Restrictive Covenants Are Under Scrutiny, and Deserve Your Attention

The U.S. Federal Trade Commission (FTC) has recently been taking strong, visible steps to eliminate “unfair and anticompetitive” restrictive covenants that officials say stifle small business formation, limit worker mobility and suppress wages.

A restrictive covenant is a legally binding promise in a contract that limits or prohibits certain actions. In employment situations, it is most often used to curb “unfair business competition.” The most common types include noncompete agreements, nonsolicitation agreements and confidentiality/nondisclosure agreements (NDAs).

According to Timothy Rybacki, a shareholder at the Littler Mendelson employment law firm, the upside to employers’ continued use of restrictive covenants far outweighs the downside “if they are drafted correctly and used on the right people.”

And just like people, he said, not all restrictive covenants are the same.

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‘A Pyramid Structure’

Whenever implementing any type of restrictive covenant, Rybacki recommended employers envision a pyramid structure.

At the top, he said, are noncompete agreements, which typically express that an employee can’t engage in activities that may create undue competition on behalf of an entity in the same specific industry sector (e.g., a software engineer designing a product for a direct competitor that is similar in function to the originating company’s). Such agreements typically cover a specified time period (e.g., two years after the individual leaves the organization).

The second level covers customer-related nonsolicitation or nonacceptance agreements, which typically occur within sales-related roles. At the bottom, the widest level covers agreements that simply protect confidential company information.

“The higher you go [up the pyramid], the more scrutiny you get from the courts, both as to the scope and who you have sign them,” Rybicki said. “At those higher levels, you’ll also need to find a balance between being unattractive to potential candidates who may be looking to join the organization and protecting your interests.”

Pros and Cons

Employers can spend years developing customer relationships, training their employees and creating valuable proprietary information; therefore, restrictive covenants are designed to protect those interests, said Ari Lichterman, an associate at Luchansky Law, a Maryland-based employment law firm.

“The catch is that they’re only effective when used thoughtfully and purposefully,” he said.

For example, begin by asking, “What are we actually trying to protect?” Lichterman said employers should tailor restrictive covenants to the employee’s role and the markets served, limiting restrictions to what is reasonably necessary to protect the business interests at stake.

“A high-level executive with access to key business operations may warrant different restrictions than a salesperson or HR professional,” he said. “At the end of the day, restrictive covenants should be about smart risk management, and a strategically tailored restriction is far more valuable than a broad, one-size-fits-all agreement.”

While restrictive covenants can help add value to the company (in the form of protection), they also can create legal risks and hurt recruiting efforts.

Lichterman noted restrictive covenants may be a red flag to some job candidates (and transitively, to a court or industry regulator) if they believe they are being asked to sign something that is “overly broad or unreasonable.”

“If someone only works in one state, for example, do you really need them to sign a national noncompete agreement?” he said.

Federal and State Concerns

According to Bill Nolan, a partner at Barnes & Thornburg law firm, the two most recent presidential administrations have used the FTC to take very different approaches to restrictive covenants.

Under the presidential administration of Joe Biden, the commission issued a sweeping ban on noncompetes, which was then struck down by the courts last September. Conversely, the current administration under President Donald Trump is taking a more targeted, measured approach, including hosting virtual town halls to discuss the topic with employers.

But employers’ legal attention should be focused on the state level, said Nolan.

“The state laws are very active,” he said. “Washington was just added to the list of states that largely ban noncompetes, and there are many other states doing a variety of things to restrict and regulate them.”

Tennessee, for example, now prohibits noncompete agreements for workers earning under $70,000 annually and establishes clear time-based “safe harbor” periods of two years or less for standard employees.

Overall, most states seem to agree on one thing, and that is noncompete agreements shouldn’t be used as a retention tool, said Rybacki.

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