A recent federal case involving two financial trading firms in New York — where one sued the other for “stealing” their trading strategy by hiring away two employees — underscored the importance of noncompete clauses in employment agreements. During a hearing, the judge expressed surprise that the plaintiff no longer used noncompetes. “If he has got in his head such valuable data … why not have a noncompete?” the judge asked, remarking further that the plaintiff “was asleep at the switch.”
Noncompete clauses protect trade secrets, proprietary databases, and other confidential information by restricting employees from directly competing with their former employers for a specified time after they leave. Forty-seven states currently allow noncompetes, and, in general, such clauses must be reasonable in scope, geography, and duration to be enforceable.
For centuries, businesses have used noncompete clauses to protect their intellectual property (IP) and to promote innovation in a way that offers distinct advantages over other tools. Now, as the Federal Trade Commission’s (FTC) ban on noncompetes nears its effective date – pending litigation – the evidence continues to show that noncompetes offer businesses, especially small businesses, a uniquely effective tool to protect their proprietary information.
By protecting intellectual property, noncompetes promote innovation and investment in employees. As one of the FTC’s own economists explained, “Firms may be reluctant to invest in risky R&D when departing workers can transfer proprietary information to competitors. By restricting the outflow of workers with noncompetes, incumbent firms are in a better position to capture the returns to risky R&D investments.” Accordingly, scholars have found that stricter non-compete enforceability leads to more innovation, consistent with reducing information spillovers to competitors.
What scholars and economists have argued has been verified on the ground with business owners. In fact, according to a recent survey, two-thirds of businesses agreed that without noncompetes, they would have to reduce the sharing of sensitive information with employees. In every sector of the economy, employers rely on noncompetes to protect trade secrets and other confidential information, as well as their workforce investments. Noncompetes are especially critical for small businesses, allowing start-ups to protect their intellectual property, which is often their defining asset.
Eliminating noncompetes for these firms would prevent them from developing and expanding their businesses. This could deal a catastrophic blow if employees with their most important secrets and IP could walk out the door at any time.
Moreover, noncompetes promote pro-competitive interests in distinct ways that differ from alternatives, such as trade-secret laws or nondisclosure agreements. By relying on noncompetes, “employers avoid the difficulties of proving an actual or threatened misappropriation of trade secrets to secure an injunction,” a costly and time-consuming process. Scholars have found that noncompetes “may represent a more efficient mechanism to prevent proprietary knowledge transfers in certain circumstances, particularly when monitoring and the enforcement of trade secrets law is costly.”
In the case involving the two trading firms, the court stated that, in evaluating the IP dispute, the company “had the capacity to guard more greatly against mischief like this,” but the company “appears to have passed those up. These include legally permissible garden leave and non-compete agreements.” The court’s questioning reinforces the conclusions of scholars and economists that noncompetes provide an exceptional form of IP protection. Noncompetes work on an ex-ante basis to prevent former employees from being placed in situations – like working for a competitor immediately after leaving the former employer – where they may be tempted or coerced to use their proprietary knowledge.
On the other hand, nondisclosure agreements and trade secret laws primarily work on an ex-post basis and often only after expensive and time-consuming litigation to prove that the former employee used proprietary information. To be sure, such tools can also help to protect IP and offer their own distinct advantages, both as standalone tools and in conjunction with noncompetes. But none can fully replicate a reasonable noncompete.
At an FTC forum on noncompetes, a witness testified that his industry is “deeply concerned that if noncompete agreements are not allowed for key employees, the revolving door for those employees could eventually force smaller companies out of business, as they're constantly training new competition, and sensitive internal information is readily available to competitors.” As policymakers and the courts begin to evaluate the FTC’s noncompete ban, they should remember that courts, scholars, and millions of businesses view noncompetes as an indispensable tool to protect intellectual property and promote innovation. One would have to be asleep at the switch not to recognize as much.
