While President Biden’s earlier comments surrounding the 2021 executive order appeared to be focused on lower-level employees, the newly proposed rule defines “worker” in an expansive manner to include all employees as well as individuals classified as independent contractors, externs, interns, volunteers, apprentices, and sole proprietors who provide a service to a client or customer. Accordingly, the proposal, if adopted in its current form, could have far-reaching impacts on the agreements and arrangements that companies enter into with their C-suite and other key executives, as well as on other aspects of executive compensation.
We discuss a brief sample of key impacts below, but aspects of the rule could change between the proposal and any final rule ultimately adopted by the FTC. As part of the rulemaking process, the FTC has specifically solicited comments on whether “senior executives should be exempted from the rule, or subject to a rebuttable presumption rather than a ban” and/or whether “low- and high-wage workers should be treated differently under the rule.”
Limitation on New Noncompetes
The proposal would prohibit new contracts with executives that include noncompete clauses, which will fundamentally change the dynamics at play when companies negotiate arrangements in connection with hiring, promoting, or designing new incentives with key executives.
A nonexhaustive list of such arrangements includes offer letters, employment agreements, and services contracts; equity or equity-based compensation plans and award agreements (see below for further thoughts on these arrangements); bonus and carried interest arrangements; severance plans, policies, or agreements; and certain transaction-based agreements such as equity cancellation agreements, change in control or retention bonuses, and temporary transition services agreements for executives of acquired businesses. It is unclear whether there would be an exception under the proposal for situations where an executive is paid not to compete (such as a “garden leave” provision).
Required Rescission of Existing Noncompetes
The proposal would require employers to rescind existing noncompete clauses by affirmative notification in connection with the final rule’s compliance date (and the proposed rule includes a safe harbor notice for this purpose). As a result, companies would need to review all executive agreements to identify any violative restrictive covenants and provide notices to the covered executives. In many instances, these noncompete covenants were likely agreed to because executives were provided with significant incentive, retention, severance, or other compensation protections.
One issue that may arise as a result of the proposal is whether any of the benefits provided as consideration for a noncompete covenant that is rescinded can be cancelled or forfeited under the contractual “frustration of purpose” doctrine.
Recently Terminated Executives
The proposal would become effective in connection with its compliance date, at which time it would apply to all “workers” and would prohibit maintaining any contract that includes a violative noncompete clause. It is unclear whether this would apply to executives who are no longer current workers at the time of the compliance date and who may be receiving severance or other benefits that were only provided as consideration for, or were part of a contract negotiated to include, a noncompete covenant.
Potential Impacts with Equity Compensation
The proposal has a limited exception for the sale of a business, but unlike a similar exception in California’s ban on noncompete clauses, the proposal’s exception has a bright-line rule and only applies where the individual is an owner, member, or partner holding at least a 25% ownership interest in a business entity.
It is unclear whether equity compensation (either in connection with the sale of a business that doesn’t meet this requirement or granted on an ongoing basis) can continue to be structured so that it is provided both as an incentive and as consideration for executives agreeing not to compete with their employer while holding the award or after employment. It is also unclear whether the proposal would apply to provisions requiring executives to forfeit stock or other equity compensation as a consequence of competition.
The proposal does not expressly address commonly used “clawback,” forfeiture, or repayment mechanics. However, the proposal includes unhelpful commentary suggesting that the amount of any forfeiture or clawback could lead to a determination that it represents a “de facto” noncompete provision prohibited by the rule.
Section 280G
Under Section 280G of the Internal Revenue Code (Code), a corporation will be denied an income tax deduction on any “excess parachute payments” made to certain executives in connection with a change of control, and the executives receiving such excess parachute payments will be subject to a nondeductible 20% excise tax penalty, in addition to regular federal and state income tax. One of the primary exemptions that companies use to exempt compensatory payments from treatment as a parachute payment is by establishing by clear and convincing evidence that such payment is reasonable compensation for services to be provided after the change in control (which includes refraining from providing services due to an enforceable noncompete covenant).
To the extent that covenants based on noncompete clauses are unenforceable under the proposal, a significant tool used to reduce parachute tax penalties will cease to be available, potentially increasing the cost of impacted transactions. This is particularly an issue for public companies that are unable to use private company shareholder votes to cleanse 280G issues with respect to compensation that would otherwise be a parachute payment.
The proposal does not contain a provision that would exempt completed transactions that have relied on noncompete covenants in various capacities (including in the 280G calculations). Companies that have engaged in recently closed transactions could face a scenario where they might need to rerun 280G calculations to remove reliance on noncompete covenants to reduce the value of parachute payments and reevaluate their 280G tax position.
As with all of the considerations listed herein, any action with respect to previously determined calculations would not be required or necessary until the rule is finalized.
Section 83
Under Section 83 of the Code, transfers of property in connection with performance of services are generally included in the gross income of the person performing the services in the first taxable year in which the property is not subject to a substantial risk of forfeiture (i.e., when it is substantially vested) or is transferable. Based on a facts and circumstances test, noncompete covenants can be used to support a substantial risk of forfeiture, thereby postponing taxation until the substantial risk of forfeiture lapses.
If the proposal is finalized as proposed, companies would have to reevaluate their reliance on noncompete covenants for purposes of Section 83 transfers.
Section 3121(V)
Under Section 3121(v) of the Code, amounts deferred under nonqualified deferred compensation plans are taken into account as wages for purposes of FICA tax at the later of when the services are performed or when the amount is no longer subject to a substantial risk of forfeiture. Section 3121(v) utilizes the same “substantial risk of forfeiture” definition as in Section 83, so, depending on the circumstances, an enforceable noncompete covenant can postpone FICA tax.
If the proposal is finalized as proposed, the prohibition of noncompete covenants would require companies to reevaluate the FICA tax treatment of such deferred compensation.
