Fixing Recently Proposed Bans on Non-Competes

On June 20, 2023, the New York State Legislature passed a bill that would impose a blanket ban on New York employers from entering into non-compete agreements with employees. The bill now goes to Governor Kathy Hochul for her consideration. If enacted, New York would join four other states—California, Oklahoma, North Dakota, and Minnesota—which ban all non-compete agreements, regardless of position or income level.

In New York City, on June 8, 2023, City Council members introduced a bill that, if enacted, would prohibit employers from entering into new non-compete agreements and make all existing non-compete agreements unenforceable.
 
At the federal level, in January, the Federal Trade Commission issued a proposed rule that would ban non-compete agreements nationwide on the grounds that such agreements constitute an “unfair method of competition.” The FTC is still considering the proposed rule after receiving tens of thousands of comments from the public.

These recently proposed city, state, and federal rules contain several serious deficiencies and fail to properly balance the interests of the business community and workers. Specifically, the proposed city and state laws fail to include exemptions for non-competes entered in connection with the sale or dissolution of a business and non-competes in franchise agreements. They also fail to include provisions dealing with highly-paid executives, notice requirements, or the effect of termination without good cause.

Non-Competes and the Sale or Dissolution of a Business

There are strong policy interests for allowing the enforcement of non-compete agreements in connection with the sale or dissolution of a business. A buyer of a business justifiably seeks assurance from the seller that the seller’s owners are not going to turn around the next day and open a competing business. For this reason, as noted by the FTC in its notice of rule-making, most agreements for the sale of a business include a provision that the seller’s owner will not open a competing business for a period after the sale.

The proposed federal nationwide ban, and the four states which currently ban non-compete agreements, including California, Oklahoma, North Dakota, and Minnesota, all make an exception for non-compete agreements in the sale or dissolution of a business. In a comment letter dated April 18, 2023, the attorneys general for 17 states, including New York, did not object to the FTC’s proposed exemption for such agreements.

Despite this, the recently proposed New York state and New York City laws do not contain such an exception. This will significantly stifle business acquisition activity in the state, as New York businesses will have more difficulty selling if the owners are not permitted to enter into such agreements.

Non-Competes in Franchise Agreements

Franchise agreements are analogous to the purchase/sale of a business, in that the franchisor is selling the goodwill of its system of operation. The franchisor justifiably seeks assurance that, after helping the franchisee to establish the franchised business, the franchisee and its owners are not going to turn around and change the sign on the door, and continue operating the same type of business in the same or nearby location under a different brand.

For this reason, the proposed federal rule correctly contains an exception for franchise agreements. The FTC’s notice of proposed rule-making explains: “The Commission believes that, in some cases, the relationship between a franchisor and franchisee may be more analogous to the relationship between two businesses than the relationship between an employer and a worker.” Fed. Reg. Vol. 88, No. 12, at 3520. In addition, the FTC’s franchise regulations require disclosure of a non-compete to a prospective franchisee in the franchise disclosure document. 16 CFR 436(i); 436(q).

This need to clarify arises from the broad definition of an “employer” in the proposed federal, state and city rules, which encompass independent contractor and franchise agreements.

The proposed federal rule applies to any “employer,” defined as any person or entity that “hires or contracts with a worker to work for the person.” A worker is defined as any natural person who “works for” an employer, and explicitly includes independent contractors “who provide a service to a client or customer.” This broad definition would arguably include an individual franchisee who provides a service (i.e., operating a store) to a franchisor.

Again, New York did not oppose the franchise exemption in the comment letter dated April 19, 2023, except to request the commission clarify that the exemption should not apply where the franchise label is used to disguise a glorified employee.

The proposed New York state law applies to an agreement between an “employer” and a “covered individual” defined to include any person who “performs work or services for another person on such terms and conditions that they are, in relation to that other person, in a position of economic dependence on, and under an obligation to perform duties for, that other person.” This language is unusual as it does not appear in any other U.S. state or federal statutes or caselaw, and appears to have been taken from some European and Canadian labor statutes, which some U.S. commentators have argued should be used to create a third category of worker, called a “dependent worker.”

The statute as drafted would create an inherent inconsistency with the earlier definition section of the Labor Law, NY Labor Law 190(3), defining an “employer,” which has been interpreted to exclude independent contractors.

The proposed New York City law defines “employer” as any person that hires or contracts with a worker to work for the person. A “worker” is defined as any natural person who works for an employer, and explicitly includes independent contractors.

The broad nature of these definitions requires the state and city laws to be modified to include an exemption for franchise agreements, similar to the one proposed by the FTC.

Highly-Compensated Employees

One of the policy interests favoring non-compete agreements is encouraging companies to provide training by protecting this investment with a non-compete. In a 2019 research article, Evan Starr, prominently cited in the FTC’s notice of proposed rule, found a strong correlation between states with higher levels of enforceability of non-compete agreements and the level of training.

Non-compete opponents point to the overuse of non-compete agreements for lower-paid workers who do not receive any specialized training. In contrast, highly-compensated employees are more likely to be in a stronger bargaining position to push back on a proposed non-compete agreement.

Because of these competing policy interests, many states that recently adopted restrictions on non-compete agreements rely on salary thresholds. Illinois only bans enforcement of non-compete agreements against employees making less than $75,000, while Washington’s threshold is $100,000 and the District of Columbia’s is $150,000.

The proposed federal rule, New York State and New York City laws, would ban enforcement of non-compete agreements at any salary level, regardless of the company’s investment in the employee.

The FTC should adopt a federal salary threshold that would allow non-compete agreements above a base-line amount, leaving states free to adopt higher thresholds. This type of scheme would be similar to the current federal salary threshold for the exemption from overtime laws for executive, administrative and professional salaried employees, under which states such as New York are free to adopt (and have adopted) higher thresholds.

Notice Requirements

One issue cited by opponents of non-competes is that surveys show that employees often aren’t aware they are being asked to sign a non-compete, or that they have already signed one.

As a result, Colorado, Illinois, Massachusetts, and Washington have adopted a requirement that employers must provide written disclosure of the non-compete at the time of the offer or at least two weeks before the start of employment. In addition, if the agreement is required after the start of employment, these states require it to be supported by reasonable consideration independent from the continuation of employment, and the employer must provide written notice with a suggestion to consult an attorney at least two weeks before it goes into effect.

If non-competes are permitted in certain circumstances, a notice requirement would help to ensure that employees are armed with accurate information in deciding whether to accept or stay at a job that requires a non-compete.

Effect of Termination Without Cause

Another unfairness cited by non-compete opponents is that in most states, an employer can enforce a non-compete against an employee, even if the employer terminates the employee without good cause.

For this reason, many states such as Massachusetts, Montana, and Washington have statutory provisions or caselaw which generally bans enforcement of non-compete agreements where the employer terminated the employment without good cause. The Uniform Law Commission’s 2021 proposed Uniform Restrictive Employment Agreement Act contains similar provisions.

In order to avoid abuse, the FTC, New York State, and New York City, should adopt a similar rule which prohibits enforcement of a non-compete where the employer terminates without good cause, or the employee leaves for good cause.

Conclusion

Prudent legislation addressing non-competes requires a balancing of business and worker’s interests. The currently proposed federal, state, and city rules take an overly heavy-handed, across-the-board approach, which fails to properly balance these interests in connection with the sale of a business, franchise agreements, highly-compensated employees, notice requirements, and terminations without cause.

David T. Azrin

Partner with Gallet Dreyer & Berkey, LLP