FTC’s Non-Compete Agreement Ban Collides with the Fall of Chevron Deference

Well, while you were buying burgers and brats getting ready for your 4th of July barbeque, the rubber may have met the road for the Federal Trade Commission's (FTC) ban on non-compete agreements. The FTC recently made waves with its announcement of a new rule banning non-compete clauses across all industries. This rule, if implemented, could have significant implications for private equity firms, which often rely on non-competes to protect the value of their acquisitions, and venture capital firms, whose technology portfolio companies are heavy users of non-competes with management and other key employees. However, a July 3rd court ruling has put the implementation of this rule on notice (though not nationally on hold), bringing the immediate effect of the fall of Chevron Deference into sharp focus.

The FTC’s Announcement

On April 4, 2024, the FTC announced a groundbreaking rule (FTC Announces Rule Banning Non-Competes) that would prohibit non-compete clauses, citing that such clauses unfairly limit workers' ability to seek better employment opportunities and suppress wages. The rule voided all non-competes for non-management employees, left existing non-competes in place for senior management, but banned all non-competes going forward. In making the rule, the FTC relied on its authority under Section 5 of the Federal Trade Commission Act (FTC Act), which prohibits unfair methods of competition, as the legal basis for this regulation. The FTC, as a regulatory expert, decided that non-competes were ‘unfair competition’ and banned them.

Non-Competes in Private Equity

Private equity firms frequently use non-compete clauses when acquiring businesses to ensure that sellers (or key employees) do not immediately set up a competing business and diminish the value of the acquisition. These clauses are viewed as essential for protecting the investment and ensuring that key relationships and proprietary knowledge do not leave the company shortly after the sale. Venture capital firms would be impacted as well; technology start-ups typically require non-compete agreements for management and other key positions at the firm.

Non-compete agreements are crucial in several scenarios:

• Protecting Acquired Assets: When acquiring a business, the PE firm invests heavily in the company’s existing customer base, proprietary knowledge, and key relationships. Without non-competes, sellers could set up shop across the street, leveraging their knowledge and relationships to siphon off clients and employees.
• Safeguarding Intellectual Property: Especially in technology and healthcare sectors, non-competes prevent the dissemination of critical IP to direct competitors.
• Ensuring Management Continuity: Non-competes can secure the commitment of key management personnel, ensuring they don’t leave to join or start a competing business immediately after the acquisition.

FTC Overreach?

In interpreting its statutory mandate to protect against ‘unfair competition’ to include non-compete agreements, the FTC was relying on Chevron Deference. ‘Chevron Deference’ is a legal principle from the 1984 Supreme Court case Chevron U.S.A., Inc. v. Natural Resources Defense Council, Inc., which compels courts to defer to a federal agency's interpretation of ambiguous statutory language within its own regulations. This doctrine has historically provided agencies like the FTC with significant leeway in implementing and enforcing rules.

However, the recent Supreme Court ruling in 2024 significantly curtailed Chevron Deference (or some would say, put the final nail in the coffin of the concept which had increasingly been reigned in by Supreme Court rulings), emphasizing that courts should not automatically defer to agency interpretations, particularly when the agency’s authority is not explicitly clear in the legislation. This shift has profound implications for the FTC’s non-compete rule.

Why the FTC’s Rule May Fall Outside Its Statutory Authority

Not surprisingly, the FTC’s decision is being challenged. Last week, Texas Judge Brown issued a preliminary injunction on the ban until the case is heard on August 30th (Federal Judge Blocks Non-Compete Ban) . While the injunction only pertains to the litigants (and is not nationwide), the court found that the FTC lacked statutory authority to issue the ban. While yet to be fully litigated, given the fall of Chevron Deference, here’s why the ban is unlikely to pass muster (as my profile attests, I'm not a lawyer. Tell me what I'm missing...):

• Ambiguity in Authority: The FTC’s reliance on Section 5 of the FTC Act to implement a sweeping ban on non-competes may not withstand scrutiny. Section 5’s broad language regarding "unfair methods of competition" does not explicitly grant the FTC the authority to ban non-compete clauses universally.
• Legislative Intent: The Court may question whether Congress intended for the FTC to have such expansive power without clear, specific legislation. The absence of explicit statutory language authorizing a nationwide ban on non-competes weakens the FTC’s position.
• Major Questions Doctrine: The Supreme Court’s recent rulings emphasize the "major questions doctrine," which requires clear congressional authorization for agencies to make decisions of vast economic and political significance. A universal ban on non-competes likely qualifies as such a decision, necessitating explicit legislative approval.

Implications for Private Equity

The intersection of the FTC's rule and the judicial pushback against Chevron Deference presents a critical moment for private equity:

• Uncertainty in Deal Structuring: Private equity firms must navigate a period of uncertainty as the legality of non-compete clauses hangs in the balance. This uncertainty complicates the structuring of acquisitions and the valuation of potential deals.
• Risk Management: Without the assurance of enforceable non-compete clauses, private equity firms need to explore alternative mechanisms to protect their investments. This might include more robust earn-outs, retention bonuses, or other contractual protections. Obviously, these tools are already in use, but non-competes prove most effective when a key seller isn’t going along with the acquisition. In such cases, if more of the payout is based on an earnout (and thus provides the seller incentive not to compete with the business), the seller receiving less cash upfront would seem to be the most injured party.
• Value to Employees: The value of a business transaction might shift more toward employees rather than equity holders. Non-competes increased the cost of leaving, so without them, more value will need to be put into retention tools, such as equity or retention bonuses, to keep employees from jumping ship.
• Legal Precedents: The fall of Chevron Deference means that federal agencies may face greater challenges in implementing broad regulations without explicit congressional authorization. This could reshape how private equity firms approach compliance and regulatory risk in the future.

Moving Forward: Alternative Strategies

As the legal battles unfold, private equity firms should proactively consider alternative strategies to mitigate the risks traditionally managed by non-compete clauses:

• Enhanced Due Diligence: Conduct thorough due diligence to identify and evaluate the risks associated with key personnel potentially leaving the company post-acquisition.
• Retention Incentives: Implement robust retention programs, including bonuses and equity incentives, to keep critical employees and prevent them from joining competitors.
• Non-Solicitation Agreements: While non-competes are under scrutiny, non-solicitation agreements may still offer a viable way to protect customer and employee relationships.
• Non-Disclosure Agreements: Continue to enforce NDAs to protect proprietary information and trade secrets, ensuring that sensitive information remains confidential even if employees leave.

Conclusion

The evolving legal landscape, marked by the FTC’s non-compete ban and the diminishing Chevron Deference, underscores the need for private equity firms to be aware of the changing regulatory landscape adapt and innovate in both due-diligence and acquistion structuring. While the court's ruling offers a temporary reprieve and may indicate the rule will not stand, the FTC's scrutiny may signal a perception that non-competes are unfair or abused, and the increased focus certainly increases the probability specific legislation finds its way into a Congressional bill, formally giving the FTC authority to act.

What do you think about these developments? Share your thoughts and let's discuss the future of deal structuring in the comments below.

Let me Know:

• Do you believe the FTC's non-compete ban will ultimately be upheld or overturned?
• What alternative strategies do you see as most effective for protecting private equity investments?
• How should firms prepare for the potential changes in regulatory oversight?
• Are the FTC's instincts correct, and (if the rule is overturned) should legislation from Congress address the use of non-compete agreements?

#PrivateEquity #NonCompete #Regulation #ChevronDeference #BusinessLaw