Kent J. Schmidt

Transcript

Voiceover

Welcome to another episode of the SharkCast on litigation risks management where we explore why businesses are so frequently sued, and how to mitigate and navigate the dangers lurking in these risky waters. Join us now as we welcome our host Kent Schmidt, Litigation Partner at the law firm of Dorsey & Whitney.

Schmidt

Welcome to another episode of SharkCast. Today we’re gonna tackle a subject that has been around for a long time, but has been in the forefront of discussion over the last couple months, and that is non-compete agreements. A few months ago earlier this year, the Federal Trade Commission in the U.S. issued a new rule relating to non-competes in employment context, as well as other contexts as well, and there’s been a lot of discussion on this topic of course, given the importance of the subject matter and the wide impact that this rule is having. A lot of individuals from the Labor and Employment groups, as well as the Anti-Trust groups, and just commercial litigators are focused on this issue. I can’t think of anyone that is more qualified to address non-competes, at least in my orbit, than Nicholas Pappas, who is a partner in our New York office. So I’ve asked Nick to come on as a guest today. So welcome to SharkCast. Very glad to have you here to discuss non-competes.

Pappas

Thanks, Kent. It’s great to be here. Look forward to a lively discussion today.

Schmidt

Well, one of the reasons I thought you would be an excellent guest to discuss this is because we like this discussion on topics on SharkCast to be very practical, pragmatic, in terms of where the rubber meets the road as I like to say, and you have spent a significant part of your career both litigating non-competes as well as drafting and reviewing provisions and contracts on non-competes. So in other words, on both sides, the transactional precursor work and then after the non-compete becomes very important because it’s being litigated. Can you tell us a little about that experience and how that has been brought to bear in analyzing the FTC rule before we even get into what this rule is and its various nuances and current status?

Pappas

Sure, Kent. I’ve been focused on non-compete agreements since I became a lawyer 37 years ago. My first non-compete case was as a law clerk in the U.S. District Court. And I’ve been focusing on them as a junior lawyer and throughout my career. I practice employment litigation, I’ve been doing it as a litigator mostly in court cases. But because of my work in large law firms over the years I’ve also had to represent usually the employer, although sometimes the executive, in negotiating non-compete agreements. So I’ve really had to dig deep and learn the ins and the outs of how one would both negotiate a non-compete on the front end and then when things break down to then litigate them on the back end.

Schmidt

So with that background I’d like to ask you for general lay of the land, not a 50 state survey. But before the FTC rule comes into effect, and before we get to the FTC rule, we have 50 state variations on non-competes. What is the general majority/minority, I of course know California non-competes, that’s pretty well known as a very strong employee protecting state. But what’s the general lay of the land on a state law basis?

Pappas

So as, I’m usually on the employer side so I’ll tell you how I look at these issues depending on what state I’m in on the employer side. First of all, there are three states, like California, that totally prohibit non-competes. We would throw in the District of Columbia, which also prohibits non-competes. Minnesota last year adopted a statute prohibiting non-competes on a prospective basis. New York almost did. The Legislature passed one prohibiting non-competes, but Governor Hochul vetoed that at the last minute. There’s a whole other tranche of states that while they don’t prohibit non-competes completely, prohibit them for what I would call low-wage workers, or hourly workers with different varying thresholds. So they would allow them for people making certain amounts of money, prohibit them for others. There are other states that have statutes regulating non-competes that require certain notification requirements. And then what I would consider the, sort of the vast majority of all states have what I would call the common law regulation of non-competes. That is they look at things like does the non-compete have a legitimate interest, does the non-compete protect good will or confidential information or trade secrets, is the non-compete narrowly drafted or is it overbroad? And then there are other things like jurisdiction and geographic scope of non-competes. So those are all topics that as an employer-side lawyer I’ll look at and then advise the employer how to draft these things, negotiate these things, or when I’m litigating ways of either attacking the enforceability of non-compete or defending the enforceability of the non-compete.

Schmidt

And as litigators we, as you have indicated, are usually on one side or the other in this, and I as well have been on both sides. But I think it’s important that we acknowledge the legitimate tension that exists, whether it’s a lawmaker or a judge trying to decide whether a particular non-compete is enforceable in a context. There is a balancing between the rights of the employee, the ability to go to a new company and advance their career, and the rights of the employer to protect the information and the competitive advantage that they have rightfully so as they see talent walk out the door, and different courts approach it different ways. You’ve been on both sides of this. What are your thoughts on that, that tension and the balance?

Pappas

Yeah. So as I said, I represent the employer, but I might be the employer on the hiring side where I’m hiring somebody from an employer where there’s a non-compete, or I might be on the side where my employee left and I’m defending. So you’re right, on that score I’m always representing the employer, but I could be on either side of the battle. Maybe aligned with the executive or not aligned with the executive. And you’re right, and you identified a public policy that the employee will usually point to, which is the free flow of labor. Right? And the ability in the United States for everybody to maximize their economic potential and their talents and to support their families and you see that all throughout the case law. Courts do want to promote the free flow of labor and for people to feed their families. But at the same time the employer, on the employer side, the courts do recognize a legitimate interest in protecting trade secrets, confidential information, the goodwill of the business. And so inevitably there’s a balance between the two sides and the two interests. And there’s, as I said, in the vast majority of states this is a common law thing and you can look at the case law to see where a particular fact pattern may fall in the balance. In some states this has been affected by statutes. You’re absolutely right, that’s, there’s always gonna be a balancing that has to be done, even in the common law jurisdictions.

Schmidt

So as you have summarized, we have 50 state schemes of either a decisional law or statutory or regulations that govern this. And then earlier this year along comes the FTC and says we’d like to weigh in on this. And would you summarize in brief detail what the FTC has done on the non-competes, and then we’ll break it down and go into the details?

Pappas

Yeah. So this saga actually started January of last year, 2023. The FTC published a proposed rule, which is largely the same as the final rule but with some important changes. And when the FTC published the initial rule it invited comments from the public. And the FTC received I think over 19,000 comments, some more substantive than others, and took a while upon receiving those comments to digest those comments, to respond to those comments. And as you mentioned, Kent, on April 23, the FTC published its final rule with about 570 pages of commentary. And then the 570 pages was the FTC’s effort to explain how it viewed the commentary and how it would respond to the commentary, and it made some important changes to the initial rule that it proposed. So you know, what we could talk about today, I could talk about the timing of when this final rule will go into effect. It’s not yet in effect. There are a number of exceptions that the FTC adopted. There are some lawsuits out there on the final rule. And then finally there’s things we could talk about today about how employers should prepare for what’s coming next, and that’s a big question mark for a lot of clients that we advise.

Schmidt

So let me ask you a question right off the bat here on the FTC’s rule. First of all, why wasn’t this left to Congress, and maybe a subpart of that is have there been prior efforts in Congress to just pass a provision in the United States Code rather than doing this through this regulatory process? And I’m sorry, my questions getting more and more compound the longer it goes.

Pappas

Yeah, I object, counsel. I object to [UNINTELLIGIBLE] questions. But I will try to take them one at a time.

Schmidt

Since we’re not in a deposition. You know, I’m just curious, if the FTC is essentially done here what Congress would not have the appetite to do given the prevailing political wind.

Pappas

You’re absolutely right. There have been multiple bills over the last several years, even before the Biden administration, but even after the Biden administration there’ve been several bills, some bi-partisan by the way.

Schmidt

Well that’s refreshing. I wasn’t aware there’s any bi-partisan activity in Congress. But…

Pappas

Yeah, bi-partisan meaning you sometimes will see one or two members from each side peeling off. It’s not bi-partisan in the sense of being overwhelming, as much that we can get through the Senate. I mean, that’s really the bottleneck here, right? You’ve gotta get over 60 Senators to agree to anything these days, and even then getting it through the House is a challenge. But at the end of the day, Kent, there are bills doing what the FTC rule does, which is being a total prohibition. There are bills that are out there doing what I mentioned earlier, which is to prohibit non-competes for low-wage workers, and then there are other bills out there with different permutations of those two things. So you see a lot of activity, but nothing’s getting through Congress. I think that’s a fair read, which is probably why the FTC decided it would take action. And the FTC has been studying this issue, even going to the last administration, it had invited scholars to comment, it held hearings on the subject, and then as I said in January published this proposed rule. But the FTC’s jurisdiction is itself the ground for why it took this action. So the Section 5 of the Federal Trade Commission Act allows the FTC to ban unfair methods of competition and to regulate what it considers unfair methods of competition. So in effect what this new rule does is it takes the position that non-competes are in fact always an unfair method of competition. That’s the matter of great controversy and debate and we’ll get to the litigation in a moment, but that’s actually the subject of what the litigation is about these days.

Schmidt

So the FTC at least has something to tether the rule to in terms of their mandate of operation and of promulgating rules like this. It is a little troublesome that the rule came as a result of congressional gridlock. So that I’m sure has given a lot of fodder and support to the challenges of the FTC rule in the courts. Without going into too much detail on all the nuances of the challenge, what are kind of the major crust of the arguments being made by those that are challenging the rule?

Pappas

You know, I think I would summarize them in several buckets. There’s something called the major questions doctrine, that doctrine being that something that affects vast portions of the economy can be regulated but we need clear and specific authorization from Congress. And the argument there is the Section 5 of the FTC Act, which I just described, would be not sufficiently clear under the major questions doc, and at least that’s the argument that the litigants in this case, mostly the Chamber of Commerce, but others as well are making in three different courts right now; the Eastern District of Texas, the Northern District of Texas, and the Eastern District of Pennsylvania. Another argument is that, as I mentioned, the FTC Act applies to unfair methods of competition. There’s a large group of litigants, mostly for example the National Retail Federation, has argued that non-competes are not in fact unfair. They’re in fact quite fair and they argue the FTC simply didn’t consider and arbitrarily gave back of the hand to evidence that non-competes are in fact very procompetitive and not unfair methods of competition. There’s an argument that the statute was never intended to allow the FTC to engage in this broad kind of rulemaking authority. And that even if the FTC did have authorization and it didn’t violate the major questions doctrine that this delegation of rulemaking authority is unconstitutional because it in fact is an administrative agency performing the function of a legislature, and that would be unconstitutional according to this argument. And finally there’s an argument that the FTC rule, if it’s adopted, would nullify the law in 47 states and overturn 30 million contracts, and that that’s improperly retroactive. And if there’s any way for the FTC to do this it could only be prospective. So that’s in a very broad brush what the litigation is going to be about and what the courts will rule upon. And we have one court that has said it’s going to rule on July 3. So the mystery will be resolved by July 3, one way or the other.

Schmidt

So notwithstanding the fact that the entire rule is in jeopardy and there could be some modifications of it in order to comply with any of these orders that come down in the litigation, what are some of the highlights of the rule relative to companies that companies should be aware of if they’re gonna comply at least with the rule out of an abundance of caution?

Pappas

Yes, so let’s define what is in the words of the rule. Let me read it. It may get a little, I’ll read slowly because the definition of what is a non-compete provision is critical. Right? So here’s what it says. And the final rule broadly says that every term or condition of employment that prohibits a worker from or penalizes a worker for, or functions to prevent a worker from seeking or accepting work in the United States with a different person where such work would begin after the conclusion of the employment, that includes the term or condition, or operating a business in the United States after the conclusion of the employment, that includes the term or condition. So in a nutshell, it’s a broad prohibition of all non-compete provisions, which either penalize or function to limit somebody’s work opportunities after leaving employment. And I wanna focus on the word worker. It’s not employees; it’s workers. So if you’re are a worker, that would include employees, independent contractors, externs, interns, volunteers, apprentices, or sole proprietors, who provide a service to a person. So that’s an enormously and breathtakingly broad rule and a very broad prohibition. So this FTC rule is broad. And so you mentioned well, what should an employer do and how should they comply? We could probably talk about the exceptions if you like, because that’s something if you wanna comply you need to focus on very carefully as the employer.

Schmidt

In many senses the FTC rule is broader than California, which before this point in time I didn’t really think was possible ‘cause I thought California’s was about as broad as could possibly be. One unique aspect of the California statute that was recently enacted is essentially putting some teeth in it so that there’s actually penalties for having such a provision. I think the logic behind it is companies will continue to use non-enforceable non-competes, and if 20 or 30% of the employees are not wise enough to know that it’s unenforceable it still has a benefit to the company. So why not just keep an unenforceable non-compete in the employment contract? And the disincentive for that now is a penalty. Isn’t there the same type of provision in the federal rule?

Pappas

The enforcement mechanisms for the rule are probably not as strong as California, but it’s complicated and undoubtedly this will be one of the many areas for litigation. So first of all there is no private right of action for an individual to enforce the FTC rule, not under the FTC Act. But the FTC itself has enforcement authority to seek injunctive relief to prevent unfair methods of competition. Further if the FTC does that and there is an injunction, the FTC also can then seek a penalty of up to $50,120 per day for violating an injunction. So I’m not an FTC expert. Our anti-trust partners will probably correct me on all of this but, so we’re really talking about government enforcement. Something that’s not been really focused on, and I haven’t seen much in the literature thus far, is even if something is unlawful under federal law, are there state statutory provisions that would allow a, you know, an individual to bring a cause of action under state law to enforce the federal prohibition, and I believe there are state unfair trade practice laws that would allow, for example, I think California being a classic example, has unfair trade practice laws that might allow that. So those laws do have damage provisions, penalty provisions, attorney fee shifting provisions that might come into play in this circumstance. So it’s complicated, but suffice it to say this would potentially expose employers simply for having unlawful agreements in place to the possibility of penalties. Now having said all that, the FTC rule doesn’t nullify, directly, existing non-competes, but says they’re unenforceable. So that may be a semantic debate ‘cause there was, the earlier iteration of the rule actually required withdrawal and nullification non-competes but the current rule, as it’s presently situated, simply requires notice from the employer that the employer will not enforce existing non-competes.

Schmidt

Can you talk for a moment about, if the FTC rule or some variation goes into effect, how that interplays with state rules in terms of the FTC being a floor or a ceiling. Is the scenario that, going forward, employers have to comply with both the FTC rule and whatever the applicable state law is and whatever the higher standard is, is what you have to comply with?

Pappas

I would answer with a yes or no. Right? So some states, for example Florida is a classic example, has a statute authorizing and promoting non-competes. I would say that statute is preempted by the proposed federal regulation. On the other hand there are states like California that may be more protective of free flow labor. It’s both Kent, but I think that the largest effect of the FTC rule is to nullify most state rules, but there is a possibility for greater rights if it’s not inconsistent with FTC rule.

Schmidt

So the takeaway for me on all of this, is you really cannot be relying on the concept of non-competes with very, very limited exceptions such as senior executives and so forth, and even then probably narrowly construed. Nick you’ve talked earlier about some of the exceptions to the FTC rule. Can you go over some of the major exceptions and a few of the nuances in the rule?

Pappas

Sure. So the first exception applies to “senior executives”, and the rule defines senior executive very narrowly, so while there is such an exception, and so non-competes will be permitted for senior executives, even under the rule. That exception is really narrow. I mean they think the FTC estimated it would apply to may be 1% of all workers. And a senior executive is someone who is both in a policy making position, so for example like a CEO or a president, but also has policy making authority, meaning final authority to make policy decisions that control significant aspects of a business entity or a common enterprise, so very important point. If you are a CEO of a division that may not be a senior executive under this definition. It’s the entire enterprise that needs…

Schmidt

Even if the division operates as a separate entity? Has a separate, you know, subsidiary entity.

Pappas

I think that’ll be an issue for litigation to be honest with you. I think it’s unclear under the rule to be honest, but I think the FTC intended this to be a very narrow exception to the carve-out. There’s an exception for sales of business. So let’s say you’re an owner of equity, and you sell your business. Even under the FTC rule you would be permitted to have a non-compete there to protect the goodwill of the business. However, the FTC says it’s got to be a bonafide sale of business, very important. And what does that mean? If I own 0.1% of the equity and I sell that 0.1%, am I, is it legitimate or is it not legitimate under the rule? I mean we had the California example where, which has a similar rule for good faith or non-sham transactions, but if it’s a sham transaction, it would not be permitted under the sale of business exception. So another important factor, the FTC actually broadened this exception. Its initial rule required 25% ownership of equity in order for the sale of business exception to apply. It took away that 25% rule so now it just has to be a bonafide sale of business. So if I sell 1% of the business or 2% of the business, can I have a non-compete then? I would argue that it has to be good faith and bonafide and if it is it should work. If there’s an existing litigation out there the FTC rule doesn’t apply so those cases remain in play. And very importantly, the FTC doesn’t have jurisdiction over the entire economy so for example not for profits are not covered by the FTC rule, and similarly there’s large exceptions for banks and airlines. So I don’t know the full extent of the bank prohibition. It’s interesting that the FTC will commentary did say that it thought its rule would apply to broker dealers and investment advisors, so the bank exception may not be so broad but there is some question about how broad the FTC’s jurisdiction is which is something again that will be an area for further litigation and further work by lawyers. So I think that’s in broad brush, Kent, those are the exceptions to the rule that are in place.

Schmidt

Does the FTC rule get into the question of duration, or geographic scope, or similarity of business? I know a lot of states that allow non-competes require to be reasonable in scope with those type of factors.

Pappas

So you’re talking about if the FTC rule allows a non-compete for a senior

Schmidt

Right. For executives for example.

Pappas

Then does the rule govern, I don’t think the rule gets into that. I think the rule’s focus has mostly been on the nullification piece, the nullifying of non-competes, but of course you still have the FTC general rule that you can’t be, have an unfair method of competion. So I suppose under that broad standard, perhaps there’s, you get to the same place. Where you gotta have a legitimate interest, and limited duration, and limited geographic scope, which is of course the case under state law as well.

Schmidt

Okay. Let’s, now for the sake of our discussion assume that notwithstanding the court challenges this FTC rule and non-competes is going to be enforced or subject to some perhaps limitations and variations will be enforced. What’s an employer to do? They have, as we said earlier, legitimate interest in protecting their business plans, their trade secrets, their proprietary information and having senior executives or even mid-level individuals that the company walk out the door and go work for a company with all that knowledge up in their head, even if they’re not stealing data and taking a thumb drive with them, there’s reason for heartburn. What are employers to do to protect their interests?

Pappas

So first of all, focus on the effective date. If the rule is not adjoined by, in one of these litigations, which my strong suspicion is there will be an injunction before the rule comes into effect, but if the rule comes into effect it’ll come into effect on September 4, 2024. That’s the actual effective date. And with thinking about what happens on September 4th employers should, before that date, audit themselves to do a couple of things. Number one, categorize and identify where non-competes are, what employees have non-competes. For example, do you have a sales force with direct non-competes? Do you have executives with equity arrangements that have non-competes built into them? Do you have non-disclosure agreements? The second thing you should do is figure out how, as an employer, you want to protect your sensitive most sensitive information. I said NDAs or confidentiality agreements might be prohibited but they’re generally okay. Right? I mean generally having an NDA out there and a confidentiality agreement doesn’t prohibit somebody from working for a competitor. So focus on how to protect your confidential information, strengthen your confidentiality agreements, prevent dissemination of confidential information beyond where they need to be disseminated. So impose what I call good housekeeping, have good passwords, have multiple authentication levels, keep secrets secret, label things appropriately. There’s all kinds of things employers can do short of having a non-compete agreement to protect confidential information. Protecting customer good will and workforce stability. There’s a lot of things employers can do to promote customer good will and workforce stability. I mean, for example, increase wages. That would be the California rationale. Right? Why California for a 100 years has had these prohibitions out there. Californian employment lawyers would argue to me all the time how great the rule is and that’s good for workers. The workers will make more money. The FTC pointed to that as a rationale for the rule. The workers should make more money and they would without these non-compete restrictions. So there’s all kinds of things employers can think about. I don’t think there’s going to be a one size fits all solution here, but certainly something worth analyzing and thinking about with your employment lawyer well in advance.

Schmidt

Well I think that’s about all the time we have today to discuss non-competes today. This is an interesting, as they say on the local news, developing story, so we’ll be checking back routinely on this as we see the litigation unfold and some of the details of the rule perhaps refined in its finally iteration or maybe go into effect in its current form but obviously an area for companies to be focused on in the coming months. Thanks so much for all your insights on this Nick. At this point in our show we like to do what we call the deeper dive and learn a little bit more about our guest and some aspects of their life that’s not necessarily related to the law and Nick I’d like to ask you a little bit about your ethnic heritage as your name suggests your ancestors being from Greece, and I know that Greece is a common destination for you. Can you tell us what it’s like to go back to Greece on occasion and visit some of your family there?

Pappas

Sure. We, my wife and I love Greece. It’s, as you said Kent, both my parents were born in Greece and we’ve gone many, many times. I was there a year ago. Visited Crete for the first time. Love the islands a lot. We’re planning a trip in September going to Mykonos for I think my third time, my wife’s fifth time. We just love the Greek Islands. We love the food. The Mediterranean diet is our type of diet. You know, fish and salads and fruits, you know and great wines if you are a wine person. So thanks for that question. In terms of family, you know when I get together with family in Greece, there’s about 30 or 40 people that gather. The last time we did that was under the Acropolis, you know, at a rooftop restaurant which was wonderful. Lots of cousins, you know, nieces, nephews, the whole family. It’s like a family reunion when we go back. We often consider should we simply not tell anybody that we’re going to go back to Greece so as to have a quiet and private vacation, but that doesn’t seem to ever work. We always, the word gets out and the family convenes so it’s always a fun time.

Schmidt

Well I’m sure that most your family is also listening to SharkCast so the word will get out in that way as well.

Pappas

Exactly.

Schmidt

But let me ask you a couple questions about Greek culture. I’ve been a number of countries in Europe but Greek is on my list of countries to get to. What are some of the things you appreciate most about lifestyle of your counterparts in Greece? Whether your family or friends and how that compares to our lifestyle here in the US and maybe even some takeaways that we might be able to learn from and adapting our lifestyle to a little more of a Greek lifestyle.

Pappas

Well I would say it’s a more, it’s a slower lifestyle. The sunshine, I think, makes people healthier and I’m not going to make any judgments, obviously my family has chosen to be in the United States which I, we love America, have always loved America. As a good immigrant, my father and mother taught me that this is the greatest country in the world even though they’re from Greece, and I do agree with that. The opportunities here are a blessing to all of us. The rule of law here is a blessing to all of us. As a lawyer, I can say that. I very much appreciate our system here. That’s not to say I don’t love Greece. I do love Greece. I love the people. I think there’s a definite culture there and you feel it and you see it, and people are kind, and generous, and gentle, and love to laugh. And they love to dance. They love to joke. It’s a wonderful experience. If you get to go Kent, I recommend it strongly. It’s a great place to visit.

Schmidt

Well I think that’s a takeaway from visiting lots of places in Europe. There’s so many ways that they relish life, enjoy life, slow down. I mean try and get ahold of someone in Europe in the month of August. Good Luck. They take time off. They enjoy family and there’s some good lessons to all of us who are working really hard and spending long hours burning the candle at both ends to not forget to slow down and enjoy some of those wonderful things in life. So I hope you enjoy your upcoming visit to Greece and when I have it on my itinerary, I’ll know who to reach out to.

Pappas

Absolutely and thank you for that. I enjoyed the SharkCast very much and thank you for the opportunity.

Schmidt

With that I’d like to thank you for being here and thank our listeners for tuning in. As always I’m indebted to the extraordinary team at Dorsey for making this podcast and episode possible. For more resources on this and other litigation risk go to litigationrisks.com where more information can be found including a book on managing litigation risk written by yours truly. Until next time my friends this is yet another reminder that there are a lot of sharks swimming out there in the murky waters so swim safely.

Voiceover

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