‘I hate this rule’: the FTC's controversial non-competes ban
When it comes to trade secrets theft, it is the murky episodes of corporate espionage, cyber-attacks and state-sponsored theft that tend to dominate the headlines.
But the more prosaic reality is that—in the vast majority of cases that land on lawyers’ desks—the alleged culprits are invariably disgruntled, ambitious or simply naive employees.
To make matters worse, a key tool that US companies have predominantly used to curb this threat is at risk.
On January 5, the Federal Trade Commission (FTC) unveiled a proposed rule that would ban employers from imposing a clause on workers that many say has deterred acts of theft.
Jim Gale, partner at Cozen O’Connor, is aghast at the development, lambasting it as “absolutely horrible”.
He argues that, if implemented, the ban will encourage trade secrets theft, make theft harder to prove in court, and will, ultimately, stifle innovation.
“I hate this rule. I understand that the FTC was trying to protect low-income workers. But many states have already enacted statutes that would protect them—and that's a good thing.”
But, he adds, if this rule passes, many companies will spend a lot of money on research and development, only to have that leave to go to a competitor.
“That's going to have a huge impact.”
The end of non-competes?
A non-compete clause blocks employees from working for a competitor, or starting a rival business, typically within a certain geographic area and period of time after the worker’s employment ends.
According to the FTC, about one in five US workers—approximately 30 million people—are bound by a non-compete clause and are restricted from pursuing better employment opportunities.
Under the new rule, it would be illegal for an employer to enter into or attempt to enter into a non-compete with a worker.
The issue of non-competes gained traction when a US sandwich shop, Jimmy John’s, gained publicity for all the wrong reasons after it imposed non-compete clauses on its low-income workers.
As Gale points out, this scenario is vastly different to a situation in which engineers “making hundreds of thousands of dollars a year who have actual trade secret knowledge” have been poached by a rival—and companies are no longer in a position to act.
The application of this rule to solve unfair workplace practices, he observes witheringly, is like using “an axe rather than a scalpel to perform brain surgery”.
The rule also has its proponents. As Robert McCauley, partner and co-leader of Finnegan’s Trade Secret practice group points out, California has, as far back as 1872, championed the policy of employee mobility and prohibited employers from requiring or enforcing non-compete agreements against former employees.
“Advocates of this policy state that employee mobility and robust competition were a bedrock for innovation in, for example, Silicon Valley, and that workers and society have greatly benefited from these laws,” explains McCauley.
And even President Biden has made his distaste for non-competes clear, issuing his Executive Order on Promoting Competition in the American Economy in July 2021, which favoured a ban.
Defend Trade Secrets Act conflict
But for Gale, the crux of the problem is that in his experience, 80% of major trade secrets cases are brought citing a violation of a non-compete clause.
Critically, even if a company does have a strong inkling that a former employee stole a secret before being enticed by a competitor; under this rule, there will be little it can initially do, unless it has iron-clad proof or can later prove that a former employee actually used the secret.
He argues that the rule conflicts with the aims of the Defend Trade Secrets Act (DTSA) of 2016, which arguably made it easier for companies to pursue trade secrets lawsuits in federal courts.
“There was an increase in trade secret litigation after the DTSA, about a 20 to 30% increase according to Lex Machina. This rule actually undermines the enactment of the DTSA, which was enacted by Congress, whereas this proposed law is being put forward by a few individuals who have never been elected,” says Gale.
McCauley agrees that there are issues with abolishing non-compete clauses.
“Critics point out that innovative companies spend vast sums to research and develop their proprietary technology, which their employees often carry in their heads.
“Yet laws that prohibit non-compete clauses have allowed competitors to improperly acquire and exploit innovator R&D investments by hiring away employees who use and/or disclose proprietary information at their next job,” he explains.
Stealth mode start-ups
This dilemma is exacerbated for the innovator company, he adds, when its knowledgeable employees are hired away by start-ups that operate in “stealth” mode for significant periods of time.
“The company, now the former employer, has no idea whether or to what extent its proprietary information is being improperly used and/or disclosed at the upstart competitor company, and may not know for years, if ever.”
It is such predicaments, he explains, that offer support for non-compete agreements, in the cases of employees “with proprietary knowledge” and/or who “have reached particular levels of responsibility”.
What’s more, as Carolyn Luedtke, partner at Munger Tolles and Olsen, explains, the rule, if implemented, may call time on the so-called inevitable disclosure rule.
Deriving from PepsiCo v Redmond (1995), the court entered an injunction preventing a former manager of the beverage giant from working at Coca-Cola even though he did not have a non-compete clause in his employee agreement, giving rise to the future use of this doctrine.
As Luedtke notes, this doctrine is based on the premise that if an employee goes to a competitor, he or she cannot help but use the confidential information in his or her memory in the new job, and therefore the person cannot take the new competitive position.
“Many states reject this doctrine, but for those that follow it, courts may re-examine whether it has lasting impact given the FTC’s rule that noncompetition agreements are anticompetitive,” she predicts.
Rule of reasonableness
For Seth Gerber, partner at Morgan Lewis, the rule, if implemented, would mark a significant shift in the legal ideology of many states.
Despite the entrenched opposition of California to non-competes—a stance later emulated by Oklahoma and North Dakota—the majority of states inclined instead towards the ‘ rule of reasonableness’.
Forming part of English common law since the 18th Century, the non-compete clause evolved out of this rule, as the English courts deemed it “reasonably necessary” to protect an employer's legitimate interests.
As Gerber explains, this imported doctrine, which has until now allowed courts to evaluate the scope of the non-compete, has gradually fallen out of favour.
“The use of non-competes as a way of protecting innovative ideas has certainly been subject to challenge over the years; we've seen certain states reduce protections through non-competes by limiting them to higher wage workers.”
But the Commission has gone a step further. “The FTC’s comments seem to indicate that it is prioritising employee mobility, increasing workers’ wages, and allowing workers to take innovative ideas from one company to another,” says Gerber.
This, he adds, is “the Silicon Valley model of business” where a premium is placed on “the overall economic progress in innovation, through a sharing of ideas more than the impact that that has on a particular company, and the dilution of its specific IP”.
Alternative protection: watch the fine print
So what options would remain available to companies to protect IP and proprietary information if the ban is brought in?
Gale predicts an upsurge in cases centring on unadjusted unjust enrichment, unfair competition, deceptive and unfair trade practices, and potentially some tortious interference claims.
“Employers will indirectly try to do what they're unable to do directly, with the loss of non-competes. But the key question will be whether those cases will be sustainable,” he reflects.
According to Gerber, the onus is now firmly on trade secrets owners to tighten up their trade secret protection plans, as they will have to resort to asserting claims for misappropriation of trade secrets and breach of confidentiality.
This means that a company now needs to ensure that even in the absence of a non-compete, or with a less restrictive non-compete, it retains the ability to go to court and prevent a former employee from breaching a duty of confidentiality or stealing trade secrets.
And in absence of non-competes, the fine print in confidential agreements, he cautions, will be scrutinised as never before.
“There may be a closer alignment between the scope of what companies try to protect as confidential information and what they're able to actually identify, classify and protect his trade secret information,” adds Gerber.
But, he cautions: “if the confidentiality clause is too broad, then the employee will successfully argue that it is unenforceable”.
Practical measures: data loss prevention
Luedtke takes a sanguine view of the FTC development, pointing out that there are already several other existing options for companies to protect trade secrets and confidential information.
State and federal trade secret statutes allow a company to sue in state or federal court if they are convinced that an employee misappropriated trade secrets.
But crucially, to prevail on such a claim in states that do not recognise non-competes and/or inevitable disclosure, the employer will need to show that trade secrets were taken or used in a wrongful way, and that it took reasonable steps to keep that information secret.
This, she adds, means that employers will need to be even more vigilant when it comes to internal investigations and outboarding measures to detect any trade secrets theft.
For example, installing data loss prevention (DLP) software that tracks suspicious downloading of confidential documents to thumb drives or uploading to cloud-based storage accounts like Dropbox is essential.
Another measure, advises Luedtke, is the forensic analysis of a departing employee’s laptop to see if there are “nefarious activities” such as uploading documents to the cloud, downloading documents to storage devices, emailing documents to a personal email, or running file wiping software to try to cover the tracks of misappropriation.
“The goal would be to find out evidence of theft and then act promptly to recover the information and/or ask a court to bar competitive use of the information,” she explains.
Challenges ahead
As for the non-compete ban, the good news for detractors is that its implementation, in its present form at least, may never materialise.
“The reality is that litigation challenging the rule seems likely to happen, in which some party would challenge the FTC’s authority to promulgate such a rule. It is unclear how that litigation will turn out and whether the court will stay the application of the rule pending the litigation,” predicts Luedtke.
Gale is franker: “It’s as if the FTC is saying: ‘we don't care if there's a legitimate, protectable business interest. We don't care about protecting that at all’. Hopefully, the rule will face many challenges, and be struck out, because, if enforced, it would interfere with the laws of about 47 states.”
But Gerber argues, even if this rule gets watered down significantly, the pendulum is still swinging firmly against the once mighty non-compete.
“The mere threat of changes to the enforceability of non-competes or narrowing of the enforceability of them on a nationwide basis leaves trade secret owners with one less tool to protect their IP,” he says.
“If the government is valuing overall economic growth and a sharing of innovative ideas more than an individual company’s protection of its specific IP, it’s now up to that individual company to take the necessary steps to protect it,” he concludes.
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