In a unanimous decision the Supreme Court has decided the pleading standard necessary to survive a motion to dismiss for a complaint alleging an ERISA fiduciary entered into a prohibited transaction in Cunningham v. Cornell University. That case involved whether fiduciaries breached their duties of prudence and loyalty by paying excessive fees to service providers, namely Fidelity and the Teachers Insurance Annuity Association.

Background. ERISA proscribes a number of transactions as prohibited transactions. These are stated in terms of a transaction between a plan fiduciary and a “party in interest”. The trouble is that the definition of “party in interest” is quite broad, including all entities providing services to the plan. Without exceptions, any transaction with a service provider would be a prohibited transaction because a service provider is a party in interest. Section 1106 of ERISA says “[e]xcept as provided in Section 1108,” a fiduciary of a plan “shall not cause the plan to engage in a transaction” with a party in interest. Section 1108 contains 21 exemptions to the general prohibited transaction rule. Section 1108(b)(2)(A) states an exemption that permits “contracting or making reasonable arrangements with a party in interest for office space, or legal, accounting, or other services necessary for the establishment or operation of the plan, if no more than reasonable compensation is paid therefor.”

Decision. The high Court decided that plaintiffs need only allege a plan fiduciary engaged in a prohibited transaction, “no more, no less.” It need not plead or prove that any of the many exceptions to prohibited transactions do not serve as an affirmative defense, preventing relief. In so holding, the Court reversed the decision of the Second Circuit that dismissed the suit, holding that prohibited transaction claims based on service provider compensation have to have as a foundation allegations the services were either unnecessary and/or excessive in cost. That is, the complaint must plead the exception for reasonably necessary services for reasonable compensation does not apply. In so holding, the Second Circuit joined the Third, Seventh and Tenth Circuits. Those Circuits disagreed with cases in the Eighth and Ninth circuits holding that simply alleging a fiduciary entered into a transaction with a paid service provider was sufficient.  Therefore, the Supreme Court heard the case to resolve the split in the Circuits.

Justice Sotomayor, who wrote the opinion, reasoned that it is well settled in statutory construction that the burden of proving exceptions to statutory prohibitions rests on the one claiming such exception. In addressing the defendant-respondent’s argument that not requiring the complaint to address the exception would lead to more meritless litigation getting beyond motions to dismiss and forcing fiduciaries to bear more costs, Sotomayor stated those are serious concerns but they cannot overcome the statutory text and structure. She further stated that district courts can use existing tools under the Federal Rules of Civil Procedure to screen out meritless claims. For example, if a defendant files an answer claiming a Section 1108 exemption, the court can require the plaintiff file a reply showing the exemption does not apply.

The high Court’s decision means that many cases will get past the motion to dismiss phase. This is likely to mean the onslaught of excessive fee cases will continue.

Happy New Year! You may have noticed that December 29, 2024 came and went without the Internal Revenue System (“IRS”) issuing a new Employee Plans Compliance Resolution System (“EPCRS”) Revenue Procedure to incorporate the self-correction of eligible inadvertent failures in both qualified retirement plans and in IRAs.

Legislative Deadline Missed.

The IRS was directed in the legislation known as SECURE 2.0 that changed the law to permit self-correction of eligible inadvertent failures to update EPCRS within two years of the enactment date of December 29, 2022. The IRS was also supposed to apply such correction principles to a new correction program for IRAs by that date. When asked when the new EPCRS Revenue Procedure will be issued, Louis Leslie, Technical Assistant to the Director of Employee Plans said, “the plan is to get the new Revenue Procedure out during the first half of 2025.” Until then, employers should continue to follow the guidance of Notice 2023-43 with respect to eligible inadvertent failures. See IRS Issues Interim Guidance On Correcting Eligible Inadvertent Failures But Questions Remain.

EBSA Updates Voluntary Fiduciary Correction Program.

Meanwhile on January 14, 2024, the Employee Benefits Security Administration (“EBSA”) which administers the Department of Labor’s Voluntary Fiduciary Correction Program (“VFCP”) for the correction of fiduciary breaches, updated the program to add a new Self-Correction Component (“SCC”) to permit self-correction of two specific types of transactions: Delinquent Participant Contributions and Loan Repayments; and Eligible Inadvertent Participant Loan Failures. The VFCP permits plan fiduciaries, including plan sponsors, to correct certain fiduciary breach violations under the Employee Retirement Income Security Act (“ERISA”) by applying to EBSA for relief. The VFCP specifies nineteen enumerated categories of fiduciary violations that are eligible for correction. Plan sponsors may submit corrections to EBSA and if the plan sponsor’s correction is approved, EBSA will issue a “no-action” letter to the employer. The no-action letter states that EBSA will not take any civil enforcement action, including legal action and assessment of civil penalties, against the plan sponsor with respect to the corrected fiduciary breach. Under the SCC, the process is streamlined with the submitter simply filing a notice on the EBSA Web site. A no action letter will not be issued but the submitter still gets the benefits of one.

Delinquent Participant Contributions and Loan Repayments.

Participant contributions and loan repayments are considered delinquent when the employer fails to remit them to the plan timely. In general, an employer must transmit these contributions to the plan as soon as they can be segregated from the employer’s general assets, but in no case later than the fifteenth business day of the month immediately following the month in which the contribution is either withheld or received by the employer. There is a safe harbor rule for plans with fewer than one hundred participants, providing that contributions and payments are deemed timely if deposited within seven business days of withholding or receipt.

To be eligible for the SCC the total Lost Earnings on the delinquent participant contributions or loan repayments (“Delinquent Contributions”) must be $1,000 or less. Additionally, the Delinquent Contributions must have been remitted to the plan within 180 days from the date withheld from participants’ paychecks or receipt by the employer. The Lost Earnings on the Delinquent Contributions must be calculated using the Department of Labor’s online calculator and paid to the plan from the date the amount would otherwise have been payable to the participant in cash for amounts withheld from wages, or the date the payment is received by the employer for amounts paid to the employer. This differs from the calculation of Lost Earnings under the VFCP application process which is measured from the date the Delinquent Contributions could reasonably have been segregated from the employer’s general assets.

Instead of an application under the VFCP, under the SCC, a plan official or authorized representative such as an attorney or accountant (“self-corrector”) will electronically file a notice with EBSA on its Web site (“Notice”). The Notice requires the following information be provided: the name and email address of the self-corrector; the plan name; the plan sponsor’s employer identification number; the plan’s three-digit plan number; the Principal Amount and Lost Earnings, as defined under the program, and date paid to the plan; the date of withholding or receipt by the employer of the delinquent contributions; and the number of participants affected by the correction. Once filed, the self-corrector will receive by return email an SCC Notice and Acknowledgement (“Acknowledgement”) acknowledging the submission of the Notice.

The self-corrector must also collect docurments relevent to the correction and complete an SCC Retention Record Checklist which must be provided to the Plan Administrator. The checklist requires the following to be attached: a brief statement of why the employer did not make the contribution timely; proof of the corrective contributions; copies of the calculation from the online calculator; a statement describing employer policy changes, if any, to prevent reoccurrence; and a copy of the Acknowledgement. The self-corrector and each plan official seeking relief under the SCC must also sign a statement under penalty of perjury certifying that he or she is not under investigation, as defined under the program, and has reviewed the Acknowledgment, checklist, and documentation and to the best of his or her knowledge and belief the contents are true, correct, and complete. The statement must be provided to the Plan Administrator.

Eligible Inadvertent Participant Loan Failures.

In the past, in order to use the VFCP with respect to participant loan failures, the failures had to first be corrected with the IRS through the Voluntary Correction Program of EPCRS. However, in 2021 the IRS allowed Participant loan failures to be self-corrected under EPCRS. Further, Notice 2023-43 allowed Participant loan failures to be self-corrected as eligible inadvertent failures. The VFCP has now been updated to allow plan fiduciaries who have self-corrected a Participant loan failure as an eligible inadvertent failure under the new EPCRS or Notice 23-43 until the new EPCRS Revenue Procedure is issued.

Under the SCC for Participant loans an Eligible Inadvertent Participant Loan Failure is a participant loan failure that meets the requirements to be self-corrected as an eligible inadvertent failure under EPCRS. Additionally, a self-corrector can still use the SCC even if under investigation, as defined in the VFCP, provided the self-corrector is eligible to correct the failure under EPCRS. IRS Notce 23-43 permits a Participant loan failure to be self-corrected if the employer is under examination provided the sponsor had demonstrated a specific commitment to implement self-correction before the examination or during the examination if the loan failure is considered insignificant under the factors set forth in EPCRS.

Participant loans that do not meet the requirements of Code section 72(p) concerning the amount, duration, and level amortization that are self-corrected as eligible inadvertent failures under EPCRS may be self-corrected under the SCC. Additionally, loans that have been defaulted due to a failure to withhold repayments from the Participant’s wages, failures to obtain spousal consent, and loans exceeding the number of loans allowed under the plan can be self-corrected under SCC, if self-corrected under EPCRS.

To use the SCC, self-correctors must file the SCC Notice electronically with EBSA as under the SCC for Delinquent Contributions. However, the Notice requires information on the type of loan failure, amount, date identified and date corrected under EPCRS. Self-correctors are also required to provide documents regarding the self-correction to the Plan Administrator but do not have to complete the SCC Checklist. The documents to be provided are contact information; a short description of the type of Participant loan failure; the loan amount(s), the date the failure was identified; the date of correction; the correction method; and the number of Participants affected by the correction; and the Penalty of Perjury statement described above. The Plan Administrator must retain the documents.

Prohibited Transaction Exemption Also Amended.

In conjunction with the updated VFCP, EBSA also amended Prohibited Transaction Exemption (“PTE”) 2002-51, providing a class exemption for excise tax relief in connection with certain transactions corrected pursuant to the VFCP. The amended PTE extends the excise tax relief available under the VFCP to the failures now eligible for self-correction under the SCC. In order to rely on PTE 2002-51, self-correctors must receive the Acknowledgment from EBSA following filing the Notice. PTE 2002-51 amendments also eliminated the requirement that relief is not available to VFCP applicants that had taken advantage of the exemption for a similar type of transaction within the previous three years.

Conclusion.

While we still await the updated EPCRS, the updated VFCP adding self-correction components for certain transactions is a welcomed development. While there are still significant document retention requirements they aren’t terribly burdensome, if the employer is going to correct the failure anyway. In addition, when it comes to Participant loans, all the data is needed to correct them as an eligible inadvertent failure under EPCRS. It is likely that more employers will take advantage of the SCC under VFCP to get the assurance that EBSA will not begin an investigation or assess penalties.

On December 10, 2024, the United States Court of Appeals for the Second Circuit upheld a lower court’s dismissal and denial of leave to file an amended complaint in a case against Deloitte LLP alleging that its retirement plan (Plan) fiduciaries breached their duty of prudence by allowing the Plan to pay excessive fees to its recordkeeper. The case is Singh v. Deloitte LLP. The appeals court ruled when plan participants alleging their plan has been charged too much for administration costs, the complaint must demonstrate clear “apples-to-apples” comparisons to other plans, which the plaintiffs in this case did not do. Rather, the plaintiffs alleged that from 2015-2019 they paid direct and indirect (revenue sharing) expenses of $59.58 to $70.31 per participant compared to the 2019 direct costs of six other similar sized retirement plans that ranged from $21.00 to $34.00 per participant.

Apples to Oranges. The court found that the complaint only alleged conclusorily that the Plan’s recordkeeping fees exceeded those of the other plans and did not allege the specificity needed to state a claim. The complaint alleged next to nothing about the recordkeeping services provided to the Plan or the six comparable plans. Further, it failed to make apple-to-apple comparisons with other plans.

First, the original complaint compared the Plan’s direct and indirect recordkeeping costs to the direct recordkeeping costs of the comparable plans, alone. In their amended complaint the Plaintiffs only compared direct expenses among the plans, ignoring the indirect expenses. The court found that this meant the complaint failed to compare total recordkeeping costs and the direct expenses alone could not provide the complete picture.

Second, the complaint compared the Plan’s direct recordkeeping expenses from 2015-2019 to the fees the similar plans paid in 2019 alone, without any explanation. Further, the complaint did not specify the type of recordkeeping services that were provided for the fees to any of the plans. Therefore, the allegations lacked sufficient context for the court to infer that the services provided were comparable to those provided to the Plan or that the 2019 fees were a meaningful benchmark.

The court agreed with the lower court that absent greater specificity as to the type and quality of services provided to both the Plan and the comparable plans, Plaintiffs failed to state a claim for breach of the duty of prudence.

Conclusion. This case importantly lays out what plaintiffs must plead in an excessive fees case to survive a motion to dismiss. That is, an apples to apples comparison of fees spent for similar services in similar plans demonstrating the fees for the Plan in question are excessive.

Under Internal Revenue Code section 83(b), taxpayers who receive property, such as stock, in exchange for services that is subject to forfeiture, or is unvested for a certain period, may elect to pay income tax on the fair market value of the property as if it were not subject to forfeiture, or fully vested, in the year transferred instead of the year or years in which it vests (83(b) Election). For example, an employee may be issued 100 shares of employer stock at the beginning of 2025 that vests 20% on each December 31 that the employee remains employed from 2025 to 2029. Without the 83(b) Election, the employee recognizes taxable income on the fair market value of the 20 shares that vest each December 31, if still employed. This means that the stock must be valued each year and if it increases in any vesting year, the employee pays more tax in that year than if he or she filed the 83(b) Election. On the other hand, if the 83(b) Election is made, the employee recognizes income in 2024 on the fair market value of all 100 shares of stock on the date of transfer. In this manner, if the stock appreciates during the vesting period, the employee saves taxes. For this reason, the 83(b) Election is tax advantageous for employees receiving property for services in growing companies, such as start-ups.

To be effective an 83(b) Election must be filed by mail with the IRS office where the taxpayer making the election files his or her income tax return no later than 30 days following the date the property is transferred to the taxpayer. The election must contain certain information as provided in regulations, including: the name and Taxpayer Identification Number of the taxpayer making the election; a description of the property subject to the election; the date of transfer of the property; the fair market value of the property on the initial transfer; the type of restrictions on the property; and the amount, if any, paid for the property. The taxpayer must also provide a copy of the election to the transferor of the property.

The 83(b) Election has been in the Internal Revenue Code since 1969 and, until recently, there has never been an IRS Form for making the election. A sample election form was provided in 2012, in Revenue Procedure 2012-29. On November 7, 2024, the IRS released Form 15620 providing a uniform form for taxpayers to make the section 83(b) election. Form 15620 differs from the guidance in the Revenue Procedure as it asks for the name, address and Taxpayer Identification Number of the person transferring the property in exchange for the services (e.g., the employer). It also must be signed by the taxpayer under penalties of perjury. Importantly, taxpayers are not required to use the Form 15620 but can still file their own statement based on the sample from the Revenue Procedure or from the regulations. 

As of now, the Form 15620 or any other 83(b) Election cannot be filed electronically. However, the creation of Form 15620 may be the first step in allowing it to be filed electronically in the future.

On October 3, 2024, the IRS issued guidance on applying the Long-Term, Part-Time Employee (LTPT) rules to 403(b) plans beginning in 2025, as enacted in the legislation known as SECURE 2.0 in IRS Notice 2024-73 (Notice). The LTPT rules were first enacted to apply to 401(k) plans in the legislation known as the SECURE Act. LTPTs are part time employees who work more than 500 hours of service for a consecutive period. Originally for 401(k) plans that was three years for plan years beginning after December 31, 2020, but SECURE 2.0 changed it to two consecutive years beginning for plan years after December 31, 2024. SECURE 2.0 also extended the LTPT rules to 403(b) plans. LTPTs must be eligible to make elective deferrals to the plan but do not have to be eligible for matching or nonelective employer contributions. LTPTs also do not need to be included in discrimination tests for matching contributions. The Notice addresses how the LTPT rules coordinate with other exclusions from 403(b) plans.

Non-ERISA 403(b) Plans. First, the Notice confirms that the LTPT rules do not apply to non-ERISA 403(b) plans. For example, a governmental 403(b) plan is not subject to the LTPT rules because it is not a plan subject to ERISA. This eliminates plans of public schools.

Part-Time Employee Exclusion. While 403(b) plans are subject to the Universal Availability rule that basically says all employees of the employer sponsoring the plan must be eligible to make elective deferrals to the plan if any employee is eligible to make such deferrals, there is an important exception for part-time employees. Generally a 403(b) plan can exclude employees who normally work less than 20 hours per week. The Notice confirms that a 403(b) plan may continue to have the 20 hours per week exclusion. However, if an employee who normally works less than 20 hours per week nonetheless works 500 hours in two consecutive years, the employee becomes eligible to make elective deferrals. Additionally, if after becoming eligible as an LTPT, the employee meets the plan’s general eligibility requirements (e.g., 1,000 hours of service), the employee cannot be excluded from employer contributions.

Student Employee Exception. Another exclusion allowed under a 403(b) plan is students who are performing services at the school, college, or university at which they are enrolled and regularly attending classes. The Notice confirms that because this exclusion is not dependent upon service, such student employees are not affected by the LTPT rules. That is, they will not become eligible if they render 500 hours of services as a student employee for two consecutive years.

Effective Date. The Notice is effective for plan years beginning after December 31, 2024. Additionally, the Notice provides that the Treasury Department and IRS anticipate issuing proposed regulations for LTPTs in 403(b) plans that will be similar to the not yet finalized final regulations relating to LTPTs for 401(k) plans. The Notice also provides that the final 401(k) plan LTPT regulations will not be effective until plan years beginning after January 1, 2026. However, the law is still effective. Comments are requested by December 20, 2024.

Conclusion. Although plan amendments for LTPT rules are not required until the end of the 2026 plan year, 403(b) plan operations must be compliant by January 1, 2025. It should also be noted that employers can amend their plan by January 1, 2025, to provide that all part-time employees are immediately eligible for deferrals, and avoid having to administer the LTPT rules.

SECURE 2.0 codified that for plan years beginning after 2023, 401(k), 403(b), governmental 457(b) and SIMPLE IRA plans can provide matching contributions based on a participant’s repayment of student loan obligations that meet the requirements to be a qualified student loan repayment (QSLP). The Internal Revenue Service (IRS) had previously blessed such a plan design in a private letter ruling in 2018. On August 19, 2024, the IRS issued interim guidance in Q & A format, on such plan design to assist employers in implementing such programs in Notice 2024-63 (Notice).

QSLP. To be a QSLP, the employee-participant must be legally obligated to make the payment of the loan to pay for attendance at an educational institution by the employee, employee’s spouse, or employee’s dependent. The Notice states that a co-signer is legally obligated but a guarantor is only legally obligated when the primary borrower defaults. The employee must certify the payment is a QSLP.

The Notice provides that the plan cannot limit matching contributions to repayments of student loans for only certain employees or for pursuing only certain degrees, or for attending only certain schools. Also, a plan cannot prevent participants who are eligible to receive QSLP matching contributions from also making elective deferrals. Likewise, if a participant makes elective deferrals the participant can’t be precluded from being eligible to receive QDLP matching contributions. In addition, the QSLP matching contributions cannot have requirements stricter than those for matching contributions on elective deferral. A QSLP matching contribution for a plan year may be made omly with respect to QSLP loan repayments made in the same plan year.

Certification. The employee must annually certify the following items (1) the amount of the loan payment; (2) the date of the loan payment; (3) that the payment was made by the employee; (4) that the loan being repaid is a qualified education loan and was used to pay for qualified higher education expenses of the employee, the employee’s spouse, or the employee’s dependent; and (5) that the loan was incurred by the employee.

All items that must be certified can be done through the affirmative certification of the employee. Alternatively, items 1-3 can be certified by independent verification by the employer. An example provided in the Notice is where the loan payments are made through payroll deduction and the employer has all the information. Items 1-3 must be certified annually. Items 4 and 5 can only be certified by affirmative certification. However, an employee registering the loan with the plan satisfies this and need not be repeated annually.

The certification requirements can also be met by registering the loan with the plan to certify items 4 and 5, followed by passive certification of items 1-2 to the plan or employer by the lender, and the plan notifying the participant that it assumes item 3 has been satisfied (unless the employer has actual knowledge to the contrary), with the employee given a reasonable amout of time to correct the information in the notice.

Importantly, the notice provides that if an employee’s certification of a QSLP is determined to be erroneous, the match based on that certification need not be corrected.

Matching Procedures. Plans may establish any reasonable administrative features to implement a QSLP match feature. Whether procedures are reasonable depends on all facts and circumstances including whether the matches are effectively available to all eligible employees and whether employees have a reasonable opportunity to collect and furnish claim submission documentation. A plan may establish a single QSLP match claim deadline or multiple reasonable deadlines, such as quarterly.

ADP Testing. A plan that includes a QSLP match feature that is subject to ADP testing may elect to test the QSLP match feature separate from the rest of the plan. There are two methods to test the QSLP match feature separately. Under method 1, all employees who receive QSLP matches are tested separately. If such employees also make elective deferrals, those are taken into account in the separate test and are excluded from the main ADP test. Under method 2, if an employee that receives a QSLP match also made elective deferrals, those elective deferrals are included in the main ADP test and are excluded from the separate test. The two methods are designed to give employer’s flexibility in passing the ADP test. For a safe harbor plan not subject to the ADP test, a QSLP match feature can be added as a mid-year change, provided the notice and election opportunity conditions are satisfied.

Conclusion. The notice applies to plan year beginning after December 31, 2024. For plan years beginning before January 1, 2025, an employer may rely on a good faith, reasonable interpretation of section 110 of SECURE 2.0. The guidance in the Notice is a good faith, reasonable interpretation of that section. Therefore, following the Notice before 2025 will meet the standard. However, it should be noted that the Notice does not se forth the only reasonable, good faith interpretation of the section 110.

As reported in previous posts, on April 23, 2024, the Federal Trade Commission (FTC) issued a final rule that generally prohibits covenants not to compete (Rule). The rule was set to become effective September 4, 2024. See FTC’s Non-Compete Rule Affecting Executive Compensation Challenged in Courts. The Rule was immediately challenged in courts. On July 3, 2024, the United States District Court for the Northern District of Texas issued a preliminary injunction preventing the rule from being enforced against the Plaintiff in that case before the merits of the case were decided. However, the court refused to expand the injunction to all employers nationwide on a motion for reconsideration on July 10, 2024. See Court Denies Expanding Preliminary Injunction on FTC Non-Compete Rule. The court stated it would provide its decision on the merits of the case by August 30, 2024.

Meanwhile, two other cases had been filed, challenging the Rule. One was filed in a Pennsylania District Court and the other in a Florida District Court. On August 15, 2024, the Florida court agreed with the Northern District of Texas and issued a preliminary injunction against enforcement of the Rule against the Plaintiff until the court decides the merit. Like in Texas, the injunction only applies to the Plaintiff in the case. However, on July 23, 2024, the Pennsylvania District Court denied a preliminary injunction, finding that the Rule was likely valid.

On August 20, 2024, the Texas court issued its decision on the merits, finding that the FTC over stepped its authority in issuing the rule and that the Rule was arbitrary and capricious. Importantly, the court ruled that the Rule is set aside on a nationwide basis. The court rejected the FTC’s argument that the decision should be limited to the Plaintiffs bringing the case.

Employers can breathe a sigh of relief that the Rule will not go into effect on September 4. However, the FTC is likely to appeal the Texas court decision. Additionally, once the Pennsylvania District Court decides the merits, it is likely to uphold the Rule. If that decision is then appealed, there could be a split in the Appellate Circuit Courts that could set up the matter for review by the U.S. Supreme Court. California Employers should also remember that California state law prohibits covenants not to compete, with certain exceptions.

As reported in my previous article, Court Grants Preliminary Injunction Against FTC Ban on Non-Compete Agreements, the District Court granting the preliminary injunction from the FTC enforcing its ban on non-compete agreements limited the relief to only the plaintiff bringing the case, Ryan LLC, and not all business nationwide. I predicted that the Plaintiff would ask that the injunction be given nationwide effect when the court heard the merits of the case in August. On July 10, the Plaintiff and Plaintiff-Intervenors (Plaintiffs) filed a motion to reconsider the preliminary injunction ruling to expand it nationwide. Alternatively, they sought to apply the preliminary injunction to the members of the Plaintiff-Intervenor business associations in the case, the Chamber of Commerce of the United States, the Business Roundtable, the Texas Association of Business, and the Longview Chamber of Commerce, on associational standing grounds. The Plaintiffs reasoned that by limiting the preliminary injunction, all affected businesses must bear the expenses of preparing to comply with the FTC ban when it becomes effective on September 4, 2024, until the court decides the merits by August 30, 2024. Further, they noted, the court already ruled that the Plaintiffs have a likelihood of prevailing on their position that the FTC exceeded its authority in adopting the ban.

On July 11, 2024, the court denied the motion to reconsider in a one paragraph Order simply stating that the Plaintiff and Plaintiff-Intervenors “have not shown themselves entitled to the respective relief requested.” The Order doesn’t prevent the Plaintiff and Plaintiff-Intervenors from seeking a nation-wide permanent injunction when the court hears the merits of the case.

Another Challenge. In a separate case filed in a Pennsylvania district court in April, challenging the FTC ban, ATS Tree Services v. FTC, the court is expected to issue its ruling on the plaintiff’s motion for a preliminary injunction by July 23, 2024.  That court could issue a nationwide preliminary injunction if it chooses.

Supreme Court to Decide? Ultimately, both cases are likely to be appealed by the losing party to the United States Court of Appeals for their respective judicial circuits (the Fifth and Third Circuits, respectively), once the merits are decided. Should the circuit courts have opposing opinions the cases might wind up before the United States Supreme Court to decide the fate of the FTC ban.

As I wrote in April, a lawsuit filed by Ryan, LLC in the United States District Court for the Northern District of Texas, challenged the recently adopted Federal Trade Commission’s (FTC) rule making most non-compete agreements unenforceable (Rule). See FTC’s Non-Compete Rule Affecting Executive Compensation Challenged in Courts. On July 3, 2024, the court granted a preliminary injunction against enforcement of the Rule against the plaintiffs in that case (Plaintiffs), pending a decision on the merits. The court issued the preliminary injunction because it found the Plainiffs had a likelihood of succeeding on the merits that (1) the FTC exceeded its statuory authority in enacting the Rule; (2) the Rule was arbitrary and capricious; and (3) the Rule would cause irreparable harm to the Plaintiffs if a preliminary injunction were not issued.

FTC Exceeded Authority. Plaintiff’s claimed that the Rule exceeds the FTC’s statutory authority because the statute creating the FTC (FTC Act) does not authorize substantive rulemaking. The court stated the FTC Act grants the FTC the power to “classify corporations and to make rules and regulations for the purpose of carrying out the provisions” of the FTC Act. However, the judiciary remains the final authority with respect to questions of statutory construction and courts must reject administrative agency actions which exceed the agency’s statutory mandate. The court stated the question is whether the FTC’s ability to promulgate rules concerning unfair methods of competition include the authority to create substantive rules regarding unfair methods of competition. It concluded that the FTC Act gives the FTC authority to issue rules of agency organization procedure or practice not substantive rules. The court agreed with the Plaintiffs who pointed to the lack of a statutory penalty for violating rules promulgated by the FTC as demonstrating the lack of substantive rulemaking power. The court concluded that the text and structure of the FTC Act reveal the FTC lacks substantive rulemaking authority with respect to unfair methods of competition. Therefore, when adopting the Rule, the FTC exceeded its authority and the Plaintiffs are likely to succeed on the merits.

Arbitrary and Capricious. The court also found that there is a substantial likelihood that the Rule is arbitrary and capricious because it is unreasonably overbroad without a reasonable explanation as to why the FTC chose to impose such a sweeping prohibition. Further, the FTC did not sufficiently consider alternatives to the general ban.

Irreparable Harm. The court found that if a preliminary injunction were not issued, Plaintiffs would suffer immediate irreparable harm because they would not be able to rely on existing non-compete agreements or enter into new ones and would be required to notify workers that existing non-compete provisions are now invalid. This would increase the risk that departing workers might take intellectual property and proprietary methods to competitors. Further, significant time and resources would have to be spent to counteract the effect of the Rule.

No Nation-Wide Relief. While the court granted a preliminary injunction to prevent the FTC from enforcing the rule against the named Plaintiffs, it refused to make the preliminary injunction apply nation-wide. The main reason for limiting the injunction was that the Plaintiffs did not argue for nation-wide application in their briefs. The court stated it intended to issue a decision on the merits on or before August 30, 2024.

Stay Tuned. This preliminary decision indicates that the court is likely to issue a permanent injunction when it decides the case on the merits in August. Plaintiffs will likely ask for the decision to have nation-wide effect. Given the Supreme Court’s recent decision in Loper Bright Enterprises v. Raimondo, overturning Chevron‘s deference to administrative agencies, this could be the end of the FTC Rule.

On April 23, 2024 the Federal Trade Commission (FTC) issued its final rule that prohibits most non-compete clauses. The rule is effective 120 days after its publishing in the Federal Register (scheduled for May 7). However, lawsuits challenging the rule have already been filed.

Prohibition on Non-Compete Clauses.

Clauses preventing employees, especially higher-paid executives, from leaving their employer and going to or starting a competing business (Noncompete) have been a feature of many employment agreements, severance plans, and incentive compensation for a long time. Court rulings and state legislation have limited the scope of enforceable Noncompetes over the years. For example, in California a Noncompete is only enforceable where it prohibits the seller of a business interest from competing with the sold business. In January of 2023, the FTC proposed a nationwide ban on Noncompetes for all workers, including executive and other highly paid employees or independent contractors.

The final rule deems Noncompetes an unfair method of competition. It prohibits employers from entering into Noncompetes in the future and voids existing Noncompetes. It also requires employers to notify applicable employees and former employees that their Noncompetes are no longer enforceable. A change from the proposed rule is that there is an exception for existing Noncompetes with “senior executives”. A senior executive is an individual earning more than $151,164 in the preceding year (which is the top 15 percentile for full-time salaried workers in the nation) who is in a “policy-making position”. This is quite narrow as to be in a policy-making position one must be: the president, CEO or equivalent of the business; an officer of the business who has policy-making authority; or a non-officer of the business who has policy-making authority similar to an officer. Policy-making authority means final authority to make policy decisions that control significant aspects of a business entity. It does not include authority to only advise or exert influence over policy decisions or authority to make policy decisions for a subsidiary but not the entire common enterprise. This narrow definition excludes many highly paid employees such as sales and investment professionals or executives without policy-making authority.

Similar to California law, the rule does have an exception for a Noncompete entered into by the seller of a business entity or that persons interest in a business entity or the sale of all or substantially all the assets of a business entity. The final rule expanded the proposed rule which limited the exception to sales by substantial owners of the business only.

Open Questions.

The rule defines a Noncompete as a contractual term between an employer and worker that: prevents the worker from seeking or accepting work in the United States with a person; or operating a business in the United States after the conclusion of the worker’s employment. Questions remain as to whether nonsolicitation clauses prohibiting the solicitation of customers or employees would constitute a Noncompete under the rule.

Court Challenges.

As soon as the FTC issued the final rule, two lawsuits were filed challenging it. The Chamber of Commerce of the United States was joined by the Business Round Table in a suit filed in the federal district court for the Eastern District of Texas. Another suit was filed in the Northern District of Texas by the business tax services firm of Ryan LLC. Other suits are expected. The suits argue that the agency exceeded its administrative authority when issuing such a broad prohibition. The suits ask for a stay of enforcement and preliminary injunction preventing the FTC from enforcing the rule before the litigation is concluded.

The FTC believes it has clear legal authority to issue the ban. It set forth its position in the lengthy preamble to the final rule.

Conclusion.

If not affected by the court cases, the rule would not be effective until this September. Employers with existing Noncompetes should stay tuned to the litigation. However, employers should also begin to review all of its Noncompete agreements including those in employment agreements, severance plans, and incentive bonus plans to determine which are excepted as involving senior executives and which would not be enforceable if the rule stands. Additionally, if the rule stands, employers will have to reconsider whether changes to its benefit programs are warranted.