The FTC’s Proposed Ban on Non-Compete Agreements:

Non-compete agreements have been widely seen as problematic in the United States.  Even where theoretically enforceable, individual states and their respective courts overlay a series of restrictions, exceptions, and balancing tests to limit their application.  Moreover, under certain circumstances courts are permitted to “blue pencil” such agreements to conform their terms and make them enforceable.  Typically, the enforceability of a non-compete examines and balances the geographic, temporal and activity scope of a non-compete against the legitimate interests of the employer.  Where excessive, the court may reform the non-compete agreement to be reasonable.

While contract law is traditionally the concern of State government, the Federal Trade Commission has announced plans to impose its own broad prohibition against non-complete agreements pursuant to the FTC’s Section 5 authority (deceptive and unfair business practices).  This new rule would “provide that it is an unfair method of competition for an employer to enter into or attempt to enter into a no-compete clause with a worker; to maintain with a worker a non-compete clause; or, under certain circumstances, to represent to a worker is subject to a non-compete clause.”  Moreover, this rule purports to act retroactively and require employers to actively rescind non-compete agreements. 

Finally, the rule is not strictly speaking limited only to traditional non-competes.  Instead, the FTC will examine contracts using a “functional approach” to determine whether they operate as de facto non-competes, irrespective of their contractual packaging.  Among the types of agreement specifically called out for FTC “functional” scrutiny is the Non-Disclosure Agreement (NDA). 

Subjecting NDAs to “Functional” Scrutiny

NDA’s are commonplace in our information driven economy.  According to the FTC’s proposed rule notice, between 33% and 57% of all workers are subject to at least one NDA.  NDA’s can be packaged as stand-alone agreements, but in the employment context it is common for NDA provisions to be merely one part of a larger employment agreement. 

Whether an NDA “functions” as a prohibited non-compete will “depend not on what the provision is called, but how the provision functions.”  Importantly, for purposes of the rule a “NDA … refer[s] to contractual provisions that are designed to protect trade secrets and other business information that has economic value.”[1] 

If “appropriately tailored NDAs … fall outside of the scope of the proposed rule, … [because] they generally do not prevent workers from working for a competitor or starting their own business altogether.”  Unlike workers subjected to traditional non-competes, according to the FTC, workers subject to NDA provisions “remain free to work for whomever they wish, wherever they wish and at whatever they wish, subject only to the terms that prohibit them from disclosing or using certain information.” 

In other words, in the FTC’s view, NDAs “may affect the way a worker competes with their former employer after the worker leaves their job. However, they do not generally prevent a worker from competing with their former employer altogether; and they do not generally prevent other employers from competing for that worker’s labor. For example, if a worker leaves their job with their employer and goes to work for a competitor, an NDA the worker signed with their employer may prevent the worker from disclosing certain information to the competitor. However, a standard NDA would not prevent the worker from seeking or accepting work with the competitor.” 

Where the line between an “appropriately tailored” NDA and an NDA that surreptitiously functions as a prohibited non-compete is not at all explained by the FTC.  The lone example of cited by the FTC, Brown v. TGS Mgmt., is simply so extreme as to be an inadequate illustration.  Therein, a California appellate court tore up an NDA that, according to the FTC, defined “confidential information as any information that is usable in or relates to the securities industry” having the de factor result of a total non-compete.  As represented by the FTC, this NDA is so overly broad as to be comedic.  Certainly, the FTC does not mean to suggest that any NDA short of the Brown NDA would be “appropriately tailored” under its functional rule. 

Consequently, we are left with vague platitudes that “good” NDAs merely limit the way that a worker competes with their former employer while “bad” NDAs prevent a worker from competing altogether. 

The FTC’s Proposed Rule Conflicts with the Defend Trade Secrets Act:

At the same time as the FTC places some unknown number of existing NDAs under a cloud the FTC touts NDAs as an effective and appropriate alternative to non-competes.  Just as Schrodinger’s Cat may be both alive and dead, your firm’s NDAs may be an encouraged alternative to a non-compete or an unlawful, de facto non-compete that (by the way) you will be legally required to rescind. 

To see how this works (or not) a bit of trade secret law background is required.  Under the Defend Trade Secrets Act (as well as the Uniform Trade Secret Act), a trade secret can consist of nearly any category of information provided that the information is secret, protected by “reasonable measures,” and that the information derives independent economic value from not being generally known.  “Reasonable measures,” typically include – as the FTC itself notes – the nearly ubiquitous NDA. 

One reason that NDAs are perhaps a go-to “reasonable protection” stems from the requirements that transform trade secret disclosure to actionable trade secret “misappropriation.” Pursuant to 18 USC § 1839(5), misappropriation means (among other things) “disclosure or use of a trade secret … without express or implied consent by a person who …  acquired [the trade secret] under circumstances giving rise to a duty to maintain the secrecy of the trade secret or limit the use of the trade secret.”  While such a duty could arise in other ways, the simplest way to impose such a duty on an ordinary employee is through contract – through an NDA.    If a contractual duty is unlawful and unfair competition, violating an unlawful duty would not be actionable.  On the prospective employer’s side, misappropriation will result from the use of “improper means” to acquire a trade secret.  “Improper means” includes the “breach or inducement of a breach of a duty to maintain secrecy,” but does not include other “lawful means of acquisition.”  In other words, a competitor cannot (currently) induce a prospective employee to breach an NDA.  However, this may change if the NDA is unlawful and unfair competition.  Indeed, the FTC might consider inducing a breach of an unlawful NDA to be pro-competitive. 

To see how this might shake out, let us engage in a small thought experiment:  Smith wishes to work for ACME Corporation, a direct competitor of Mega Corporation, Smith’s current employer.  Smith is invited in for an interview and asked whether Smith is subject to any applicable NDAs – a perfectly reasonable line of questions for a cautious firm.  After answering in the affirmative, ACME “rejects” Smith’s prospective employment and puts in writing that ACME would have hired Smith (at a higher compensation package) but-for the overly restrictive NDA, as the NDA will make Smith too difficult to integrate into ACME’s workplace teams (or some other plausible corporate puffery) and that he should re-apply after his NDA expires or is otherwise lifted. 

Keep in mind that none of this requires ACME to be behaving in any untoward fashion at all, simply acting in a reasonable and risk adverse manner in the desire to avoid trade secret disputes with their competitor. 

Now Smith is armed with plausible evidence that his NDA provisions are not “appropriately tailored” at all, but rather an unlawful obstacle preventing him from competing in any way with his employer.  Recall, that the FTC seems to believe that any NDA that prevents an employee from moving to a competitor is a de facto non-compete.  Here the competitor seemingly avers that there is no realistic manner for Smith to work at ACME with the NDA in place. 

An FTC investigation is threatened and not desiring to be subjected to Federal oversight pursuant to a consent decree that polices all of their HR decisions, Mega folds and allows Smith – and its valuable trade secrets known to Smith to walk out the door. 

Granted, even in this scenario, Mega could prevent Smith from, for example, removing documents or data but absent that Smith would be free to use all that he knew, all that he could recall or all that he could recreate in the service of his new employer. 

Where does this leave employers? Obviously, greater care will be needed in drafting NDA such that they are more narrowly drawn.  Such NDAs may also need to be regularly reviewed and revisited to ensure that they align with an employees current access to company information, rather than writing such language generally as a one-size-fits-all provision.  In addition, greater emphasis needs to be placed on physical and information technology controls on important information as contractual terms – though “reasonable measures” under the DTSA – may not actually be reliable enough to effectively protect trade secrets post incident.