Moore

Photo by Netania Moore

Raphael Moore is general counsel of the Veterinary Information Network.

Noncompetes — folks love them or hate them, often depending on whether they are employers or employees. With the U.S. Federal Trade Commission recently passing a rule largely banning the contract term nationwide, let's step back for some perspective.

Understanding the origins of noncompetes can help people regard them less emotionally and more analytically. So we'll start with history, then consider the ban and legal challenges to it, and end with how employees and employers can best deal with the current state of affairs.

Historical context

A noncompete is a clause in a contract that restricts an ex-employee from competing against their former employer, usually within a specified geographic area for a defined period of time. As used in the United States, the concept originated centuries ago in English common law.

In the 1400s, the English deemed any type of restraint on trade as unenforceable. Back then, the English economy was very dependent on apprenticeships. A master, or employer, would enter into a contract to provide training to an apprentice in exchange for cheap labor for a few years. Following the apprenticeship, the expectation was that the employee would have attained the status of a skilled employee, or journeyman.

The master wanted to then prevent the former apprentice from competing against him, but because the whole economy was dependent on masses of apprentices, courts would not allow such restrictions for fear the system would crumble. Add the fact that the bubonic plague had caused a shortage of employees, and there wasn't much appetite to restrict individuals from earning a living.

By the 1700s, worker shortage was less of an issue, so the pendulum swung to favor employers. The notion of "geographically limited restrictions" came into play, with English courts allowing employers to set restrictions that were not too onerous: As long as a former employee could find a job in a nearby village, the restriction was acceptable.

By the 1800s, economies were shifting to a capitalist model. Courts became receptive to the concept of freedom to contract. As goods began moving beyond local communities and it became easier to provide services to faraway lands, there was a realization that workers were likewise mobile. Courts wanted to allow employers and employees alike to find terms that would be attractive to both. If an employee were willing to take on certain restraints, why not let them?

The concept of "reasonable" restraints started taking hold. In 1837, a state Supreme Court for the first time approved restraints, provided they were limited in time and place. In the case, Alger v. Thacher, the Massachusetts court did not specify the limits, noting that "what shall be deemed a reasonable limitation ... must depend on the circumstances of each particular case."

By the start of the 1900s, that concept was accepted by most courts. Even when the federal Sherman Antitrust Act of 1890 passed to prohibit restraints on trade, courts continued enforcing noncompetes as long as they were perceived as reasonable. A notable exception was California, where state law dating to 1872 deemed them unenforceable.

When economies shifted from industry and manufacturing toward "human capital," the case for noncompetes became stronger, as employers realized that their employees could leave with all their "knowledge" overnight.

Currently, most states allow noncompetes, provided they follow specific standards. The goal is to give employers the ability to protect their intellectual property and investment while giving employees the ability to earn a living and giving both sides the freedom to contract.

But in the past 15 years or so, the pendulum has been swinging again, with many arguing that the balance struck by courts and legislatures has resulted in widespread exploitation of employees and suppression of innovation. Some point to existing employer protections under civil and criminal rules — such as protection of intellectual property like client lists, tort laws that prevent interference with contracts, and theft statutes — to support the proposition that employers can protect their interests without broadly worded noncompetes.

In 2007, the Oregon Legislature started tinkering with what it considered "reasonable" by setting minimum compensation thresholds and requiring pay during the noncompete period. A couple of years later, Massachusetts and Georgia started following Oregon's example. Today, dozens of bills are pending or signed into law that change noncompetes to protect employees. Nearly a dozen states ban them for low-wage jobs and have very specific notice requirements to employees, among other provisions. And considering the experience of states like California, which has largely banned noncompetes for more than 150 years with no material adverse consequences to employers, there has been an ongoing push to address inequities in noncompetes on a national level.

That brings us to the FTC rule.

A national ban

On Tuesday, the FTC published in the Federal Register a rule to render most employer-employee noncompete agreements in the country unenforceable. The rule takes effect Sept. 4 — assuming no court says otherwise, which is a big assumption. Multiple lawsuits have already been filed, and a request to block the rule is pending.

The arguments being made against the rule are:

• The FTC lacked, or exceeded, its statutory authority. Although the agency is allowed to regulate "unfair methods of competition," it has never regulated employee noncompete agreements, and Congress did not give it clear authority to do so.
• All legislative power is vested in Congress, so even if Congress granted the FTC authority to pass the rule, it should not have done so.
• In changing hundreds of years of contract law and by applying retroactively, the rule has a vast impact that was not considered by the FTC and is, therefore, arbitrary and capricious.

Parts of these arguments have legal merit, and I don't see the rule remaining intact in its present state. Considering the suits have been filed in multiple federal circuits, the issue may well be settled ultimately by the U.S. Supreme Court.

Since it is unlikely that noncompetes are going anywhere soon, let's consider what to do about them today.

Be reasonable

Employment contracts should be fair to both sides. Employers should be able to view them like an employee, and prospective employees should be able to see them like an employer. If you can't put on the other's hat and still find a term 100% fair, it shouldn't be in the contract.

There is nothing inherently wrong with noncompetes if they are equitable. Properly worded, they can protect the employer's investment and business, and in doing so, better secure employees' jobs and even result in higher wages. But employers who overreach, such as by unduly preventing their employees from earning a living or requiring them to stay in untenable employment situations, create nightmares for employees.

How do you create an equitable noncompete? By setting terms that balance power based on who has control over an issue and who bears the risk. This is true for every contract term, whether a noncompete or otherwise.

To illustrate: If I buy your used car, it may be a lemon. Since I have no control over how you maintained it, it would be fair for me to require you to offer me a warranty to offset my lack of control and the risk I'm taking. If I want to pay you for the car with a personal check, you have no control over whether I have funds in my account, so it would be equitable for you to require cash payment to offset your risk.

How do you design fair and balanced noncompetes in an employment contract? It's not that hard.

First, consider that every employment agreement can end in one of four ways.

1. by the employee for cause (as when an employer engages in sexual harassment, violates labor laws or doesn't provide contracted benefits)
2. by the employee not for cause (as when an employee quits for reasons unrelated to employer fault)
3. by the employer for cause (as when an employee violates workplace policies or commits a crime)
4. by the employer not for cause (as when an employer exercises at-will termination)

From a standpoint of fairness, noncompetes should apply only in scenarios No. 2 and No. 3. That is, if an employee decides to leave without cause (scenario No. 2), that departure is solely in the employee's control, and for balance, it may be equitable to prevent them from competing within reasonable limits.

Equally so, if an employer fires an employee with good reason (scenario No. 3), it can be equitable that the employee be reasonably prevented from competing, since the employee's decision to breach policy or commit a crime is wholly in their control. In both scenarios, the employer has all the risk, and the noncompete clause balances that risk.

In scenarios No. 1 and No. 4, a noncompete would be inequitable. If the employee left with cause because, say, their guaranteed shifts were changed without consent, they weren't getting paid their contracted compensation or they were sexually harassed — all matters under the sole control of the employer — they shouldn't be held to a noncompete.

Similarly, if the employer terminated the employee without a justifiable reason, the employee should not be subject to further penalty in the form of a noncompete.

To reiterate, it is all a matter of risk-shifting — putting the risk with the party who can control that risk. This approach places the burdens on those in control.

Other elements can make the overall concept even more just. One example is a sunrise provision, whereby the noncompete doesn't kick in until after, say, 90 days of employment. Consider the 90 days a test period. If the employee is miserable, the job's not a good fit or things are simply not working out, it would be unjust to trigger a noncompete. The waiting period is fair for the employer, too, because the employee hasn't been around long enough to abscond with clients.

Another equitable provision is a "ramp period." Let's say both sides think a noncompete for two years post-employment is reasonable. Rather than the full two years kicking in immediately, the noncompete period could match the length of employment, ramping up to a two-year maximum. If the employee left after nine months, the noncompete would last for nine months. If the employee left after three years, the noncompete would be for the full period — two years.

These are just some of the many creative tactics available to achieve a reasonable agreement that recognizes the needs of the employer to have some protections; the needs of the employee to be able to change jobs; and the protection of clients, who should be able to choose their own provider.

Raphael Moore, JD, LLM, has been general counsel of the Veterinary Information Network, an online community for the profession, since the 1990s. He enjoys figuring out esoteric legal issues and is a frequent contributor to VIN legal and practice management discussions. An avid hiker, he has a knack for being attacked by bears in Yosemite. He lives with his wife and their two daughters in a geodesic dome on the outskirts of Davis, California, where he raises alpacas, goats and chickens.

Update: In a decision issued Aug. 20, a federal judge in Texas struck down the FTC's noncompete rule, saying the agency "exceeded its statutory authority” in implementing the "arbitrary and capricious" rule. The FTC might appeal. Other challenges to the federal ban are working their way through other courts. The FTC may still take action against individual employers for overly broad noncompetes, and state regulations, including bans against noncompetes, are unaffected.