Are Employee Noncompete Agreements Coercive? Why the FTC's Wrong Answer Disqualifies It from Rulemaking (For Now)

82 Pages Posted: 14 Sep 2023 Last revised: 27 Mar 2024

Date Written: August 30, 2023

Abstract

The Federal Trade Commission recently proposed a rule banning nearly all employee noncompete agreement (“NCAs”) as unfair methods of competition under Section 5 of the Federal Trade Commission Act. The proposed rule reflects two complementary pillars of an aggressive new enforcement agenda championed by Commission Chair Lina Khan, a leading voice in the NeoBrandeisian antitrust movement. First, such a rule depends on the assumption, rejected by most prior Commissions, that the Act empowers the Commission to issue legislative rules. Proceeding by rulemaking is essential, the Commission has said, to fight a “hyperconcentrated economy” that injures employees and consumers alike. Second, the content of the rule reflects the Commission’s repudiation of consumer welfare and the Sherman Act’s Rule of Reason as guides to implementing Section 5.

Affected parties will no doubt challenge the Commission’s assertion of authority to issue legislative rules. This article assumes for the sake of argument that the Commission possesses the authority to issue such rules enforcing Section 5. Still, prudence can counsel that an agency refrain from issuing rules before it has fully educated itself about the nature of the economic phenomena it hopes to regulate. Such prudence seems particularly appropriate when the Commission has very recently adopted an entirely new substantive standard governing such conduct. Deferring a rulemaking does not mean inaction. The Commission could develop competition policy regarding NCAs the old-fashioned way, investigating and challenging such agreements on a case-by-case basis.

The Commission rejected these prudential concerns and proceeded to ban nearly all NCAs, assuring the public that it had educated itself sufficiently about the origin and impact of NCAs to conduct a global assessment of such agreements. The Notice of Proposed Rulemaking (“NPRM”) offered three rationales for the proposed rule, drawn from a late 2022 Statement of Section 5 Enforcement Policy. First, the Commission opined that NCAs are “restrictive” because they prevent employees from selling their labor to other employers or starting their own business in competition with their employer. Second, NCAs result from procedural coercion, because employers use a “particularly acute bargaining advantage” to impose such agreements. Third, NCAs are substantively coercive, because they burden the employee’s right to quit and pursue a more lucrative opportunity.

The first rationale applied to all NCAs. The second and third applied to all NCAs except those binding senior executives. Such executives, the Commission said, bargain for such agreements with the assistance of counsel and presumably receive higher salary and/or more generous severance in return for entering such NCAs. Because NCAs also have a “negative impact on competitive conditions,” the NPRM also concluded that they are presumptively unfair methods of competition.

The Commission conceded that NCAs can create cognizable benefits. Nonetheless, the Commission concluded that such benefits do not justify NCAs, for two reasons. First, less restrictive means can “reasonably achieve” such benefits. Second, such benefits do not exceed the harms that NCAs produce.

The Commission also rejected the alternative remedy of mandatory precontractual disclosure of NCAs for two interrelated reasons. First, such disclosure would not prevent employers from using overwhelming bargaining power to impose such restraints. Second, disclosure would not alter the number or scope of NCAs and thus would not reduce their aggregate negative economic impact.

The procedural coercion rationale played an outsized role in the Commission’s Section 5 analysis, informing the findings that NCAs are also “restrictive” and substantively coercive. Moreover, the outsized emphasis on procedural coercion dovetailed nicely with the NeoBrandeisian claim that ordinary Americans are routinely helpless before large concentrations of private economic power. Indeed, when the Commission released the NPRM, Chair Khan separately tweeted that NCAs reduced core economic liberties.

Still, the Commission offered no definition of “coercion” or explanation of how to determine whether employers have used coercion to impose NCAs on employees. Instead, the Commission articulated several subsidiary determinations regarding the characteristics of employers and employees that, taken together, established that employers always possess and use an acutely overwhelming bargaining advantage to impose nonexecutive NCAs. Thus, the Commission emphasized that labor market power is widespread, due in part to labor market concentration, most employees are unaware of NCAs before they enter such agreements, NCAs generally appear in standard form contracts, employees rarely bargain over such agreements, most employees live paycheck-to-paycheck and thus have no choice but to accept NCAs, and individuals negotiating over terms of employment discount or ignore the possibility that they will depart from the job they are about to accept and thus downplay the potential impact of an NCA on their future employment autonomy.

This article contends that the Commission’s procedural coercion rationale for condemning nonexecutive NCAs does not withstand analysis. In particular, the Commission’s various subsidiary determinations that support the procedural coercion rationale have no basis in the evidence before the Commission, contradict such evidence and/or disregard modern economic theory regarding contract formation. For instance, a recent study by two Department of Labor economists finds that the average Herfindahl-Hirschman Index in American labor markets is 333, the equivalent of 30 equally-sized firms, each with a 3.33 percent market share, competing for labor in the same market. A previous version of the study was published on the Department of Labor’s website several months before the Commission issued the proposed rule. The NPRM offers no contrary evidence regarding the proportion of labor markets that are concentrated. “Hyperconcentration of labor markets” is apparently a myth.

Moreover, the NPRM ignores record evidence that 61 percent of employees know of NCAs before they accept the offer of employment. The NPRM’s failure to address these data is particularly strange, insofar as the NPRM cites the very same page of the academic article where these data appear three different times for other propositions. The Commission also erred when it assumed that employers with labor market power will use such power coercively to impose even beneficial NCAs. This assumption would have made perfect sense in 1965. However, since the 1980s, scholars practicing Transaction Cost Economics have explained how firms with market power, including labor market power, will not use that power to impose beneficial nonstandard agreements, including NCAs. The Commission was apparently unaware of this literature.

Nor does the lack of individualized bargaining and reliance on form contracts suggest that employers use power coercively to impose NCAs. Form contracts often arise in competitive markets and reduce transaction costs. Background rules governing contract formation, robust state court review of NCAs and exit by potential employees can constrain employers’ ability to obtain unreasonable provisions and induce employers to pay premium wages to compensate employees for agreeing to NCAs. These considerations may explain why a majority of employees who had advanced knowledge of NCAs considered the agreements reasonable, a finding the NPRM ignores.

Nor does it matter that most employees work paycheck-to-paycheck. The Commission ignored the possibility that such individuals may be employed when seeking a new job, bargain from a position of relative security and can thus “walk away” from onerous NCAs. The Commission also ignored economic literature establishing that the presence of some such individuals in a labor market can ensure that employers offer reasonable terms to all potential employees, including unemployed job seekers.

Refutation of the procedural coercion rationale for banning nonexecutive NCAs requires reconsideration of the other two rationales as well. For instance, nonexecutive NCAs are the result of voluntary integration and thus not procedurally coercive or substantively coercive, either. Moreover, because some nonexecutive NCAs are voluntary, the Commission must abandon its erroneous assumption that the beneficial impacts of NCAs necessarily coexist with coercive harms. Proper assessment of business justifications requires the Commission to ascertain the proportion of NCAs that constitute voluntary integration, revise downward its estimate of coercive harms and reassess NCAs’ relative harms and benefits. This revision could result in a determination that NCAs’ benefits in fact exceed their harms. Finally, recognition that beneficial NCAs are the result of voluntary integration requires the Commission to reconsider the mandatory disclosure remedy, which the Commission rejected based on the erroneous belief that employers use bargaining power to impose even fully-disclosed and beneficial NCAs. Such reconsideration could of course lead to revising the scope of the proposed ban or rejection of any ban.

The Commission may well be entirely capable of assessing the global impact of NCAs on economic variables such as price, output, and wages. However, the Commission rejected such a rule of reason approach in favor of a standard that turns in part on the process of contract formation. Thus, the Commission necessarily took on the task of gathering information regarding the process of forming NCAs and of assessing that data in light of applicable economic theory. The Commission’s demonstrably poor execution of this task reveals that it lacks the capacity to conduct a generalized assessment of NCAs under a governing standard that treats procedural coercion as legally significant.

Because it lacks the capacity to assess the process of forming nonexecutive NCAs, the Commission should withdraw the NPRM and start over. There are two alternative paths the Commission may take to develop well-considered competition policy governing NCAs. First, the Commission could revert to the rule of reason approach it rejected in 2021. The Commission could draw upon its considerable study of the impact of NCAs on wages, prices and employee training and promulgate a rule that bans those agreements the Commission believes produce net harm, after reconsidering regulatory alternatives such as mandatory disclosure.

Second, the Commission could continue to embrace its new Section 5 standard but take an “adjudication only” approach to implementation. The Commission could simultaneously take other steps through various forms of public engagement to educate itself about contract formation in general and the formation of NCAs in particular. The Commission could build on data it has to this point ignored regarding various attributes of employers, employees and labor markets more generally. Adjudication and self-education could be mutually reinforcing. Self-education could inform the Commission’s determination of which NCAs to challenge, while information generated in adjudication could improve the Commission’s knowledge base about NCAs. Ultimately this two-track approach could generate sufficient information to justify a well-considered rule governing NCAs.

Keywords: Federal Trade Commission, Unfair Methods of Competition, Employee Noncompete Agreements, Coercion, Section 5, Rule of Reason, Transaction Cost Economics, Voluntary Contract Formation, Myth of Labor Market Hyperconcentration

Suggested Citation

Meese, Alan J., Are Employee Noncompete Agreements Coercive? Why the FTC's Wrong Answer Disqualifies It from Rulemaking (For Now) (August 30, 2023). 18 Virginia Law & Business Review 245 (2024)., William & Mary Law School Research Paper No. 09-476, Available at SSRN: https://ssrn.com/abstract=4558012 or http://dx.doi.org/10.2139/ssrn.4558012

Alan J. Meese (Contact Author)

William & Mary Law School ( email )

South Henry Street
P.O. Box 8795
Williamsburg, VA 23187-8795
United States
757-221-1609 (Phone)
757-221-3261 (Fax)

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