Non-compete clauses in employment contracts – is time up?

Momentum is growing for Australia to follow the US's and UK’s lead in curtailing non-compete clauses.

Non-compete clauses in employment contracts are facing growing global regulatory scrutiny, with law and policy reform being considered to ban or limit their use. In the US, the Federal Trade Commission (FTC) is seeking to combat use of non-competes against American workers by proposing a rule that would make non-compete clauses unenforceable. Non-compete clauses are already banned in a number of US states, including in California. In the UK, the government has proposed to impose a statutory limit of three months on non-compete clauses.

In Australia, momentum is gathering to follow the overseas regulators’ lead. Treasury’s Competition Taskforce’s review will consider non-compete and related clauses, with an intent to increase competition and productivity. A consultation paper is likely to be released in April.

More recently, and adding to the impetus:

• New data from the Australian Bureau of Statistics (ABS) was released on 21 February 2024, arising from a survey of businesses on their use, and future expected use, of restraint clauses. Treasurer Jim Chalmers has described the data as “confronting”, with the government confirming that it will release an issues paper outlining options for reform in April, and develop a policy position “in the coming months”.
  
  
• Professor Allan Fels AO has recommended that non-compete clauses be banned in his Final Report on the ACTU commissioned Inquiry into Price Gouging and Unfair Pricing Practices (released in February 2024). The Report states that non-compete clauses cause a “chilling effect” on employees moving between firms, and hamper the transfer of talent from less to more efficient organisations. In addition, the Report notes that these clauses prevent part-time and casual employees from finding alternative employment, which stifles employment growth.

Commercial rationale for non-compete clauses

Contractual non-compete clauses seek to limit a worker’s ability to accept a job with their previous employer’s competitor and/or from operating a competing business. These restrictions typically apply to a particular geographical area and for a defined period of time. They are enlivened when workers cease working for their previous employer.

Several commercial justifications favour non-compete clauses. From an employer’s perspective, non-compete clauses protect against leakage of trade secrets, know-how and otherwise sensitive commercial information. Where rival businesses also use non-compete restrictions, imposing comparable clauses can maintain an even playing field. Consumers may also benefit as clauses that seek to promote uninhibited internal information sharing can spur innovation and productivity.

Treatment of non-competes under Australian law

Australian common law has long accepted the enforceability of non-compete clauses (as in the UK), provided the restraint is reasonably necessary to protect employers’ legitimate business interests. The restraint’s purpose must be to prevent the employee from using connections with customers and clients, including know-how and trade secrets, obtained through their employment to compete against their previous employer.

When examining a restraint’s reasonableness, courts consider the impugned clause’s temporal, geographic and sectoral restraint on the individual. Non-competes are often drafted in ‘cascading’ style (particularly outside of New South Wales), which lists alternative restrictions spanning from expansive to confined. This means the clause’s unreasonable aspects can be read down, whilst still leaving a more confined restraint in force.

The Competition and Consumer Act 2010 (Cth) (CCA) preserves these common law ‘restraint of trade’ principles, to the extent they are consistent with the CCA. A specific exception in the CCA also provides that the prohibitions on cartel conduct, and anticompetitive information sharing or agreements (including exclusive dealing), do not apply to matters relating to remuneration, conditions of employment, working hours or working conditions of employees.

Potential competition issues with non-compete clauses

Despite this exclusion in the CCA, features of non-compete clauses have potential to hinder competition and negatively impact employee outcomes. Possible effects include:

• locking out new entrants: entrepreneurial employees subject to non-competes may be prohibited from starting a competing business;

• raising actual or perceived barriers to entry: prospective new entrants may be discouraged if they know (or assume) that necessary talent will be immobile due to non-compete clauses;

• stifling innovation: lack of information and knowledge flow between firms (which likely stems from movement of workers) may decrease product and service innovation;

• reducing wage growth: non-compete clauses prevent employees from receiving wage increases that commonly accompany switching between employers; and
  
  
• decreasing negotiating power: low employee turnover can reduce remaining workers’ ability to obtain higher pay, increased flexibility and/or other benefits.

The US FTC proposes new rule that would make non-competes illegal

Non-compete clauses are pervasive across the US labour market. Treasury has estimated that nearly one in five Americans is currently subject to a non-compete, and almost 40% have been bound by one during their career. These clauses are imposed liberally across the workforce, binding construction workers and personal care employees alike.

On 5 January 2023, the FTC announced it was considering implementing a rule that would make it illegal for employers to insert non-compete clauses into employment contracts and similar agreements. The agency sought public comments up until April 2023, with the next step being to publish a final version of the rule. At this stage it is anticipated that a final version of the rule will be released and voted upon in April 2024.

In its current form, the proposed rule is broad in its application, and would make it a violation of the Federal Trade Commission Act (FTC Act) for employers to:

1. enter into or attempt to enter into a non-compete with a worker;
   
   
2. maintain a non-compete with a worker; or
   
   
3. represent to a worker, under certain circumstances, that the worker is subject to a non-compete.

The FTC has indicated it would also require employers to rescind existing non-compete clauses and actively inform current and past workers that they are no longer in effect. The FTC estimates that the proposed rule would increase American workers’ earnings between $250 billion and $296 billion per year.

As currently proposed, the FTC’s rule has broad application. ‘Worker’ is defined as a natural person who works, whether paid or unpaid, for an employer. This term includes independent contractors, interns and volunteers. Additionally, the rule would use a functional test (substance over form) to determine whether a clause operates as a ‘de facto’ non-compete. The FTC has suggested that disproportionate training repayment contracts and excessive terms in non-disclosure agreements can effectively operate as non-competes.

The proposed rule contains two key exceptions:

1. M&A context: sellers of businesses or assets who are substantial owners, members or partners in the target business could still be bound by non-competes; and
   
   
2. Franchisee arrangements: non-competes would also be effective against franchisees in a franchisee-franchisor relationship.

UK proposes three-month statutory limit

In the UK, the Department for Business and Trade released a paper on non-compete clauses in May 2023, which announced plans to impose a three-month statutory limit on the use of non-competes. This announcement has recently been bolstered by a report by the Competition and Markets Authority (CMA), which found that around 30% of employees in the UK are impacted by non-compete clauses. The proposed three-month limit is unlikely to apply to wider workplace contracts such as partnership or shareholder agreements, and would not impact non-solicitation clauses. Interestingly, the UK government considered the option of requiring paid compensation in exchange for entering into a non-compete, which is common in countries including Germany, France and Italy, but ultimately ruled this out.

Regulatory scrutiny of non-competes in Australia

In Australia, there has historically been limited data available on the prevalence and effect of non-compete clauses. However, the ABS has recently released the results of an ‘experimental and exploratory’ survey on the use of restraint clauses (which Treasurer Jim Chalmers described as “confronting”). The ABS data follows a recent survey conducted by the economic research institute, e61 Institute, which found that:

1. at least one in five Australian workers are subject to non-compete clauses, including many low wage workers; and
   
   
2. 50% of the Australian workforce is bound by some type of post-employment restraint, including non-compete clauses preventing disclosure of confidential information, solicitation of clients and poaching of co-workers.

The Australian government’s 2023 Employment White Paper, released on 25 September 2023, also identifies concerns that non-compete clauses may be hampering job mobility, innovation and wage growth.

Further, in a speech last year, Assistant Minister for Competition Andrew Leigh expressed concern that market concentration in the Australian economy means fewer employers are competing for workers. Relying on findings from recent Treasury research, Leigh suggested this reduction in employer-side competition leaves employees facing stagnant wage growth, limited prospective employer choices and diminishing bargaining power. Leigh is seeking to understand whether these problems are further exacerbated by the potential effects of non-compete clauses described above.

Finally, Professor Allan Fels AO has recommended that non-competes be banned in his Final Report on the ACTU commissioned Inquiry into Price Gouging and Unfair Pricing Practices (released in February 2024). The Report states that non-compete clauses cause a “chilling effect” on employees moving between firms, hamper the transfer of talent from less to more efficient organisations, and prevent part-time and causal employees from finding alternative employment, stifling employment growth.

What’s next?

The government will release an issues paper outlining options for reform in April this year, with Assistant Minister Andrew Leigh confirming that the government will develop a policy position “in the coming months”.

The ACCC has been asked to advise the government on both the competitive impacts of non-compete clauses in Australia, and whether regulatory action is justified. On 12 April 2023, Chairperson of the ACCC, Gina Cass-Gottlieb confirmed that the ACCC was looking into whether restrictive employment clauses were hampering the economy. Further, the Treasury’s ‘Competition Taskforce’ (which will conduct a review of competition law, policies and institutions to ensure they are fit for purpose) will release a consultation paper specifically seeking submissions on non-competes in the coming months. It goes without saying that the proposals for reform overseas, particularly in the US and the UK, will be closely considered, and under the current government it seems only a matter of time before legislative change is proposed.

Key takeaways

Momentum in Australia is gathering speed, with an increasing spotlight in the current economic climate on productivity, job mobility and the impact of non-competes on hindering employee movement and economic growth over time.

With the emerging trends of increasing global regulatory scrutiny employers should:

• keep abreast of the government position. We expect that there will be opportunities to make submissions in response to the government’s issues paper;

• increasingly use non-compete clauses with caution, reserving them for senior employees where there is objective justification for their use linked to protection of identified legitimate business interests; and
  
  
• consider using alternative contractual protections. If bans or limitations on the use of non-compete clauses are introduced, the most powerful means to protect your business where you have senior employees holding prized trade secrets may be the use of longer notice periods, combined with an ability to utilise gardening leave as needed. In conjunction with this option, we recommend checking for other unintended effects – for example, you may need to consider whether you have incentive plans where vesting continues until termination, but cannot be stopped at the commencement of garden leave.