On January 5, 2023, the Federal Trade Commission (FTC) announced that it was proposing a rule that would largely prohibit the use of non-competition agreements. Non-compete agreements and other forms of employee restrictive covenants are common in the insurance industry. They are a critical part of every insurance merger & acquisition (M&A) transaction. So, it is no surprise that many in the insurance industry are wondering what such a rule might mean for them. Could existing non-competes really be sweepingly invalidated? Will agencies and brokers really no longer be able to use them?
Some background on non-compete agreements
Restrictive covenants such as non-competes have long been used by employers as a means of protecting their legitimate business interests, such as confidential and proprietary information. Some employers, on the other hand, use non-competes for illegitimate reasons, such as seeking to prevent employees from leaving their employment or working for a competitor.
Whether or not a restrictive covenant is enforceable is typically governed by the statutes and common law (i.e., court decisions) of the individual states, not the federal government. Some states (such as California, North Dakota, and Oklahoma) have enacted statutes that make employee non-compete agreements largely unenforceable, with certain limited exceptions such as in the context of the sale of a business. However, even though non-competes are universally viewed as restraining trade and therefore are generally disfavored, most states deem them enforceable, provided that they are used by employers to protect legitimate business interests and are reasonable in their restrictions, geographic scope, and duration.
Why is the FTC proposing a new rule around non-competes?
The increasing use of non-competes for illegitimate purposes and the inconsistency for enforceability from state to state, have sparked a call on the federal government to intervene. As a result, in July 2021, President Biden issued Executive Order 14036 which, among other things, directed the FTC “to curtail the unfair use of non-compete clauses and other clauses or agreements that may unfairly limit worker mobility.” The directive feels strategic, given that three of the four Commissioners of the FTC are Democrats.
In response to the President’s mandate, the FTC proposed a broad rule that, with certain exceptions, prohibits the use of any agreement that effectively precludes a worker (not just those that fit into the definition of an employee) from working in the same field as (i.e., competing with) their former employer. Notably, however, the rule does not purport to prohibit the use of other restrictive covenants such as confidentiality, non-solicitation, non-piracy, and non-acceptance provided they don’t have the effect of a non-compete.
Potential impact on the insurance industry
Traditional non-competes are often used in the insurance industry as a way for agencies and brokers to protect their client base and prohibit producers from taking clients with them should they decide to work for another broker or start their own agency. In this context, such non-competes would be largely deemed invalid by the FTC’s proposed rule.
However, a more common way for agencies and brokerages to protect their business without resorting to a non-compete is through the use of non-solicits, non-piracy and non-acceptance provisions. As long as these types of provisions are not written to have the effect of precluding a worker from working in the same field as their former employer, they would not be impacted by the FTC’s proposed ban on non-competes.
Additionally, non-competes are routinely used in, and are a critical component of, M&A transactions that take place in the insurance sector. They protect the buyer from the worst-case scenario: the selling principal either starts a new agency or goes to work for a competitor and recaptures the business that he or she previously sold to the buyer. Although the proposed rule recognizes a legitimate use of a non-compete in this context, it severely restricts such use to those that own 25% or more of the selling entity. Therefore, a non-compete between a buyer and an individual who owned 24% or less of the selling agency would be invalid and unenforceable, thereby creating significantly more risk to the buyer in such a transaction. Suffice it to say, if the FTC’s proposed rule became effective in its current form, it could have a significant effect on the insurance distribution sector.
What are the chances for this proposed new rule?
At this point the FTC’s rule is just a proposal. There is a 60-day period of public comment before it can become final and published in the Federal Register. From that point, 180 days must pass before it would formally go into effect. Opposition to the proposed rule is expected to be substantial. Formidable questions exist, including, among others, as to whether the FTC even possesses the requisite authority to issue such rules. While the FTC is charged with protecting consumers and competition by preventing anticompetitive, deceptive, and unfair business practices, it has never historically regulated non-compete agreements in the employment context. If the proposal is elevated to the legislative branch, given the political makeup of the U.S. House of Representatives and U.S. Senate, Congressional action on the issue is highly unlikely.
Even if it becomes effective, legal challenges to the rule will be asserted and likely take years to adjudicate in the federal courts. And the court of last resort, of course, is the highly conservative U.S. Supreme Court, which would undoubtedly scrutinize such a rule heavily.
So, while the FTC’s desired outcome – to effectively eliminate agreements that may unfairly limit worker mobility – may never fully come to fruition, the FTC’s efforts should catch many employers’ attention. It should serve as a warning to employers who have relied on the use of non-compete agreements for illegitimate purposes and that regulatory and potentially statutory responses are being considered. But for now, the enforceability of restrictive covenants will remain status quo and continue to be determined based on individual state law.
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