Eric Posner | Why non-compete clauses should be banned

Last week, the US Federal Trade Commission, FTC, issued a rule banning provisions in employment contracts that forbid employees to work for a competitor after they quit or are fired. Within hours, a Texas firm sued to block the rule, and the following day, the US Chamber of Commerce, a business lobby, sued as well.

But the FTC’s rule is based on a mountain of empirical evidence showing that non-compete clauses harm workers, consumers, innovation, and employee mobility. Moreover, they are already regulated in most states, and banned in a few – including California, home of Silicon Valley, the single most innovative place in the world.

Businesses argue that they need non-compete clauses to prevent employees from stealing proprietary information. Suppose a distributor has compiled a list of customers after years of outreach. An employee may be tempted to take the list to another firm and, for a higher wage, use it to poach customers from their previous employer.

Businesses also argue that non-compete clauses protect investments in training. Suppose a firm teaches new employees how to use accounting software. If the employees can immediately move to another firm, they can obtain a higher wage because they require no training at the firm that hires them.

But neither theory actually justifies enforcement of non-competes. Strict laws protect firms’ trade secrets without preventing people from switching jobs when they need to. An Uber executive who had worked at Google was sent to jail for using Google trade secrets to benefit his new employer. And natural labour-market frictions prevent employers from losing investments in training. It is costly and inconvenient for most employees to switch jobs, and firms can require employees to agree to pay back the cost of training if they leave the job before the firm has recovered its investment.

Even if non-competes can be justified in rare cases involving special circumstances, they cause significant hardship for workers. Suppose a New York City doctor with a non-compete wants to switch to another employer, because working conditions have been degraded, wages have stagnated, he was passed over for promotion, or the hospital chose to emphasise medical services that he believes are immoral or unwise. If subject to a non-compete clause, he must either take a vacation or work as a barista for a year or two while waiting for the restriction to expire; or he must uproot his family and move to a city or state that is beyond the geographic boundaries of the non-compete. Most people are unable to do these things.

A common response is that the doctor freely agreed to the non-compete, may have been paid a higher wage because of it, and thus should not complain now that things worked out badly. But many employees do not even know that they are subject to a non-compete; and among those who ‘voluntarily’ agree to it as a condition of being hired, few may understand what it means, or realise that it may be illegal.

After all, non-compete clauses are often boilerplate in long employment contracts, or they are presented to employees only after they join a firm and have lost their power to negotiate. Many non-competes are written vaguely and broadly, with some prohibiting not only post-employment competition but even the act of looking for a job with a competitor during that period.

Moreover, non-competes interfere with labour markets. Job mobility is essential to the economy’s health. Workers need to be able to move to wherever they are most productive, and to be able to change jobs in response to changing economic conditions.

When a worker is bound by a non-compete clause, even if she is well paid for agreeing to it, she will be unable to work for a competing employer who values her work more. Many new firms will not be able to enter the market because they cannot find employees who are free to move to a new job. The forgone labour productivity results in higher prices, harming consumers.

Neither of these problems would loom large if non-competes were used responsibly. But they are not. Because firms, under existing law, pay no penalty for using overly broad non-competes, they have imposed them on employees with alacrity. One survey of workers in 2017 found that 18 per cent – implying tens of millions of people across the United States economy – were bound by these provisions. Another estimated that the figure could be as high as 46.5 per cent. Millions of low-wage workers performing low-skill tasks are subject to the same restrictions.

And those restrictions harm workers by reducing not only their employment opportunities, but also their wages. One study, for example, shows that when Hawaii banned non-competes for tech workers in 2015, their wages increased relative to those of other workers in Hawaii and to tech workers in other states. Moreover, the ban also promoted business formation.

Another study of all US private sector workers shows that wages are higher in states that ban or strictly limit non-compete clauses than in those that impose weaker limits on them. A study of a ban on non-compete clauses for low-wage workers in Oregon showed that it increased both wages and mobility.

Some studies come to more mixed conclusions. For example, a 2020 study finds that non-compete provisions are associated with higher earnings for physicians; but the provisions are also known to cause higher prices for medical services. Another study shows that non-competes increase wages for highly compensated executives, but cause broader social harm by preventing more productive firms from hiring them away.

The FTC’s 570-page commentary on its ban discusses these and other studies with great care, far exceeding the evidentiary threshold that courts require for approving new regulations.

Business interests thus have argued that the FTC lacks the statutory authority to issue such a rule, regardless of its benefits. While that contention has been rejected by courts in the past, the ban’s challengers brought their case in the notoriously conservative Fifth Circuit, and the conservative majority on the Supreme Court has already signalled its own distrust of broad agency regulations.

Still, there is reason for optimism. With growing awareness of abuse in labour markets, and given the FTC’s careful marshalling of the evidence, the courts may well wave this one through.

Eric Posner, a professor at the University of Chicago Law School, is the author of How Antitrust Failed Workers.© Project Syndicate 2024www.project-syndicate.org