The Federal Trade Commission’s recent proposal to ban noncompete agreements has rocked the commercial world, leaving some business litigators questioning the wisdom of such a rule as well as its ultimate prospects of surviving review by the U.S. Supreme Court.

The FTC unveiled the proposed rule following its approval for comment by a 3-1 vote of commission members. With certain exceptions, the rule would make it illegal for an employer to: (1) enter into or attempt to enter into a noncompete with a worker; (2) maintain a noncompete with a worker; or (3) represent to a worker that the worker is subject to a noncompete agreement.

Importantly, the proposed rule provides a sale-of-business exception for an owner, member or partner who owns at least 25 percent of a business that is being sold.

The rule would apply to both employees and independent contractors, and it would require employers affirmatively to rescind existing noncompete agreements and notify employees that they are no longer subject to the contract’s terms.

“My initial reaction was, ‘Wow, that’s a broad proposal,’” said attorney Robert G. Young, who practices Massachusetts.

Adoption of a nationwide ban on noncompetes would be a dramatic change, agreed Matthew H. Parker, who chairs the Rhode Island Bar Association’s Labor Law & Employment Committee.

Gregory S. Bombard, who represents clients in trade secret cases, said he is concerned that an employer’s risk of being victimized by the misappropriation of confidential information will be greater than ever.

“The ability of an employee to walk out the door with a thumb drive didn’t exist 15 or 20 years ago,” Bombard said. “You could argue that a noncompete agreement is more powerful, useful and necessary than it ever has been before.”

Devil is in the details

The FTC is proposing the addition of new Subchapter J, consisting of Part 910, to Chapter I in Title 16 of the Code of Federal Regulations.

The key elements of the proposed rule begin with Section 910.2(a), which declares: “It is an unfair method of competition for an employer to enter into or attempt to enter into a non-compete clause with a worker; maintain with a worker a non-compete clause; or represent to a worker that the worker is subject to a non-compete clause.”

For existing noncompete agreements, Subsection 910.2(b)(10) directs employers to rescind those clauses no later than the “compliance date,” which would be determined upon adoption of the rule.

“An employer that rescinds a non-compete clause pursuant to paragraph (b)(1) of this section must provide notice to the worker that the worker’s non-compete clause is no longer in effect and may not be enforced against the worker,” the rule states.

Parker takes issue with the rescission rule, particularly with respect to workers who enjoy a high level of bargaining power, such as key executives.

“If you are an employee who signed a noncompete years ago, and your company has been paying you and providing you with consideration based upon that prior agreement, going forward you will not be bound by the noncompete part of that agreement,” Parker said. “If the FTC rule goes into effect, that employee no longer would be underneath that noncompete agreement, but they would still get the benefit of the additional severance that they negotiated [in exchange for the noncompete].”

Section 910.3 provides a key exception to the ban for a noncompete clause that is entered into by a person who is selling a business “or otherwise disposing of all of the person’s ownership interest in the business entity, or by a person who is selling all or substantially all of a business entity’s operating assets, when the person restricted by the non-compete clause is a substantial owner of, or substantial member or substantial partner in, the business entity at the time the person enters into the non-compete clause.”

The definitions section of the proposed rule contains an important limitation to the sale-of-business exception. For purposes of the rule, “substantial owner,” “substantial member,” and “substantial partner” mean someone holding at least a 25 percent ownership interest in a business entity in question.

Young sees the proposed definition as a problem.

“You could have someone who is a 24 percent owner and has been CEO of the company for 10 years,” he said. “The company gets sold and that person can go across the street the next day and open a competing business. That would be a massive change.”

In terms of preemption, the proposed rule explicitly provides that Section 910 supersedes state laws and regulations, except insofar as state law provides greater protections than the FTC’s rule.

Another troublesome aspect for business lawyers is that the proposed rule’s definitions include a “functional test” for whether a contractual term is a noncompete clause.

“The term noncompete clause includes a contractual term that is a de facto noncompete clause because it has the effect of prohibiting the worker from seeking or accepting employment with a person or operating a business after the conclusion of the worker’s employment with the employer,” the rule states.

Young said the functional test poses the risk of overturning nonsolicit agreements and nondisclosure agreements.