July 24, 2019 Supporting Manhattan-area entrepreneurs, businesses, events

The Cost of Noncompetes

An employment contract is essentially a negotiation of power. In an ideal negotiation, a potential employee has the power to set the price for their labor based on their skills or their ability to acquire the skills necessary to create value for an employer. An employer also has the power to negotiate that price based on a variety of factors including access to capital, existing revenue, a labor force, or technology like an assembly line, a high-end computer, or an industrial kitchen.

The employment contract reflects the negotiation between employer and potential employee by outlining the benefits and responsibilities of a job, in addition to clauses that define expectations for employment, the costs for failure, and how that contract can be terminated by either party. A handful of those clauses can extend beyond the employment contract and three of those, nondisclosure, non-solicitation and noncompete clauses, are very valuable to an employer. In an ideal negotiation, these clauses would also increase the bargaining power of the potential employee, which would typically lead to additional compensation. As nondisclosure and non-solicitation clauses protect information and revenue streams that would remain with an employer following an employee’s tenure, they represent a categorically different value-proposition than a noncompete clause, which would restrict the labor of the employee beyond their tenure with an employer.

In an ideal negotiation, the potential employee could recognize the cost of signing a noncompete agreement, based on future earning potential, and the value of eliminating potential competition to the employer to establish just compensation for the agreement. Practically, an ideal negotiation around noncompetes is impossible because the true cost of a noncompete agreement to the employee and the economy in which that employee participates, has only recently begun to emerge. Further, up to 70 percent of those who sign noncompetes are told of the agreement after receiving a job offer and negotiating compensation. Forty-seven percent only learn of a noncompete agreement on or after their first day of work, effectively eliminating their bargaining power and transforming a negotiation into a situation known as a “contract of adhesion,” where the options are to take it or leave it, a costly proposition for those who have arrived for their first day of work.

Modern noncompete agreements were rarely used outside of executive and highly proprietary roles until the late 1980s, when their use grew with the post-industrial economy. Such agreements are regularly included in employment contracts, to restrict an employee from working for a competitor, a client, or from starting a competitive business for a defined period of time within a geographic radius following the termination of an employment contract. These agreements often do not consider whether a past employee quit or was fired and whether termination was for cause. They are, simply, a restriction on future employment.  

Today, 16 to 20 percent of American laborers, up to 30 million people, work under a noncompete agreement, according to multiple estimates on the industry practice, and 40 percent of workers, approximately 60 million people, had signed one in a past job. Up to 45 percent of physicians work under a noncompete agreements, affecting healthcare service in rural areas and in specialty services, and in 2016, the U.S. Department of the Treasury reported that 15 percent of workers without a college degree and 14 percent of workers making less than $40,000 a year were bound by noncompete agreements. Even 12 percent of those with less than $20,000 in annual earnings had signed away their right to employment in their labor market.

While lower wage earners are affected by these agreements across industries, much of the public attention and outrage has focused on the fast food industry, where Massachusetts Attorney General Maura Healey estimated that last year 80 percent of fast-food workers worked with employment restrictions similar to noncompete agreements after signing contracts, including “no poaching” clauses. While many fast food employers relinquished their restrictions in response to public outrage, other lower wage employers, such as Jiffy Lube and Anytime Fitness still require employees to sign covenants that restrict them from working with competitors.

Some economists, including Princeton University economists Alan B. Krueger and Orley Ashenfelter, have said that these employment restrictions are one reason why average wages remain stagnant in a historically low labor market during a period of robust economic expansion. To understand this correlation, economists point to the theory of monopsony, a hallmark of the company towns that fueled the Industrial Revolution. Under a monopsony, a single buyer of goods or services can artificially depress prices and deprive the sellers of goods or laborer of their bargaining power. Similar to a monopoly, where there is a single seller, monopsonies fall under the Federal Trade Commision’s (FTC) antitrust division that regulates anti-competitive activities.

While economists continue to debate whether noncompete agreements create a large enough monopsonistic effect to explain the mysterious lack of wage growth, economists have demonstrated that noncompete agreements suppress regional innovation, average wages and job satisfaction. In her study of California’s Silicon Valley, an economy that has become synonymous with innovation, Stanford Professor Anna Lee Saxenian said that Silicon Valley “would probably not be what it is today” if noncompete agreements were enforced in California. Saxenian’s hypothesis was put to the test in Michigan, when a significant drop in patent filings, a common marker of innovation, followed the legislation that led to an increased use of noncompetes in 1985.

These agreements not only affect those bound by them: economists have shown that as the use and enforcement of noncompete agreements increase, the entire workforce sees lower wages, job mobility and job satisfaction. It’s not surprising, then, that states that enforced noncompete agreements, such as Michigan, saw a higher loss of knowledge workers across state lines, often called “brain drain,” than the four states that generally prohibit noncompete agreements: California, Montana, North Dakota, and Oklahoma.

Employers who use noncompete agreements typically view these covenants as a protection against potential “free-rider” competitors. This employer’s argument is that a competitor should be prohibited from benefiting from that employer’s intangible investment in an employee, such as specialized training, trade secrets and knowledge of potential customers. From this point of view, the information passed to an employee during training constitutes quasi-property rights, similar to patents and copyrights, and a noncompete agreement is the proper way to protect the employer’s investment in employees.

While employers have steadily increased their use of noncompete agreements since the 1980s, many in the legal industry have been surprised by the recent explosion of noncompete lawsuits. One analysis by the Boston-based law firm Beck Reed Riden LLP showed a 61 percent increase in the number of employees sued by former employers from 2002 to 2013. Given the substantial costs associated with defending these lawsuits and the risk of paying the plantiff’s legal fees, many will choose to stay in a job against their wishes or will leave an economic area rather than risk expensive litigation.

The belief that employers need to protect themselves from competitors who will take, poach or steal business or employees rests on a limited view of the economy in which one employer’s gain must come at another’s expense. Under this perspective, an employer would view an employee’s departure for a competitor as their own loss, equal to their competitor’s gain, but this individual action is one part rather than the total sum of the competitive landscape. In game theory, which analyzes decision making behaviors among interdependent actors, this is called a zero-sum game, where the net benefit from a group of related actions equals zero.

Given that information sharing across an economy likely increases innovation, average wages and average job satisfaction within that economy, it’s unlikely that the net impact of labor movement between competitors is zero-sum. It’s even more unlikely that this sort of action is a negative-sum game, where one competitor must take from the other to simply maintain the status quo, though much of the legal language presupposes that economies are a zero-sum or negative-sum game.

As the issue of noncompete agreements affects the bargaining rights of workers, free market principles, and economic dynamism, reform efforts have brought together a diverse coalition like few issues can. In March of 2019, over 60 signatories from across the political spectrum, including the Economic Policy Institute, the AFL-CIO, the Service Employees International Union, and antitrust and employment law experts submitted a petition to the FTC calling for federal prohibition of the enforcement of noncompete agreements. The petition argued that “[by] binding workers to their current employer, noncompetes reduce wages, depress business formation, and lock workers into discriminatory, hostile, or unsafe workplaces. On top of these harms to workers, dominant firms and other powerful incumbents can also use noncompetes to deprive rivals and new entrants of specialized workers and exclude these competitors from the market.”

In response, six U.S. Senators, including presidential candidates Sen. Elizabeth Warren and Sen. Amy Klobuchar, submitted a letter to the FTC calling on the federal body to “use its rulemaking authority along with other tools, in order to combat the scourge of noncompete clauses rigging our economy against workers.” The six senators went on to write that “noncompete clauses harm employees by limiting their ability to find alternate work, which leaves them with little leverage to bargain for better wages or working conditions with their immediate employer.” Republican Sen. Marco Rubio also supports noncompete reform and introduced the “Freedom to Compete Act” in January 2019. While Rubio’s bill would only prevent the use of noncompete agreements for low-wage employees, it demonstrates a growing bipartisan appetite for reform.

For Shanna Goodman, president of Manhattan-based Ampersand Business Solutions, the issue is both complex and personal, as a professional who has been affected by noncompete covenants in a variety of ways over her career. “I’ve been on multiple sides of the noncompete conversation and it’s a tricky one. Having been an employee and an employer, I can see both sides, but it does seem that noncompetes are no longer relevant in a market like ours. If someone is a skilled landscape laborer and quits or is laid off from one landscape company, I believe that they should be able to apply to work at another landscape company in town. Why is marketing and advertising any different?”

As the issue of noncompetes gains visibility and the lines between traditional competitors blur, professionals like Goodman and politicians across the political spectrum will continue asking whether a particular employer’s desire to indefinitely restrict employment justifies the economic cost to state and regional economies. In the meantime, millions of workers will continue to work under such restrictions, knowingly or unknowingly, and tens of thousands will remain out of key labor markets or will be forced to pay costly settlements to their former employers and remain silent under gag orders, all for the privilege of a day’s work.  

Josh Brewer is the agency marketing director at 502, a strategic marketing agency in  Manhattan, Kansas. He was the defendant of a lawsuit pertaining to a noncompete agreement.

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