers and their employers, particularly in the latter situation. [7] As such, state legislatures began to implement increased restrictions, such as Massachusetts, [8] or banned them outright, such as California. [9]
Now however the FTC is poised to issue a sweeping rule banning non-competes nationwide based on their depressive effect on wages. [10] It would extend to both employees and independent contractors. Furthermore, it may cover more than traditional non-compete provisions, and include non-disclosure and non-disparagement clauses which have a similar effect. Indeed, they are currently taking comments on expanding the scope even further than the proposed rule. Thus, it seems then that non-competes are about to complete their revolution -- and it only took seven centuries. [11]
Second: Why Do Non-Competes Matter to Start-Ups?
Perhaps second only to our 15th century plaintiff, start-ups are in a particularly vulnerable position with respect to non-competes. This is because start-ups’ valuations are heavily dependent on the new ideas that they bring to the market, as their new (marketable) approaches to problems is where their ultimate value lies to investors. Accordingly, if trade secrets or other confidential information is leaked or co-opted by employees, this presents a serious risk to their success as it allows the idea to diffuse to the market and competitors, decreasing any investor’s likelihood of return. Indeed, uncertainty about IP rights and protections has been linked to increased investor hesitancy, both in the US and in the EU, making IP protection critical to long-term success and successful capitalization. [12]
The importance of protecting IP then cannot be overstated. As one scholarly article writes, “a study by Harvard researcher Shikar Ghosh suggests that 75% of startups fail [and that] [v]ery often, the difference between expansion and extinction for a startup is its ability to raise additional capital.” [13] Ensuring that investors feel that the start-up’s “idea” is protected is therefore critical to ensuring capitalization, and maximizing chances its of success. Traditionally, non-competes have been a vital tool in protecting this interest. As one court wrote, non-competes “prevent [businesses’] employees and agents from learning their trade secrets, befriending their customers and then moving into competition with them.” [14] That is, non-competes operate as cost-effective confidentiality agreements. They excel at this because it is easier to determine a breach of a non-compete than a breach of a confidentiality provision as the prohibited action is both clearer and the relevant information necessary to enforce it (i.e. employment information) is more publicly available. This makes monitoring easier and enforcement less costly than confidentiality violations, thereby increasing their deterrence factor. Thus, if the proposed FTC rule is put into effect, start-ups are in a position to potentially see both their risk of confidentiality breaches increase and their potential legal costs rise, placing them in a noticeably more difficult position to succeed if they do not implement alternative plans.
Third: How Should Start-Ups Move forward?
First, concerned start-ups should consider participating in the FTC’s Notice and Comment Period, which is an administrative process that allows the public to submit their comments on proposed regulatory rules. The FTC is legally obligated to review and respond to all comments, albeit not individually. [15] To submit a comment, simply follow the instructions at this link.
Secondly, economic-modeling suggests that alternative strategies which encourage employee loyalty, such as employee stock-option plans, may have merit in reducing the risk of confidential information. [16] While these come at a cost, such costs should be weighed against the costs associated with not only investor reluctance, but also the efficiency costs which attach to overly stringent internal controls of confidential information. [17] The latter can lead to decreased productivity and innovation, both of which are critical to a start-up’s success, while the risks of the former are clear.
Finally, start-ups should consult with their legal counsel to ensure that their founders understand what trade-secret laws in their jurisdiction cover, and what they do not, to better understand the costs with potential breaches of confidentiality, and to help structure internal policies which cost-effectively promote employee retention. Coupled with “carrot” type incentives, such as the aforementioned stock-option plans, these policies may help ease investors uncertainties in a post-non-compete world. After all, if non-competes’ revolution is completed, and nobody can use them, these small changes may be the marginal difference which tips the scales in favor of one start-up over another in the eyes of investors on a playing field which may otherwise look level.
[1]See https://www.ftc.gov/news-events/news/press-releases/2023/01/ftc-proposes-rule-ban-noncompete-clauses-which-hurt-workers-harm-competition.
[2] See generally Hess v. Gebhard & Co., 570 Pa. 148 (2002) for perhaps the greatest judicial exploration of the history of non-compete law in a modern decision.
[3] Cited by Hess, 570 Pa. at 158.
[4] See id. at 158-59; Cristin T. Kist, Blocked Airwaves: Using Legislation to Make Non-Compete Clauses Unenforceable in the Broadcast Industry and the Potential Effects of Proposed Legislation in Pennsylvania, 13 Jeffrey S. Moorad Sports L.J. 391, 395-96 (2006).
[5]Boulanger v. Dunkin' Donuts, Inc., 442 Mass. 635, 639 (2004).
[6] See Hess, 570 Pa. at 160-65.
[7] See generally Pittsburgh Logistics Systems, Inc. v. Beemac Trucking, 2021 WL 1676399 (Pa. Apr. 29, 2021); MGL c.149, § 24L.
[8] MGL c.149, § 24L.
[9] Business and Professions Code (BPC) §16600.
[10] See https://www.ftc.gov/news-events/news/press-releases/2023/01/ftc-proposes-rule-ban-noncompete-clauses-which-hurt-workers-harm-competition.
[11] A causal analysis is beyond the scope of this piece, but pressures on companies have been increasing in the wake of the economic strain placed on workers due to the Covid-19 pandemic. Coupled with the growing boldness of executive agencies in the employment sphere over the last decade, exemplified by the SEC’s expansive use of fines to police severance agreements, this approach does not appear too unsurprising. See generally Richard Moberly, Confidentiality and Whistleblowing, 96 N.C.L. Rev. 751 (2018). Furthermore, Democratic administrations in the last decade have grown increasingly hostile to non-competes, based on their effects on wages and the restrictions they impose on workers’ mobility. See white house, non-compete agreements: analysis of the usage, potential issues, And state responses (2016).
[12] See Jan Krauss, Lore Breitenbach-Koller, David Kuttenkeuler, Intellectual Property Rights and Their Role in the Start-Up Bioeconomy – A Success Story?, 1 EFB Bioeconomy J. 1, 1 (2021).
[13] See Krauss, supra note 12, at 7.
[14] Miller Mechanical, Inc. v. Ruth, 300 So. 2d 11, 12 (Fla. 1974).
[15] See Shagifta Ahmed, Shannon Jouce, Adam Looney, How to Effectively Comment on Regulations 2 (2018).
[16]See Yifat Aran, Beyond Covenants Not to Compete: Equilibrium in High-Tech Startup Labor Markets, 70 Stan. L. Rev. 1235, 1267-72 (2018) (laying out a series of (4) scenarios gauging the likelihood of retention based on the intersection of human capital and the appreciation of company stock). Retention, under this model, will occur if human capital has appreciated, that is their skills and support systems have developed, and their stock values have appreciated as well, or to a lesser extent, if their human capital has not appreciated but their stock options have, as the employee will have an economic incentive to remain with the employer in order to realize his stock options.
Notably, retention will not occur if the start-up fails to realize its value. In such a case however, employee retention is inefficient, and thus is not beneficial to society. See id. at 1271. Ironically, stock-options may still benefit the start-up in this scenario because they may actually encourage investor’s likelihood to invest, as investment increases the likelihood of creating business relationships with employees who have relevant experience to a problem, from their work in the start-up, and may be able to realize their value more efficiently than the failing start-up, ultimately increasing the investor’s likelihood of return.
[17] Yifat Aran, Beyond Covenants Not to Compete: Equilibrium in High-Tech Startup Labor Markets, 70 Stan. L. Rev. 1235, 1250 (2018) (“If the law refuses to enforce noncompete, employers might react by reorganizing their businesses in an inefficient manner in order to limit employees’ exposure to trade secrets—such as splitting up tasks among multiple employees or assigning sensitive tasks only to trusted family members.”); see also William M. Landes & Richard A. Posner, The Economic Structure of Intellectual Property Law 364 (2003) (cited by the foregoing).