Could This Be the End of Noncompetes?

According to the Federal Trade Commission (FTC), one factor behind this declining labor market fluidity is the rise of noncompete clauses in labor contracts that bar an employee from working for a competitor upon leaving. While noncompete clauses may make sense in contexts where intellectual property is difficult to protect, they may be less necessary in others, such as fast-food restaurants. When typically low-paid fast food workers who were not exposed to trade secrets were asked to sign noncompetes, it raised questions about the practice.

In April 2024, the FTC announced a rule banning noncompetes, which the agency estimates affect 30 million American workers, or nearly one in five.

So, what will this mean for businesses and workers—if the ban survives the legal gauntlet?

Thomas Hubbard, a professor of strategy at the Kellogg School, notes that while noncompetes can get in the way of efficient matches between people and jobs and prevent workers from moving to higher-paying jobs, a blanket ban could also have the unintended effect of hindering knowledge-sharing and productivity within an organization, if firms hesitate to train workers.

“That’s one reason why traditionally the policy stance toward noncompetes in many cases has been a selective, ‘Well, we’ll look at them on a case-to-case basis, and not treat them all the same in all contexts,’” Hubbard says.

Banning noncompetes

Consider the example of a chef who, reluctant to share recipes with an underling, insisted on doing all the work themselves. If the chef did share their recipes, what’s to prevent the worker from taking that knowledge to a new restaurant? Noncompetes address that problem by banning the observable, detectable action of going to work at a similar firm.

“You can observe and detect whether I’m working somewhere and where I’m working, but you can’t observe what I’m doing with my knowledge,” says Hubbard.

This has made noncompetes a very desirable tool for companies where the so-called secret sauce involves particularly sensitive information or distinctive practices. But, while the FTC’s rule exempts existing noncompete clauses for “senior executives” who make at least $151,164, it bans all new noncompete clauses across the board.

This new rule might help the growing share of low-wage workers who had been asked to sign noncompetes, such as employees of the sandwich chain Jimmy John’s, who were banned from working at a competitor selling “submarine, hero-type, deli-style, pita, and/or wrapped or rolled sandwiches” within two miles of a Jimmy John’s for a period of two years. But the case for banning noncompetes at the senior level is less apparent.

In those more senior-level jobs, explains Mark McCareins, a clinical professor of strategy at Kellogg, “there’s an expectation that I’m getting paid, I’m getting reimbursed, I’m getting a severance, I’m getting a bonus, I’m getting training, and the quid pro quo for that are some restrictions, and one of which is a reasonable noncompete.”

These white-collar workers, who are often offered alternatives such as “gardening leave,” a paid cooling-off period long enough for their knowledge becomes stale (for example, in a sector such as technology), have built-in financial advantages over low-wage workers, who typically do not receive compensation while the noncompete is in effect.

Can the FTC even do this?

The rule was swiftly challenged in a Texas federal court by the U.S. Chamber of Commerce, the nation’s largest business lobbying group, on the grounds that ​​the FTC, which is charged with enforcing antitrust laws, does not have the authority to deem specific business practices anticompetitive. The U.S. Chamber also argued the rule would harm the economy by leaving small firms and startups vulnerable to losing employees with valuable confidential information to bigger firms.

Historically, McCareins notes, noncompetes were regulated and enforced by state laws, which had varying degrees of permissiveness. Some states have banned noncompetes from certain sectors of the labor force, such as healthcare workers, or for workers making under a certain income. If a worker thought their employment contract was oppressive, they could address the issue in state court, or file a class-action suit alongside other employees.

“Somebody goes in and says, ‘That noncompete should not be enforceable under our state law because it is not reasonable in scope or duration,’” McCareins says. “We’ve had a system in place that has effectively regulated these over the years.”

Moreover, the FTC has historically enforced its mandate through litigation, either in its own court or a federal court.

“What the FTC usually does not do,” McCareins says, “is act as a regulatory agent that issues substantive rules banning certain conduct across all industries.”

Workforce issues also typically fall under the ambit of the Department of Labor, which has the statutory authority to issue guidelines about labor and unions. It is telling, McCareins adds, that the FTC hasn’t traditionally been involved in workplace rulemaking. “There’s clearly a reason for that,” he says.

Given this history, it is likely that the Federal District Court in Texas will find that the FTC didn’t have the authority to issue its rule, a decision the FTC will then appeal. McCareins predicts at least 12 to 18 months of legal wrangling ahead before any potential implementation.

Gains to workers—but also costs

If the rule does go into effect this September, the Biden administration believes that the resulting increase in workforce dynamism will produce a whole slew of benefits: 8,500 additional new businesses created annually, as well as average earnings bumps for workers of $524 per year.

But Hubbard sees costs to workers, too. As a teenager, he spent summers working at two different pizza places, one mediocre, and one that was the best in town. As a pizzaiolo at the mediocre pizzeria at which there was no “secret sauce” and where he did a little bit of everything, a noncompete agreement wouldn’t have done much except limit his other employment opportunities. But at the delicious pizzeria, the owner made the dough himself every morning, and refused to share his technique with his employees. A noncompete could have made the owner more comfortable sharing that knowledge, which would have freed him up to do other things.

In theory, at the delicious pizzeria, teenage Hubbard would have learned a valuable skill, and the entire restaurant could have been more productive—and therefore would have been paid more. While in some cases, noncompetes inhibit job switching and depress wages, eliminating them could, ironically, also hurt workers by limiting their on-the-job learning.

“Banning them will tend to make workers less productive,” Hubbard says, “because people aren’t going to tell them much, which would ultimately hurt their earning potential.”