As we posted yesterday, the Federal Trade Commission (FTC) has at long last issued its final regulatory rule banning virtually all existing and future U.S. non-compete agreements. In this series, we will unpack some of the more nuanced questions surrounding the final rule. Although the series is generally applicable, today’s post is particularly geared toward private equity firms and financial institutions.

How does the sale-of-business exception work?

One of the exceptions to the final rule is that it does “not apply to a non-compete clause that is entered into by a person pursuant to a bona fide sale of a business entity, of the person’s ownership interest in a business entity, or of all or substantially all of a business entity’s operating assets.”

This language is fairly similar to an exception included in the FTC’s January 2023 proposed non-compete rule – however, there is an important change in the final rule. Specifically, the proposed rule included an exception for certain non-compete agreements between the seller and the buyer of a business that applied only to a substantial owner, member, or partner, defined as an owner, member, or partner with at least 25 percent ownership interest in the business entity being sold. In the final rule, however, the FTC has dropped the 25 percent ownership interest requirement.

In explaining its reasoning, the FTC notes that, “compared to non-competes arising solely out of an employment relationship, non-competes between the sellers and buyers of businesses may implicate unique interests and have unique effects that this rulemaking record does not address.” The FTC also notes that commenters on the proposed rule had “persuasively argued that the proposed 25 percent ownership threshold was too high because it failed to reflect the relatively low ownership interest held by many owners, members, and partners with significant goodwill in their business.” On a separate but related front, the FTC also notes several commenters had suggested that, in order to trigger the sale-of-business exception, the FTC should adopt a monetary threshold on the proceeds received by the seller. The final rule commentary makes clear, however, that, ultimately, the FTC decided against this approach.

Further on this issue, the FTC notes its concern that “firms may abuse the sale-of-business exception through sham transactions with wholly owned subsidiaries, ‘springing’ non-competes, repurchase rights, mandatory stock redemption programs, or similar evasion schemes.” The FTC explains that it therefore added the term “bona fide” and made changes clarifying that any excepted non-compete must be made “pursuant to a bona fide sale” – which generally speaking means a sale one that is made between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale – to ensure that such schemes are prohibited under the final rule.

The FTC goes on to explain that so-called “springing” non-competes and non-competes arising out of repurchase rights or mandatory stock redemption programs are not entered into pursuant to a bona fide sale because, in each case, the worker, at least in the FTC’s view, has no goodwill that they are exchanging for the non-compete or knowledge of or ability to negotiate the terms or conditions of the sale at the time of contracting. Similarly, the FTC opines that sham transactions between wholly owned subsidiaries are not bona fide sales because they are not made between two independent parties. That said, the final rule does seem to recognize that private equity sponsors have legitimate interests to protect, and there may thus be room for businesses and their legal counsel to craft bespoke arrangements that recognize those interests without running afoul of the rule (i.e., coming up with arrangements that meet the final rule’s definition of a “bona fide sale”).

In short, by acknowledging that non-compete agreements between the seller and buyer of a business may be distinct from more typical non-compete agreements between an employer and employee, the final rule recognizes that most states review non-compete agreements in the context of a business sale under a more lenient standard than non-compete agreements that arise solely out of an employment relationship. (One of the primary reasons for this difference is that non-compete agreements entered into between a buyer and seller are meant to protect the value of the business acquired by the buyer.) Also, by including this exception, the FTC’s proposed rule aligns with the non-compete laws in California, North Dakota, Minnesota, and Oklahoma. Even in these four states, which bar post-employment non-competes generally, the law nevertheless permits reasonable non-compete agreements in the business sale context.

Does the final rule bar forfeiture-for-competition clauses?

Yes. In late January, we wrote about forfeiture-for-competition clauses and their continued endorsement by Delaware courts. We have understandably received several questions as to whether the final rules bars such clauses.

With that in mind, the final rule applies to “any term or condition of employment that . . . penalizes a worker for . . . (i) seeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment that includes the term or condition; or (ii) operating a business in the United States after the conclusion of the employment that includes the term or condition.” The commentary on the final rule, in turn, specifies that one “example of a term that ‘penalizes’ a worker . . . is a forfeiture-for-competition clause, which . . . imposes adverse financial consequences on a former employee as a result of the termination of an employment relationship, expressly conditioned on the employee seeking or accepting other work or starting a business after their employment ends.”

As such, it appears that the FTC considers forfeiture-for-competition clauses to be non-compete agreements and, thus, covered by the final rule. Private equity sponsors should therefore take inventory of any incentive equity, co-investment, or rollover equity programs where competitive activity gives rise to a forfeiture or repurchase option in light of the final rule.

Does the final cover non-competes contained in separation agreements or other commonly used agreements in the private equity and financial sectors (such as incentive equity awards)?

Yes. The FTC states that it covers all terms of employment that meet the final rule’s definition of “non-compete clause,” regardless of whether the term is included in an employment agreement, an incentive equity award agreement, a separate restrictive covenant agreement, a separation agreement, an employee handbook, or some other document.

The final rule only applies to “workers” – what does that mean?

The final rule applies to all “workers,” which means as any “natural person who works or who previously worked, whether paid or unpaid, without regard to the worker’s title or the worker’s status under any other State or Federal laws, including, but not limited to, whether the worker is an employee, independent contractor, extern, intern, volunteer, apprentice, or a sole proprietor who provides a service to a person.”

This definition differs in a few ways from the definition in the proposed rule. First, the FTC added “or who previously worked” to the basic definition of “worker” as “a natural person who works. . .” Second, the FTC removed “for an employer” from the definition. This revision is designed to ensure that the final rule covers workers who are hired by one party but work for another. And third, the FTC added “without regard to the worker’s title or the worker’s status under any other State or Federal laws” prior to the list of examples of different categories of workers that the definition covers.

All of which is to say that the final rule applies to an incredibly broad swath of service providers beyond just traditional employees. That said, a non-compete agreement between, for instance, a private equity buyer and an individual who will not perform any work for the buyer post-closing, could possibly fall outside the scope of the final rule if properly crafted.

Stay tuned for our next post in this series.