Non-competition agreements and similar restrictive covenants form a bundle of rights and obligations that are hotly negotiated between buyers and sellers in every M&A transaction. These covenants often represent tradeoffs affecting the purchase price as well as post-closing rights and obligations of sellers such as continued employment. Buyers view these and the other covenants imposed on sellers as essential to securing the benefit of their bargain and realizing on the goodwill of the acquired business for which they have paid dearly.
The Federal Trade Commission, however, now seeks to upend this carefully negotiated bundle by proposing to outlaw virtually all non-compete agreements, including those of sellers in M&A and similar transactions. Despite their widespread long-standing use in these transactions and regulation by every state, the feds want to do away with non-compete agreements because they are “a widespread and often exploitative practice that suppresses wages, hampers innovation, and blocks entrepreneurs from starting new businesses.”
For the uninitiated, a non-compete agreement essentially prevents a worker from seeking a job with a competitor for a period of time after cessation of employment with the worker’s current employer. Non-competes have been around for hundreds of years and, although courts consider them to be somewhat malodorous as “restraints on trade”, they are nonetheless mostly enforceable except in three of the 50 United States. In fact, all 50 states regulate their use, with varying requirements and degrees of enforceability.
Just last month, for example, the Delaware Chancery Court struck down a non-compete provision in connection with the sale of a business because it was “unreasonable and unenforceable”. (Intertek Testing Service NA, Inc. vs Eastman, 2023 WL 2544236 (Del. Ch. Mar. 16, 2023).) This case marked the third time in the last six months that the Court, one of the most watched business courts in the country, has struck down or limited non-competes in the sale of business context.
In fairness, non-competes have crept from their historical use to bind high-level executives, highly-skilled technicians and business owners who have sold their businesses to run of the mill workers such as security guards and fast-food employees. There is no question that some non-competes are unfair to low-level workers who could be prevented from earning a livelihood. All of the state statutes permitting non-competes require to varying degrees that they be “reasonable” in scope and time period. However, even a prohibition against working for a competitor for a relatively short duration and geographic area can be devastating to an hourly worker with barely a week’s worth of savings in the bank. Moreover, lower level employees often lack the bargaining power to negotiate the terms of non-competes, which in these situations take the form of “contracts of adhesion” that the law historically has disfavored.
These are all sound reasons for limiting or even banning non-compete agreements in certain circumstances. However, in typical regulatory fashion, the FTC has taken a meat cleaver to these agreements and proposed banning them even where the justifications are weak.
In the case of the seller of a business, who typically rakes in millions from the sale and then hundreds of thousands more under long-term employment agreements designed to help the buyer with the transition, there is little justification for the FTC to regulate non-competes. These folks have plenty of bargaining power and the ability to cool their heels for extended periods of time without suffering economically. They could even start a business unrelated to the one they sold. The FTC admits there is little empirical research of the impact of non-competes in this context. So why do they need the FTC’s protection applicable to ordinary workers?
The FTC notes that the proposed rule would not apply to a seller unless the seller was also a “worker”, that is, continued to work for the buyer after the transaction closed. On the other hand, a seller who simply walked away after the closing could be restricted from competing. This is a distinction without a difference. Whether or not the seller continues to be employed, a seller has the same leverage to negotiate an appropriate agreement. Many sellers want to remain employed after the sale to, among other reasons, receiving additional compensation, assuring an orderly transition of the business, and ensuring that the business is run in a way that will maximize any post-closing earn-out or other purchase price adjustment. Upsetting this mutually beneficial arrangement will require recalibration of the interconnected consideration negotiated by sellers in these transactions.
True, the FTC has proposed a carve-out for a seller of a business who enters into a non-compete in connection with the sale, but only if the owner held 25% of the company that is being sold. The FTC picks this percentage out of thin air without any justification. Some business owners who hold far less of a company nonetheless rake in millions for their stake. Why pick this artificial dividing line?
It is also true that the FTC proposes to allow other restrictive covenants, such as no-solicitation and confidentiality provisions, to persist. These other covenants, while useful in certain contexts, require buyers to surmount additional hurdles to protect their valuable purchased goodwill. And the FTC could challenge even these restrictive covenants if they are “so broad in scope that they serve as de facto non-compete clauses.”
The biggest issue with the FTC’s proposed rule, however, is that it applies retroactively and requires the termination of existing non-competes. In the case of business owners, the non-compete is but one aspect of a carefully crafted deal negotiated by persons with equal bargaining leverage at arms’ length. To now willy-nilly abrogate one key aspect of that hard-bargained deal without considering the other interconnected considerations provides a windfall to these individuals without addressing the evils that non-competes supposedly cause at lower levels.
Most sellers of a business have the leverage and bargaining power to negotiate lucrative deals for themselves, and if they have to sit on the sidelines for a year or two if they decide to leave their company or are bid adieu, they can certainly afford to do so. They don’t need Big Brother tipping the scales on their behalf. The FTC should create a broad exclusion from the rule for the seller of a business in all cases except those where the seller receives only a de minimus share of the consideration for the sale.
*This was republished with permission from Association of Corporate Counsel. Click here to access the publication.