As a growing body of academic literature asserts, noncompetes are restraints against competition, and they are harmful to both employees and the economy. As one of the major levers that the federal government has over the economy, antitrust laws can provide significant deterrence to abuse of noncompetes by employers.
In the May 17, 2024 edition of The Legal Intelligencer, Edward T. Kang wrote, “FTC Ban on Noncompetes: Antitrust Implications of Agreements.”
Massachusetts’s Route 128 high-tech corridor was supposed to be America’s high-tech capital. In the 1970s, armed with talents from Harvard and MIT and home to computer companies like Digital Equipment Corp. and Wang Laboratories, the Boston metro area was leading the charge for minicomputer innovation. Back then, the total technology employment in the area was roughly triple that of Silicon Valley, and the notion of Silicon Valley outshining Boston as the high-tech capital seemed implausible. Fast forward to 1995. Silicon Valley saw the highest increase in export sales among U.S. metro areas, while Boston did not make the top five. What explains Silicon Valley’s rise and Boston’s decline? Legal scholars have identified one key reason: while most states, including Massachusetts, enforce noncompete agreements, California does not. The result was a strikingly open culture in Silicon Valley where employees are free to go from one company to another or start their own, enabling and sustaining more successful regional development. In the last decade, there has been a surge in public initiatives including new legislations and regulatory initiatives aiming to reign in employers’ use of noncompetes, with the most recent example being the FTC’s issuance of its final rule banning nearly all noncompete agreements. The final rule has yet to take effect, however, and legal challenges are already looming. Rather than just describing the new FTC rule, we should examine noncompetes’ anticompetitive effects, a critical aspect of the rule’s underlying rationale. As a growing body of academic literature asserts, noncompetes are restraints against competition, and they are harmful to both employees and the economy. As one of the major levers that the federal government has over the economy, antitrust laws can provide significant deterrence to abuse of noncompetes by employers.
The Spectrum of State Laws on Noncompetes
The legal system has historically addressed noncompetes almost entirely under state common law. Nowadays, the treatment of noncompete provisions varies significantly from state to state. On one end of the spectrum, five states completely prohibit almost all noncompete agreements. These states include California, Colorado, Minnesota, North Dakota and Oklahoma. On the opposite end of the spectrum regarding enforceability, numerous states rely on common-law development to assess non-compete agreements and generally uphold noncompete agreements. However, all states subject such agreements to closer scrutiny than typical contracts by applying a balancing test that requires employers to show a “protectable interest,” or requires more than minimal consideration. Generally, under the balancing test, a court must consider whether the restraint is greater than is needed to protect the employer’s legitimate interest; the hardship to the employee; and (3) the likely injury to the public. See Modern Environments v. Stinnett, 561 S.E.2d 694 (Va. 2002).
On the enforceability of noncompete agreements containing unenforceable provisions, courts in these jurisdictions are split among three approaches: the “all or nothing” approach, which voids the agreement entirely if any part is unenforceable, the “blue pencil” approach, which enables the court to enforce the reasonable terms provided the agreement remains grammatically coherent once its unreasonable provisions are excised, and the “partial enforcement” approach, which reforms and enforces the restrictive covenant to the extent it is reasonable, unless the “circumstances indicate bad faith or deliberate overreaching” on the part of the employer. See Ferrofluidics v. Advanced Vacuum Components, 968 F.2d 1463 (1st Cir. 1992).
The Anticompetitive Effects of Noncompetes
By imposing outright limits on employees’ ability to engage in competitive work, noncompetes can deter employees from leaving their employers and impede their access to economic opportunities. Moreover, noncompetes, in the aggregate, can cause broader harm to society when they impede free trade and open competition.
An example is helpful to illustrate the threat to competition posed by noncompetes. Imagine a hospital in a rural area with a fixed number of trained nurses. Suppose the hospital owner is worried that another hospital might be established in the area and bring in competition, both in the product market for medical services and the labor market for skilled medical professionals. In that case, the hospital can hire additional unneeded nurses out of the pool of trained nurses and subject all nurses to noncompetes of three years. The noncompetes would be a significant entry barrier for any new hospital that wants to enter the market. Even if a new hospital is willing to pay a significant wage premium to hire the nurses employed by the incumbent hospital, the new hospital will have to wait three years while the nurses remain unemployed. Furthermore, this entry barrier will harm not only the labor market for nurses, but also all the other labor markets, such as the markets for doctors and hospital administrators, from which the new hospital would have drawn, and the product market for medical services because there are fewer consumer choices. In summary, in addition to employees subject to the noncompete, a non-compete can harm the labor markets from which the employer draws, and the product market in which the employer operates.
Empirical studies have highlighted the harmful effects of noncompetes in the aggregate on competition and entrepreneurial activities. Enforcing noncompetes reduces the formation of “spinout” firms, which are new firms founded by employees leaving their previous employer. A one standard deviation increases in state law enforceability of noncompetes leads to a 28.7% decrease in new spinout firm formation. Venture capital is more effective at generating firms and jobs in states without noncompete enforcement than states that enforce noncompetes.
The prevalence of noncompetes and the labor markets being highly concentrated exacerbate the anticompetitive effects caused by noncompetes, creating a vicious cycle. If a labor market is competitive and many employers exist, the employers are more likely to free ride on each other rather than to pay the wage premiums for employees to sign noncompetes. However, most labor markets are highly concentrated. One study found that 60% of labor markets have a Herfindahl-Hirschman Index (HHI) exceeding 2,500, a threshold considered “highly concentrated” by the Justice Department and FTC. If employers use noncompetes infrequently, their adverse effect of deterring entry and causing market concentration might only be seen in the long term. Noncompetes are common, however. Approximately one in five American workers, which amounts to approximately 30 million people, are restricted by non-compete clauses. As a result, non-competes in aggregate are harmful to labor markets.
Using the Sherman Act to Challenge Noncompetes
As agreements in restraint of trade, noncompetes fall within the ambit of the Sherman Act. But, lawsuits challenging noncompetes under antitrust law are almost nonexistent. In earlier cases, courts dismissed plaintiffs’ challenges because they found that noncompetes involved de minimis effects on competitions and did not harm the public interest, as shown by the plaintiffs’ failure to show non-competes effects on the market. See e.g., Bradford v. New York Times, 501 F.2d 51 (2d Cir. 1974). Courts also evaluated noncompetes under the deferential rule of reason standard rather than the per se illegal or quick look standard. Under the rule of reason standard, a plaintiff cannot prevail unless she can prove that the defendant has market power, that is, the power to force the employee to do something that she would not do in a competitive market; and that the noncompete measurably reduces competition. See United States v. Topco Associates, 405 U.S. 596 (1972). Proving that a single noncompete can harm an entire labor market is difficult. Given that such challenges usually involve a single plaintiff defending against the enforcement of one non-compete, the effect of the noncompete on wages and the employee’s mobility in the labor market is likely to be lost in statistical noise. Moreover, while various versions of the rule of reason require considerations of the agreements’ potential impact on the public interest, most courts do not engage in this inquiry, and the process for making such factual determinations remains unclear. As a result, a restraint deemed reasonable in scope typically will not be invalidated due to public interest alone.
Scholars have long critiqued the application of the rule of reason to noncompetes. In the late 1970s, Prof. Charles Sullivan published “Revisiting the ‘Neglected Stepchild’: Antitrust Treatment of Postemployment Restraints of Trade,” where he argued that otherwise “reasonable” noncompetes could violate Section 1 of the Sherman Act. To remedy this problem, he asserted, “courts should look to the general use of noncompetes in the industry to determine whether the collective effect of such practices is to lock-in classes of key employees so as to create a general barrier to competition.” In reaching this conclusion, Sullivan made two factual assumptions: first, that the prevalence of non-competes is much broader than could be surmised from reported caselaw; and second, that as a consequence, non-competes were likely to have broader effects in aggregate beyond what courts would typically discern when examining the specific circumstances of individual cases.
The new empirical literature on noncompetes supports both assumptions and has revealed non-competes’ pernicious effects on labor markets. Antitrust law applies equally to labor markets as to markets for other services and products. The Supreme Court has made clear that antitrust law does “not confine its protection to consumers, or to purchasers, or to competitors, or to sellers” but that the law is instead “comprehensive in its terms and coverage, protecting all who are made victims of the forbidden practices by whomever they may be perpetrated.” See Mandeville Island Farms v. American Crystal Sugar, 334 U.S. 219 (1948). The antitrust regime should incorporate these findings and treat noncompetes as presumptively anticompetitive. Under this approach, courts will not demand proof of market power, and an employee subject to a noncompete would nearly always have a prima facie Section 1 claim. The burden will shift to the employer to rebut the presumption. Suppose the common law standard is imported into the antitrust law. In that case, the plaintiff will only have a prima facie claim when a noncompete is excessive under the common law, and the employer will have the burden of providing a business justification.
The Takeaways
There are limited situations where noncompetes are used to protect legitimate business interest. No one would buy a business, for instance, unless the seller agrees to refrain from competing with the business from the relevant market for a limited period. Most noncompetes are not designed to protect legitimate business interest, however (e.g., an employer requiring a noncompete from every employee). In the latter category, emerging evidence suggests that noncompetes create barriers to competition. Treating noncompetes as presumptively illegal under the Sherman Act will allow the courts to hold employers accountable under antitrust laws if noncompetes undermine market competition.
Edward T. Kang is the managing member of Kang Haggerty. He devotes the majority of his practice to business litigation and other litigation involving business entities. Contact him at ekang@kanghaggerty.com.
Reprinted with permission from the May 17, 2024 edition of “The Legal Intelligencer” © 2024 ALM Media Properties, LLC. All rights reserved. Further duplication without permission is prohibited, contact 877-257-3382 or reprints@alm.com.