FTC Rule Bans Non-Competes: What Does This Mean for the Healthcare Industry?
Background: What is happening and why?
On April 23, 2024, the Federal Trade Commission (FTC) issued a profound Final Rule (the “Final Rule”) banning most non-competes nationwide for workers. The Final Rule comes after a proposed rule was issued by the FTC on January 5, 2023.[1] Only hours after the Final Rule was released, the first lawsuit was filed challenging the Final Rule and seeking an injunction in the Northern District of Texas.[2] The following day, the U.S. Chamber of Commerce also filed a lawsuit seeking declaratory and injunctive relief in the Eastern District of Texas, with more lawsuits likely to follow across the country.[3] The prevailing sentiment is that one or more of the federal District Courts entertaining these lawsuits will grant injunctive relief, staying implementation of the Final Rule pending final resolution – which will likely take months (if not longer).
Nonetheless, employers across the country are scrambling to understand how the Final Rule will impact their businesses and existing non-competes with their employees, if ultimately implemented. It’s no secret that non-competes in the healthcare industry are pervasive, as healthcare workers (particularly highly trained physicians and other clinical practitioners that are in chronic short supply) are critical assets to healthcare operations. The Final Rule commentary provides example after example of non-competes impacting physicians and other healthcare workers, making it abundantly clear that the FTC is taking aim at what it views as abusive and anti-competitive practices impacting healthcare.
Healthcare companies across the spectrum will be caught in the crosshairs of the Final Rule – if ever implemented.
Under the Final Rule, no employer (not even non-profit hospitals) is completely exempt from the reach of the Final Rule, although the Final Rule gives non-profit hospitals and healthcare systems a clear “leg up” against for-profit competitors, most notably private equity firms. The Final Rule is arguably another way that the FTC is demonstrating its concern with private equity’s increasing dominance in the healthcare industry.[4] Although some aspects of the Final Rule appear straightforward, it creates questions regarding commonly utilized organizational structures in healthcare, including:
The clinical practice management model (or commonly referred to as the “management services organization (MSO) / friendly professional corporation (PC) model”) widely used by investors and other non-licensed entrepreneurs seeking to established new and innovative businesses in the healthcare space.
Technology-enabled services companies that employ senior leader physicians in both executive leadership (i.e., Chief Medical Officer) and clinical capacity (i.e., friendly physician/clinical services provider).
Physician practices that rely on non-competes to protect costly investments in physician and mid-level practitioner development, as these practices struggle to maintain independence in the face of increased labor costs, skilled labor shortages and mounting reimbursement pressures from governmental and commercial payors.
Hospitals (particularly for-profit hospitals) which also rely on non-competes to retain skilled physician talent with increasingly competitive markets, high labor costs and skilled labor shortages in key community need areas.
Non-profit hospitals engaged in for-profit ventures, even if those endeavors are arguably in furtherance of the non-profits charitable mission. Additionally, non-profit health systems commonly drop wholly-owned subsidiary entities (usually limited liability companies) through which the hospital may employ physicians and mid-level practitioners. These legal entities are not non-profits.
Key Highlights
(1) The Final Rule adopts a comprehensive ban on new non-competes applicable to workers (a broadly defined term, outlined in more detail below).
(2) Existing non-competes for senior executives - who represent less than 0.75% of workers - may remain in place under the Final Rule, but employers are banned from entering into or attempting to enforce any new non-competes, even if they involve senior executives.
(3) The Final Rule includes an exception that allows non-competes between the seller and buyer of a business.
(4) Subject to a two-factor test, most non-profit hospitals, health systems and other non-profit healthcare organizations will likely be beyond the reach of the Final Rule and non-competes between those non-profit organizations and their workers will remain viable.
(5) Employers will be required to provide notice to workers (other than senior executives who are bound by an existing non-compete) that they will not be enforcing any non-competes against them. The FTC provides model language that employers can use to notify employees.
(6) The Final Rule will become effective 120 days after publication in the Federal Register (anticipated to be published sometime in September).
What is Banned? -- Non-Competes & De Facto Non-Competes
The Final Rule defines non-compete clauses as a term or condition of employment, including a contractual term or workplace policy whether written or oral, that prohibits a worker from, penalizes a worker for, or functions to prevent a worker from (1) 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 (2) operating a business in the United States after the conclusion of the employment that includes the term or condition.[5] The Final Rule does not prohibit concurrent-employment restraints and covers only post-employment conduct.
Other commonly utilized restrictive covenant agreements, although permitted by the Final Rule, may be deemed to be considered “non-competes” if drafted in a way that is so broad or onerous that it effectively “functions to prevent” or penalizes a worker from seeking or accepting other work or starting a business post-employment, including:
Non-disclosure agreements (NDAs)/confidentiality agreements;
Non-solicitation agreements (for customers, patients, or employees); or
Training-repayment agreements that require a worker to repay the employer/third party for training costs if the employee leaves within a specified period of time.
For example, the FTC indicated that an NDA would not be a non-compete where its prohibitions on disclosure do not apply to information that (1) arises from the worker’s general training, knowledge, skill, or experience, gained on the job or otherwise, or (2) is reasonably ascertainable to other employers or the general public. If they use such a large scope of information that it would bar the worker from disclosing, in a future job, any information that is “usable in” or “relates to” the industry for which they were, such provisions would be deemed as functional non-competes and thus subject to the ban.
As a go-forward strategy, carefully tailored non-solicitation provisions, garden leave, and confidentiality agreements will play a crucial role in protecting employers.
Who Does the Final Rule Apply To?
Business Entities: The Final Rule applies to all business entities that are partnerships, corporations, associations, limited liability companies, or other legal entities, or divisions or subsidiaries thereof.
Applicability to Non-Profits: On its face, the Final Rule does not apply to not-for-profit organizations or state and local governments. However, the FTC rejected the proposition that non-profit organizations are categorically outside the scope of the FTC Act and thus the FTC’s jurisdiction to enforce the Final Rule again nonprofit organizations. Rather, the FTC set forth a two-part test to determine whether a business entity is organized to carry on business for its own profit or for the profit of its members (regardless of whether the entity has 501(c)(3) status):
Whether there is an adequate nexus between an organization’s activities and its alleged public purpose (i.e., the “source of the income” and whether the corporation is organized for and actually engaged in business for only charitable purposes); and
Whether the net proceeds are properly devoted to recognized public, rather than private, interests (i.e., the “destination of the income” and whether either the entity or its members derive a profit).
If the FTC determines that a non-profit entity is engaging in an activity and is deemed to be organized to carry on business for its own profit or for the profit of its members, the organization is subject to the FTC’s jurisdiction. In the Final Rule, the FTC provided several examples of non-profit organizations that have been deemed by the FTC or Internal Revenue Service (IRS) to be “corporations organized for its own profit or that of its members” and thus subject to the FTC’s jurisdiction:
A non-profit hospital-physician organization where the organization was deemed to be engaged in the business on behalf of its for-profit physician members (i.e., the for-profit physician members received a profit, despite the entity being a non-profit and despite one of the members being a non-profit hospital).
A 501(c)(3) independent physician association claiming tax exempt status as a nonprofit, consisting of private, independent physicians and private small group practices. The FTC found the organization was organized for the pecuniary interest of its for-profit members because it contracted with payors on behalf of its for-profit physician members for the provision of physician services for a fee.
Non-profit hospitals and other related entities that partner with for-profit entities, where the nonprofit entity ceded effective control to the for-profit partner, conferring a private benefit.
Non-profit entities that pay unreasonable compensation, including percentage-based compensation, to founders, board members, their families, or other insiders.
As noted above, non-profit hospital systems often establish wholly-owned subsidiary entities (usually limited liability companies) and may employ physicians in certain specialties (e.g., cardiology, orthopedics, internal medicine) through those subsidiary entities. Technically, those subsidiary entities are separate legal entities and are not 501(c)(3)s like their parent corporation, but are subject to the non-profit hospital’s indigent and charity care policies for patient financial assistance and are disregarded for income tax purposes. As a result, the profits from the subsidiary flow directly to the non-profit parent corporation and are then deployed by the non-profit hospital in furtherance of the hospital’s charitable mission. Although the rule seems to create some ambiguity here, arguably the wholly-owned subsidiary would receive the same treatment under the rule as its non-profit parent.
What is a “Worker”?
Workers: The Final Rule applies to all workers. “Worker” is defined by the FTC as any natural person who works or previously worked, whether paid or unpaid, without regard to the worker’s title or the worker’s status under any other State or Federal laws, including, but not limited to, whether the worker is an employee, independent contractor, extern, intern, volunteer, apprentice, or a sole proprietor who provides a service to a person.”
Notably, the definition of worker includes a natural person who works for a franchisee or franchisor but does not apply to a franchisee in the context of the franchisee-franchisor relationship.
Is an Owner Also a Worker?: One area likely to raise thorny questions (and spawn litigation) is whether a business owner who is also a worker for the business may be subject to a non-compete by virtue of such person’s ownership in the business (e.g., through a post-termination non-compete contained in the business entity’s operating agreement or shareholder’s agreement).
This dovetails with the exception for a bona fide sale of a business (outlined below), which is where we believe the ambiguity lies (and is detailed more below).
The FTC highlighted one commenter who argued that employers often impose non-competes on workers who own a portion of the business, while not applying the same restriction to outside investors who do not work for the company, and that such worker-owner non-competes should be treated as employment-related non-competes.
Although the FTC did not adopt the commenter’s proposal that “worker” includes a person who holds a direct or indirect equity or other interest in the employer and who provides services to or for the benefit of the employer, the FTC (in response to this comment) stated : “the Commission revised the definition of worker to cover all current and former workers, regardless of which entity hired or contracted with them to work, and regardless of the worker’s title or status under any other applicable law.”
Based on the FTC’s response, it appears that an owner, who also provides services to a business, would be deemed a “worker” for purposes of the prohibition on non-competes. However, it is unclear right now what will happen when an owner (who is also a worker) resigns or otherwise exits from their company, and whether the restrictive covenant in the company’s operating documents could be relied on to limit competition under the sale of a bona fide business exception (discussed below).
Exception for Bona Fide Sale of a Business
The Final Rule does not apply to non-competes entered into by a person pursuant to:
a bona fide sale of a business entity;
of the person’s ownership interest in a business entity; or,
of all or substantially all of a business entity’s operating assets.
A bona fide sale is defined as a sale between two independent parties at arm’s length, and in which the seller has a reasonable opportunity to negotiate the terms of the sale. The Final Rule eliminates the 25% ownership requirement which had been included in the Proposed Rule.
Under this exception, a worker who owns an interest in a business entity and later sells that interest pursuant to the terms of the entity’s operating agreement has arguably effectuated a bona fide sale, making any post-redemption/repurchase non-competes contained in the business’ operating agreement or shareholder’s agreement valid under the Final Rule.
However, several of the examples provided by the FTC as problematic non-competes involve share redemptions and repurchases for workers. The FTC highlighted one commenter’s plight where a manager of a small business in a niche technology industry was offered shares in the company when the business was acquired by a private equity firm. The manager accepted the shares and signed an Employment Agreement but was later sent a 120-page Share Agreement that governed how the shares would vest and also included a separate non-compete tied to those shares. It seems likely that the FTC would view this manager as a “worker” and would likely view the Shareholder Agreement non-compete as an invalid, even if the workers shares were redeemed or repurchased.
This example highlights that the sale of a person’s ownership interest in a business entity may not be as straightforward as it seems. This implicates other commonly used non-competes in ownership agreements used by healthcare entities across the board, including:
private equity and other healthcare companies under the clinical practice management model, where the private equity owned MSO sets up an affiliated clinical entity with a friendly physician (or clinical) owner who is often subject to a non-compete by virtue of that “ownership” and subject to removal by the MSO at any time; and
physician practice entities where the physician owners mutually agree to a non-compete in their governing document (operating agreement or shareholders agreement) upon a departure by a physician and redemption or repurchase of that physician’s equity by the other physician owners or the practice entity itself.
Of significance to this inquiry will likely be the amorphous standard set out by the FTC regarding (1) whether the sale was between independent parties at arm’s length, and (2) whether the seller has a reasonable opportunity to negotiate the terms of the sale. In short, this standard creates an opportunity for interpretation and litigation.
Other Exceptions to the Non-Compete Ban
The Final Rule does not apply where a cause of action related to a non-compete accrued prior to the effective date of the Final Rule.
Existing non-competes for senior executives will remain in force under the Final Rule (new non-competes, even for senior executives, are not permitted). The FTC defines “senior executives” as workers (1) holding a policy-making position and (2) who receive total compensation of at least $151,164 in the preceding year.
A policy making position includes a business entity’s president, CEO or the equivalent, officer, or any person who has policy making authority.
A senior executive’s policy making authority is the final authority to make policy decisions that control significant aspects of a business entity or common enterprise and does not include authority limited to advising or exerting influence over such policy decisions or having final authority to make policy decisions for only a subsidiary of or affiliate of a common enterprise. The Final Rule is unclear on what constitutes “final authority” and “significant aspects” under the definition of policy making authority.
The Final Rule is unclear on how final decision making would apply to certain divisions of a business entity, as only subsidiaries and affiliates are specified in the rule.
For more information, please contact Laurice Rutledge Lambert or Jennifer P. Whitton.
Footnotes:
[1] 88 FR 20441.
[2] Ryan, LLC v. FTC, No. 3:24-cv-986 (N.D. Tex. filed Apr. 23, 2024), https://files.lbr.cloud/public/2024-04/Ryan.pdf?VersionId=0yu9qPkQFUOJ5XXAaZvtgXK4EzWprx7N.
[3] Chamber of Commerce of U.S. v. FTC, No. 6:24-cv-00148 (E.D. Tex. filed Apr. 24, 2024), https://www.uschamber.com/assets/documents/Complaint-Chamber-v.-FTC-E.D.-Tex.pdf.
[4] In the FTC’s March 5 “Virtual Workshop on Private Equity in Health Care”, the heads of antitrust enforcement at FTC and DOJ, as well as senior officials at Health and Human Services (HHS) and Centers for Medicare and Medicaid Services, suggested that PE firms’ investments in healthcare have increased health care costs, while also reducing quality and access. This follows on the heels of increasing FTC regulatory enforcement against private equity firms. See for example the FTC lawsuit filed against private equity firm U.S. Anesthesia Partners: https://www.ftc.gov/news-events/news/press-releases/2023/09/ftc-challenges-private-equity-firms-scheme-suppress-competition-anesthesiology-practices-across.
[5] Federal Trade Commission, Non-Compete Clause Rule, https://www.ftc.gov/system/files/ftc_gov/pdf/noncompete-rule.pdf.