The overuse of “non-compete agreements” and what to do about them

May 9th, 2016 at 8:35 am

One reason we don’t see nearly enough wage growth in the US labor market is that employers rarely have to compete for workers. Often this is due to weak demand (persistent labor market slack), but discrimination by race and gender and low unionization rates can also play a role in reduced worker bargaining power.

A new report from the White House suggests another, quite direct form of this problem: “non-compete agreements” (NCAs), “contracts that ban workers at a certain company from going to work for a competing employer within a certain period of time after leaving a job.”

The rationale for such agreements is the protection of “trade secrets.” Without them, companies argue, employees could learn proprietary information and then market it to rival companies in return for a better employment offer.  Relatedly, companies worry that they will invest time and money into employee training only to miss out on the rewards of that investment (while their competitors gain) when freshly trained employees jump ship.

Such concerns have merit, but surely not for every type of worker. The report tells, for example, of a national sandwich chain that “required its employees to sign an expansive non-compete agreement that would ban them from working at just about any other fast-food restaurant.” Yes, some of these shops tout their “secret sauce,” but this practice reeks of suppressed competition and pay.

In fact, the White House finds that 15 percent of non-college graduates are subject to NCAs, as are 14 percent of workers earning less than $40,000 (according to my analysis, 14 percent of jobs under that pay level amounts to about 12 million workers). Add that information to the fact that most workers with NCAs claim not to possess trade secrets and one gets a sense of the problem.

Unnecessary bans on labor mobility are bad for workers and bad for the broader economy, as efficient matching between workers and jobs requires freedom of movement. But is there any evidence that NCAs actually dampen worker bargaining power/negotiating leverage? In fact, the research finds that a one-standard-deviation increase in NCA enforcement is accompanied by a 1.4 percent reduction in wages. This is an especially notable finding if you consider the claim that NCAs incentivize worker training, as that would lead you to expect higher pay where NCAs are more prevalent.

The good news is that some states are taking action against NCAs. Oregon doesn’t allow non-competes for workers who make less than the median family income, for example, and New Hampshire and Oregon both require employers to notify job applicants about NCAs before those prospective employees have officially taken a position. That’s important because more than a third of workers are asked to sign non-competes after a job offer.  Courts in Montana and New York have voided NCAs when employees are terminated without cause and several states, including Colorado, Delaware, and Texas, have restrictions on the use of NCAs in health care occupations. California, where Silicon Valley was known for generating NCAs, has rendered most of them unenforceable altogether. Yet 22 percent of California workers there have still reported that they’ve signed NCAs, so there’s more work to be done here.

These state actions all look useful to varying degrees, but a simple piece of federal action could go a long way here. Since low-wage workers should not have to—cannot afford to—sacrifice their ability to pursue higher pay, and since such workers are least likely to possess trade secrets, the federal government should consider a ban on NCAs below some salary or wage level. For example, while any level would be arbitrary, the bottom third of salaries, up to $22,000 today, might be a reasonable cutoff.

While non-competes may make sense in some instances, common sense would dictate that a) most workers do not possess trade secrets of any value, and b) there are better, less coercive ways for firms to retain their workforce. Employees who “feel involved in, enthusiastic about and committed to their work” are much less likely to leave their companies even when offered raises as high as 20 percent, and those who “exhibit high well-being” are “59% less likely to look for a job with a different organization in the next 12 months.”

As regards worker training, economists have long recognized that there’s a potential market failure here. Firms that fear the sunk costs of training will be unrecoverable if workers leave shortly after getting trained will tend to do too little of it. If enough firms think that way, a suboptimal amount of training will be on offer. The classic solution is to make worker training a “public good,” and, in fact, we see some of that occurring with publicly supported community college training initiatives tied to in-demand jobs.

Competition is the hallmark of capitalism, and the bar for restricting it, especially among lower-paid workers who stand to benefit most from competition for their services, should be very high indeed. From that perspective, taking action against NCAs is low-hanging fruit.

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8 comments in reply to "The overuse of “non-compete agreements” and what to do about them"

  1. David C says:

    In corporate America, there is a whole lot of training that is needed, and sometimes delivered, that would be next to impossible to provide as a public good. Much of it is pretty company-specific, for example, and the only feasible teachers are within the corporation. This kind of training wouldn’t be valuable to the new firm of an employee who changes jobs, but the issue of losing an investment in training if the employee leaves soon after is still a problem.

    I have seen some examples where employees sign agreements to pay back some or all of the training costs if they leave within a defined period, typically one or two years. I think this is better than blanket non-compete clauses. It’s tricky though, since it is difficult to verify that the costs claimed by the employer are accurate.

  2. Smith says:

    No way, this is a severe dumbing down of labor law and progressive policy. All non-compete agreements are and of a right ought to be unconstitutional, unenforceable and indefensible. There is a standard legal argument against these coercive sanctions, courts throw them out because they violate two principles,
    1) Public policy 2) Unconscionability
    I would throw in the 13th Amendment into that mix for good measure.
    Half way measures and arguments against ‘some’ agreements are possibly worse than no help at all since the legitimize the idea that any employer has control over a workers ability to contract out his labor in perpetuity or for some number of years after his initial employ (bondage), whether it’s 12 years or less.

    If you don’t want trade secrets passed to competitors, don’t give them out, especially to untrusted employees. This is trade secrets idea is a big joke, something used to shackle workers. Somehow Melissa Mayer was able to be hired directly from Google to Yahoo. I guess she knew nothing. Or could it be these agreements are for workers only, not the 1%?

    • Smith says:

      Leave your assistant coaching job for a head coaching job and guess what? You know all their plays and weaknesses. Leave your job as a prosecutor or SEC regulator and join a law firm, and take your knowledge with you. Do business with China, and you are forced to disclose all your technology and set up a factory with shared ownership. Switch jobs in the tech world, they ask in the application if you are restricted by any covenants. The answer is no because they are illegal.

  3. Kathy says:

    How about a “non-solicitation” clause or contract? Many of my clients are not worried about “trade secrets” per se, but are worried about a worker going to a competitor and luring away valuable customers. I counsel clients that a non-compete may not be enforceable–especially if too broad and/or too long, but a one year prohibition against contacting the clients of the former company is more reasonable and is often enforced–at least here in Maryland. Still, most of them want to have a non-compete in their contracts, in the hopes that it will make an employee think twice about going to a competitor.

    • Smith says:

      Non-solicitation is just another word for slavery. What else do you call controlling someone’s livelihood through means that are unconnected to their voluntary employment? All a company needs is a one year prohibition for non-solicitation, non-compete, and while we’re at it, don’t forget non-recruit (employees). Having to wait a year is sufficient impediment to starting a business in many if not most cases. It might as well be a thousand years. All these types of contracts need to be explicitly banned in Federal legislation, because we can’t count on the courts (i.e. Scott vs. Sandford).

      • Kathy says:

        I hardly think that non-solicitation is equivalent to slavery. It doesn’t prohibit someone from starting their own business or working for someone else, just from using the contacts and information that they got while working for someone to take that former employer’s customers. If they have a good business idea, they should work to get their own customers. And once that person does start their own business, you can bet they will be worried about their employees going out on their own and poaching their clients. I suspect that you never had your own business with employees, or you might feel differently.

        • Smith says:

          Non-solicitation does prohibit someone from starting their own business. How else do you think people often start businesses? Often in the exact way that they leave a business and take a customer or two with them. It’s wrong in principle to legally prevent this, which is why a business dares not try to extend the prohibition beyond some seemingly limited time period. It’s not applied where cost of entry is large. If I work for a shoe store, generally I’m not forced to sign an agreement saying I won’t quit and open up my own shoe store across the street and solicit the same customers, because I need money for a lease and inventory. I’m not allowed to steal an email list, but that’s not what we’re talking about, is it? In what sense does the owner of a business control the knowledge that a customer exists? In law there is a principle whereby unpatented technology of a business can be copied if it can be independently discovered, reverse engineered from a functional standpoint. No such claim is being made in non-solicitation, that the customer could not be discovered.

          Do your non-solicit prohibitions say anything about independent discovery?

          You must think of the economy as a closed system. Competition means everyone knows what everyone else is offering, that is the system we model, supply and demand.

          Advertising isn’t really about informing a customer of services, it’s about artificially raising demand.

          Moreover, what right does a business have to tell a customer who he can or can not conduct business. If that’s a primary concern, let the business try and get the customer to sign an exclusive long term contract. Most businesses can’t and instead force the employee to sign non solicitation because of a very unequal capital to labor relationship, they control the means of production and want to keep it that way. The non solicitation is just a way to raise cost of entry, barriers, dominate markets, monopolize, control labor, prevent competition and keep workers in their place.
          The fact that the business wants an employee to sign a non-solicitation is a sign that it would be of great significance and value in starting a new business. Non solicitation, non compete, non recruit, all immoral, unethical, noncompetitive, unfair restraints of trade. That is why they are on shaky constitutional ground.
          Non solicitation has nothing to do with investment and everything to do with coercion. If I open a blacksmith shop in the same village after working for an established smithy, you think I’m not getting some of customers I serviced? Even if the previous smith got his customers from costly expenditures or years of fine craftsmanship and service?

          The argument for non-solicit says end the notion of a free market, competition, and supply and demand.

          • M says:

            That’s a good point about reverse-engineering and is something that comes into play when talking about the enforceability of noncompetes.

            The obvious flip side to your “immoral, unethical, noncompetitive, unfair” coin is shouldn’t individuals be allowed to make decisions about their lives without someone else telling them what to do? If I decide I want to sign a 2-year contract with an employer, I should be able to do that. I think it’s “unethical” for you to tell me what type of employment agreement I can sign.