Noncompete Contract Clauses are Agreed-Upon Voluntarily

Eighteen percent of U.S. workers are bound by noncompete clauses in their employment contracts, according to a story by Dave Michaels and Ryan Tracy on p. A4 of June 9th’s Wall Street Journal. Lina Khan, the anti-Big Tech chairperson of the Federal Trade Commission, says that she wants the FTC to take steps to restrict private businesses’ use of such contractual provisions on the grounds that they “can stifle competition for talent.”

Noncompete clauses certainly have that explicit purpose. In fact, litigation involving contracts limiting employees’ options in seeking and accepting jobs elsewhere (and companies enticing workers away from their current jobs) has a long history under the common law.

Many of the early cases related to apprenticeship contracts. Suppose that, contrary to fact, I am an expert blacksmith and agree to pass my skills on to someone who wants to learn the trade. I agree to do so over a term of seven years, at the end of which my apprentice is fully qualified to open a new blacksmithing shop. Not wanting to train a competitor who will take business away from me, I include in the original apprenticeship agreement a clause prohibiting him or her from doing business within a specific distance of my own shop. Perhaps the contract prohibits my trainee from blacksmithing in the same town or county, specifying the number of months or years the prohibition will run, or both.

My apprentice agrees to that restriction in return for the training I provide but subsequently violates it to take advantage of a location expected to produce more business for him (and less for me). I sue and seek to recover compensation for the contract’s breach. The trial’s outcome hinges on whether the court deems the original restrictive clause to have been reasonable, in which case I win and am owed monetary damages, or unreasonable, in which case I lose.

Disputes involving the reasonableness or unreasonableness of noncompete clauses in employment contracts, considered case-by-case because the special circumstances of time and place obviously matter, predate the antitrust laws by centuries. Because the common law grappled frequently with the competitive effects of alleged “restraints of trade,” some legal scholars conclude that the first antitrust statute ever enacted on the planet, the Sherman Act of 1890, section 1 of which declares “contracts, combinations and conspiracies in restraint of trade to be illegal,” merely codified the common law’s jurisprudential precedents.

That conclusion is erroneous, however. Granting broad law enforcement powers to a federal agency is a far cry from considering factual scenarios on a case-by-case basis. Under the statutory authority of section 5 of the Federal Trade Commission Act (1914) to sanction “unfair methods of competition,” along with its ability to promulgate industry-wide rules ostensibly channeling business practices toward competitive market outcomes, the Commission is poised to abrogate mutually agreed-to noncompete clauses in private contracts.

One of the purposes of noncompete clauses is to prevent employees who gain sensitive firm-specific knowledge in their current jobs from divulging it to a rival in return for promotions, pay raises, or other benefits. Specialized knowledge comes in many forms, not just a business’s intellectual property, which may not be protected formally by patents or copyrights but instead by “trade secrets.” Information about unique production techniques, lists of current customers, methods of determining prices, marketing and advertising strategies, inventory policies, and many other aspects of one company’s business operations is valuable to competitors.

Because noncompete clauses limit employees’ job market options, they would be willing to accept such conditions only if the wages or salaries the employer pays exceed the amounts offered without restriction. The pay premium since Adam Smith has been called a compensating wage differential, which the employer is willing to offer if it is less than the added value the employee brings to the job. Noncompete clauses necessarily benefit both parties to an employment contract; they would not survive in a competitive marketplace otherwise.

The courts can err, of course. After graduating from Colorado State University’s School of Veterinary Medicine in 1988, Dr. Glenna Hopper accepted a part-time (later full-time) position with the All-Pet Animal Clinic in Laramie, Wyoming, which treated small animals. Among other provisions, her employment contract, an agreement that could be terminated by either party upon 30 days’ notice, formalized at year-end 1989, stipulated that “she will not practice small animal medicine for a period of three years from the date of termination within 5 miles of the corporate limits of the City of Laramie.” In the wake of considerable wrangling following news that Dr. Hopper had purchased Laramie’s Gem City Veterinary Clinic, practicing both small and large animal medicine, she was fired by All Pet’s owner after rejecting his demand for a $40,000 payment to buy out the noncompete clause to which she had consented.

The dispute eventually wound its way to Wyoming’s Supreme Court, which ruled in Hopper v. All Pet Animal Clinic, 861 P.2d 531 (Wyo. 1993) that a three-year noncompete clause was unreasonably long but said that one year would have passed muster. The trial record also revealed that 187 of Gem City’s clients had done business with All-Pet, suggesting that Dr. Hopper had “stolen” them to her new clinic. Nevertheless, because one year had elapsed before the matter first went to trial, a Wyoming justice dissenting from the majority’s decision not to enforce the original three-year restriction wrote that Dr. Hopper had “beaten the system.” 

If Ms. Khan has her way and two of her Commission colleagues agree to initiate action that does away with noncompete clauses, employers and employees will be worse off. Employees who would have agreed to such restrictions will see reductions in wage offers; employers who would have wanted to limit workforce defections will see more employees jumping ship and revealing sensitive information to their rivals.

We do not yet know what specific limits on noncompete clauses the FTC will seek or if such restrictions will survive challenges in the courts. Adopting broad-brush, one-size-fits-all regulations because they are easier for bureaucrats to administer would be a serious mistake, however. Resolving disputes about noncompete clauses on a case-by-case basis under a rule of reason, as they have been resolved for centuries, is far better than granting powers to the Feds, lacking access to local knowledge and vulnerable as they are to political influences, to set the terms of employment contracts coercively.

William F. Shughart II is a Research Director and Senior Fellow at the Independent Institute, the J. Fish Smith Professor in Public Choice at Utah State University, past President of the Public Choice Society as well as the Southern Economic Association, and editor of the Independent book, Taxing Choice.
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