Macchia: The chipping away at permissible uses of non-competes

In the spring of 2021, I wrote an article for this column that discussed several changes across the nation relating to the enforceability of non-competition agreements. It is now three years later, and we continue to see more and more laws chipping away at the permissible uses of traditional non-competes.

Traditionally, the question of whether a non-compete is enforceable turns on one question: is it reasonable?

This should be a simple question—but unfortunately it is not. In many states, this question is fact-specific and turns on whether an employer in a specific instance can show that the non-compete is narrowly tailored to protect a legitimate business interest.

But what is a legitimate business interest? Some states say trade secrets and confidential information, while others also include an employer’s customer base. Because the answers to these questions vary by situation and state to state, it is essential that employers stay in tune with this ever-changing landscape.

Some states make answering these questions a bit easier by specifying instances where non-competes are impermissible.

In several states, a non-compete automatically goes beyond the sphere of reasonableness if an employee earns less than a certain annual income.

For example, Illinois amended its Freedom to Work Act to, as of Jan. 1, 2022, prohibit non-competes for employees earning $75,000 per year or less. This amendment also imposed a $45,000 annual earnings minimum for customer and employee non-solicitation provisions.

Additionally, Illinois made it clear that continued at-will employment is simply inadequate consideration for a restrictive covenant agreement.

Colorado also redefined the permissible uses of non-competes with a law that became effective on Aug. 10, 2022.

This new law prohibits the use of non-competes for employees unless two criteria are met: the employee is “highly compensated” (which, as of January 1, 2024, is defined as earning $123,750 per year or more) and the non-compete is no broader than necessary to protect the employer’s trade secrets.

Colorado then goes a bit further than Illinois with respect to customer non-solicitation provisions—not only imposing an annual earning threshold, but also applying the same trade secret criteria to such provisions.

For some states, however, non-competition agreements are not reasonable or permissible for any employees, regardless of earnings.

The most well-known example is California, which has virtually banned all non-competes for over 150 years. Earlier this year, California passed two laws (SB 699 and AB 1076) that reinforced its position on both non-competition and non-solicitation agreements.

SB 699 makes clear that employers are prohibited from entering into or enforcing an agreement with an employee that includes a void non-competition or non-solicitation provision.

Moreover, unlike most states that have enacted new non-compete laws, California’s law applies retroactively. And, AB 1076 requires employers provide notice to current and former employees, to the extent they have signed employment agreements containing non-competition and/or non-solicitation provisions, that those provisions are void.

On top of that, SB 699 creates a private cause of action for employees to seek injunctive relief, actual damages, and attorneys’ fees as a result of an employer’s violation, and AB 1076 renders a violation an act of unfair competition resulting in a civil penalty.

On July 1, 2023, Minnesota joined California in the war against non-competes. Minnesota’s new law bans the use of non-competes for employees who primarily live and work in Minnesota and provides employees the right to seek recovery of reasonable attorneys’ fees incurred in enforcing their rights under this law.

Unlike California, however, Minnesota’s law is specific to “covenants not to compete” and does not impact customer non-solicitation provisions.

The state of New York also seemed to be heading down this same path when the legislature passed a non-compete ban in June 2023—but, the bill was ultimately vetoed by Governor Kathy Hochul in December 2023.

In doing so, while she explained her commitment to banning non-competes for lower wage workers, Governor Hochul indicated that the bill’s “one-size-fits-all-approach” in banning all non-competes was not protective of employers’ legitimate interests. Suffice it to say that the non-compete saga in New York is far from over.

While there has been a flurry of activity at the state level, federal action on this topic has inched towards restricting the use of non-competes but we have yet to see where this goes.

On Jan. 5, 2023, the Federal Trade Commission proposed a new rule that would ban employers from entering into non-competes with employees and independent contractors.

The proposed rule would also extend to non-solicitation and non-disclosure provisions in agreements that effectively function as a non-compete and prevent an employee from seeking or accepting other employment. And, the proposed rule would apply retroactively, requiring employers to rescind existing non-competes. As of today, we still do not know how this plays out. The public comment period closed on April 19, 2023—with over 16,000 comments lodged.

The next step would be for the FTC to publish a final rule. Once that happens, and once the rule takes effect 60 days later, I would anticipate legal challenges which may further delay enforcement of the rule.

While the future of the FTC’s proposed rule remains unknown, the FTC and the Department of Labor signed a memorandum of understanding on Aug. 30, 2023 that sets out coordination in investigations and sharing of information related to several employment and labor-related issues, including “the imposition of one-sided and restrictive contract provisions, such as non-compete and training repayment agreement provisions.”

In addition, on May 31, 2023, the general counsel for the National Labor Relations Board issued a memorandum detailing her position that non-competition agreements violate the National Labor Relations Act. While the memorandum is not the official position of the NLRB, it does indicate an area where the NLRB’s regional offices may prosecute unfair labor practice claims.

One question you may be asking: what does all of this mean for employers?

It is essential that employers stay up to date on the laws relating to the permissible use of non-competes (and other restrictive covenants) in each state in which the employer has employees.

In those states, an employer should have a good understanding on what type of provision is permissible, the situations in which a non-compete is flat-out void, the definition of what is “reasonable,” whether there is any sort of consideration requirement or minimum earnings requirement, whether a choice of law provision will be honored, or whether any new law applies retroactively to existing agreements.

Employers should also continue to track movement at the federal level to ensure they are aware of the areas in which their non-competition agreements may fall under attack. The risk of being blissfully ignorant can result in an employer having very little protections for its business.

I also caution against reaching for the stars in drafting restrictive covenants. Again, many states still fall back on what is “reasonable” under the circumstances. If an employer’s business is local only to the state of Indiana, then a nationwide non-compete most likely would not survive scrutiny.

This caution also applies in the sale-of-business context. Several states, including Delaware, have more heavily scrutinized non-competes where the restrictions go beyond protecting the actual business being sold or where the restrictions apply to very small minority owners (for example, employees with a small amount of incentive equity that is tied to employment) in the same way they apply to the majority owner.

Having the knowledge of what is permissible, and using that knowledge in the drafting of a sufficiently narrow non-competition agreement, will help ensure that employers are using restrictive covenants in a permissible manner and in a way that will be determined reasonably necessary to protect a legitimate business interest.•

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Melissa Macchia is a partner in Taft’s employment and labor relations group and leads the Indianapolis employment team. Reach her at [email protected]. Opinions expressed are those of the author.