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Noncompetes in the Crosshairs: Safeguarding the Company's Secret Sauce in the New World of Employee Mobility

    Client Alerts
  • April 07, 2023

Venture capitalists refer to “secret sauce” as the differentiator that gives one startup the edge over competitors. The secret sauce, properly protected, is a trade secret. However, employee turnover can threaten the secret in the sauce.

Companies often negotiate into executive and salesperson employment contracts a panoply of restrictive covenants that attempt to govern the activity of employees after they leave the company. These often include (1) a noncompetition clause that limits when, where, and how an employee can work competitively after leaving, (2) a non-solicitation clause that limits or bans attempts to take customers away from the former employer (and/or taking employees with them), and (3) an NDA, or non-disclosure clause that prohibits an employee from taking or disclosing any confidential or trade secrets information with them when they leave.

FTC has taken aim at noncompetes and has made other recent decisions that reveal increasing scrutiny on restrictive covenants on employees. The federal government has recently made trade secrets and noncompetes headline news. The current winds seem to be going in different directions: protecting proprietary information is getting easier while limiting former employees is getting more difficult.

What do companies need to do? Be more intentional and proactive about creating, protecting, and safeguarding information, including not only cybersecurity, but also trade secrets portfolio management and protection. Let’s look at what has happened just in the first quarter of 2023.

Biden Signs PAIP Act Making Trade Secret Protections Stronger

On January 5, President Biden signed into law the Protecting American Intellectual Property Act (PAIPA), which makes it easier to pursue foreign entities or people who steal trade secrets. This is a follow-up to the Defend Trade Secrets Act, passed in 2016 to create a federal statute to protect trade secrets and create federal jurisdiction for trade secrets suits. This law seeks to deter the theft of U.S. intellectual property by non-U.S. actors by threatening to impose economic sanctions on those engaged in trade secrets theft. This law adds to existing measures available under U.S. law, such as criminal prosecution, civil lawsuits, and/or designation to a U.S. restricted parties list such as the Entity List (maintained by the U.S. Commerce Department’s Bureau of Industry and Security). This law requires the President to report to Congress on any foreign individuals or entities that knowingly engaged in, or benefitted from, the significant theft of U.S. trade secrets since January 5, 2023. After the report, the President must impose five or more sanctions from a list of entities identified, and forbid U.S. entry to those individuals. Because trade secret thieves have been difficult to stop through civil litigation abroad, this new tool should add political emphasis that the government supports businesses in stopping information theft.

FTC Proposes Rules to Make Noncompetes Illegal Nationwide

On the same day in January, by a 3-1 vote, the Federal Trade Commission (FTC) proposed a new rule that would basically prohibit employers nationwide from enforcing any post-employment non-competition agreements, stating that noncompetes prevent “workers from freely switching jobs, depriving them of higher wages and better working conditions, and depriving businesses of a talent pool they need to build and expand.” (FTC Chair Lina M. Khan)

Moreover, the rule would nullify any existing non-competition agreements currently in place and would require employers to inform both current and former workers (including independent contractors) that such clauses are no longer in effect. Not only would noncompetes be void, but companies would be required by law to rescind them.

This rule is open to public comment for 60 days, however the comment period on this rule proposal was extended to April 19, 2023. If the rule passes, it would become effective 180 days after that, and would face significant opposition in the courts. Because this new rule so dramatically alters the landscape of American noncompete law, previously purely a state-regulated issue, many have considered the proposal a “shot across the bow” to states and the business community to clean up overreach. Recently, highly publicized punitive noncompetes against low-skill, low-income workers have made headlines, making noncompetes an easy target for lawmakers.

Non-Solicitation Clauses to Protect Customer Relations Are Not a Part of the FTC Rule

What about other restrictions like a non-solicitation clause? Importantly, the rule would not – at least expressly – prohibit employers’ use of other restrictive covenants, such as non-solicitation or nondisclosure provisions, but certain guidelines would be put in place to curb their use as well. The rule would not apply to a non-competition provision implemented within the context of the sale of a business.

Congress Makes Moves Proposing Noncompete Regulation

On the heels of the FTC move, a bipartisan group of U.S. Senators reintroduced a bill that would basically make the FTC’s move federal law. The Workforce Mobility Act of 2023, which has been unsuccessfully introduced twice before, would largely ban the use of employer noncompete agreements nationwide. Sponsors included Senators Christopher Murphy (D-CT) and Todd Young (R-IN) with Tim Kaine (D-VA) and Kevin Cramer (R-ND) co-sponsoring. If passed, the Act would codify the use of employment noncompetes as an unfair trade practice under federal law.

Not to be outdone, another bipartisan group of Senators introduced a much less far-reaching law that only bans noncompetes against low-wage workers based on overtime exemption. Senators Marco Rubio (R-FL) and Maggie Hassan (D-NH) reintroduced noncompete legislation called the Freedom to Compete Act, which would amend the Fair Labor Standards Act of 1938 to prevent employers from using noncompetes in employment contracts for certain non-exempt employees.

In an interesting, if debatable, statement of purpose for the Freedom to Compete Act, Senator Rubio specifically tied the use of noncompetes to trade secret protection:

Historically, non-compete agreements were used to prevent an employer’s trade secrets from being disclosed to competitors by former employees. However, today’s noncompete agreements can be found in employment contracts for entry-level, low-wage workers who do not have access to trade secrets. Non-compete agreements limit employment opportunities for those entry-level, low-wage workers to improve their circumstances and negotiate higher wages, benefits, and training.

In other words, according to Rubio, noncompetes are fine to protect trade secrets but have simply gone too far because low-wage workers are highly unlikely to have access to or knowledge of the company’s high-level competitive intellectual property that is a secret in the company. Their bill argues that it solves the overreach of restricting low-wage workers with limited knowledge of company trade secrets, while allowing existing state law frameworks to govern exempt workers.

Not only does the law target noncompetes, it also prohibits “de facto” noncompetes. The FTC specifically proposed that an overly restrictive non-disclosure agreement could be a de facto noncompete. Courts have also been taking a stricter view of non-disclosure agreements. For years, companies have written NDAs that purported to make anything under the sun potentially confidential and a trade secret. Recently, a court in Georgia held that this kind of NDA was patently overbroad and wholly unenforceable. The former employer alleged a common claim that the employee had emailed himself a client list before departing to a new job as a wealth advisor. The court awarded summary judgment to the defendant on whether that was a breach of a covenant not to disclose proprietary information. “In sum, the Court concludes that the Confidentiality Covenant as drafted prohibits the disclosure of information unrelated to the protection of Plaintiff’s legitimate business interests. Nasco, Inc. v. Gimbert. Because Plaintiff essentially seeks to ban disclosure of any and all information related to Plaintiff’s business, the provision is overbroad and unenforceable.” Mercer Glob. Advisors Inc. v. Crowley.

Is This Really Happening?

The FTC recently extended the comment period on this rule proposal to April 19, 2023. Apparently, at least 20,000 comments have been sent to the FTC. After the comment period, the FTC can either make the rule final or issue a revised proposal, restarting the process. If it does stick with the original rule, the Office of Information and Regulatory Affairs (OIRA) will review its impact. OIRA can clear the rules with or without changes, return the rules to the agencies for reconsideration, or encourage the agencies to withdraw them. If OIRA clears the rule, it is published in the Federal Register and becomes effective within 60 days. Congress can, but does not have to, review the rule within the 60 days. Because two laws have already been proposed, there is a guarantee this rule would receive heavy Congressional scrutiny. If a rule becomes final, employers have 180 days to comply, i.e., rescind their covenants and notify employees. Before it is finalized, this rule would be subjected to lawsuits. The U.S. Chamber of Commerce has already promised to challenge the rule.

What Should Companies Do Now?

Clearly it is time to review employment agreements to make sure they are narrowly tailored and make sense. Employers will be unlikely to get away with any kind of catch-all language as a safety net to prevent employees from working or using easily obtained information. A company should not be using noncompetes against workers who are low on the company ladder or low on the wage scale. Also, be clear in your agreements what information really must be protected and matters to the company by evaluating now exactly what the trade secrets are, beefing up their security matters, and specifically describing them in non-disclosure agreements.

The Future

The truth is that we are a long way from a federal law invalidating noncompetes. However, another truth is that unmistakable hostility to overly broad restrictions on employee mobility has become the narrative in courts and many state legislatures. Whether anything will change for noncompete law at the national level is up for debate, but there has not been this much controversy over noncompetes in decades. At the same time, over the past decade, the law has given trade secret owners powerful new weapons to protect trade secret information. Veteran trade secret lawyers frequently try to persuade companies to manage trade secrets as seriously as patents, trademarks, and copyrights. However, legal budgets are not the darlings of corporate finance.

Managed properly, trade secrets are immensely valuable property. By their secret nature they defy registration and require resources to safeguard. However, the secret sauce that makes a company different, better, or profitable is often a trade secret that must be identified and protected.