Scrutiny of Employee Covenants Not to Compete Under the Rule of Reason: An Empirical Inquiry

Authors

Daniel A. Crane, University of Michigan Law School

Document Type

Essay

Abstract

For over 300 years, the common law has scrutinized employee covenants not to compete for their reasonableness. That is about to change. On April 23, 2024, the Federal Trade Commission announced a rule that will prohibit employers from imposing noncompete agreements on workers. The rule declares all covenants not to compete in the employment context to be unfair methods of competition under section 5 of the FTC Act. If the rule takes effect, thirty million contracts will become illegal. The FTC justifies this rule based on the ostensibly pernicious effects of employee covenants not to compete—limiting employee opportunities to pursue new job opportunities, inhibiting growing companies from hiring new employees, reducing employee wages, and depriving consumers of the benefits of labor market competition. Critics of the rule dispute these empirical claims, argue that a flat prohibition on employee noncompetes would wipe away many efficient agreements, and contend that the FTC lacks authority to enact such a rule. They also contend that antitrust’s rule of per se illegality is typically reserved for restraints that almost invariably harm competition and lack redeeming virtues, and that covenants not to compete do not have that profile.

Buried in the controversy over the FTC’s noncompete rule is the question of how employee covenants not to compete (ECNCs) are currently treated in state courts. The FTC notes that three states—California, North Dakota, and Oklahoma—categorically prohibit ECNCs for most or all employees, and that some of the remaining forty-seven states restrict their enforcement in some circumstances (i.e., based on a worker’s earnings, for certain occupations, or when the employee is not given adequate notice). Outside of those statutory restrictions, the forty-seven states adjudge ECNCs under the common law’s longstanding rule of reason, which asks if the restraint is greater than necessary to protect the employer’s legitimate interests or if those interests are outweighed by the harm to the employee or the public interest. The Commission notes that there is some variation among the states in how their courts apply the rule of reason, for example, how narrowly or broadly they define an employer’s legitimate interests. The Commission also invokes studies that seek to assess variations among states in the enforceability of ECNCs in order to measure the effects of ECNCs on wages.

But how do these rule-of-reason decisions actually come out? Do most courts uphold the ECNCs, or strike them down? And, to the extent they uphold them, what reasons do they offer for doing so? These questions bear importantly on the justifications for a federal rule categorically banning ECNCs and displacing the historic common law approach. If courts are rubber-stamping ECNCs, then perhaps the rule of reason is little more than a euphemism for approval and federal action is needed to protect employee rights and the public interest in competition. Similarly, if courts are almost always invalidating ECNCs, then that could show that their ostensible justifications are pretextual and that a federal ban will save litigation costs and remove all doubt. On the other hand, if the outcome is more mixed with courts invalidating ECNCs with weak justifications but upholding others where the employer demonstrates reasonableness, that could suggest that there is already effective policing of ECNCs under the common law and that the rule will ban some ECNCs with legitimate efficiency justifications.

This Essay provides some empirical findings bearing on these questions. Based on a hand-coded dataset of 514 state court decisions scrutinizing ECNCs under the rule of reason in the last twenty-five years, I can report the following: state courts have struck down 53%, have pared down 7%, and have upheld 40% of ECNCs after analyzing them substantively for their reasonableness. This suggests that state common law already provides significant protection against overreaching ECNCs, but that, when considered individually, there may be legitimate efficiency justifications for some subset of the ECNCs that will be banned by the rule. To be sure, these findings do not necessarily mean that a total ban on ECNCs is unjustified. The courts may be wrong in justifying the ECNCs that they do, ECNCs may have an in terrorem effect even when a court would not uphold them, or the costs of individualized litigation may exceed the benefits. Nonetheless, the actual practice of the common law courts merits consideration in the litigation over the rule’s enforceability that inevitably broke out when the rule became final.

Recommended Citation

Daniel A. Crane, Scrutiny of Employee Covenants Not to Compete Under the Rule of Reason: An Empirical Inquiry, 100 Notre Dame L. Rev. Reflection 1 (2024).
Available at: https://scholarship.law.nd.edu/ndlr_online/vol100/iss1/1