Taking a Hammer to Noncompete Agreements Might Hurt Workers

(Bloomberg Opinion) -- This month, Illinois became the latest state to place severe limits on the enforceability of noncompete agreements. The new rules include a ban on the clauses for nearly all employees earning less than $75,000. 

Other states are considering their own restrictions. President Joe Biden has asked the Federal Trade Commission to consider regulating or banning the agreements.

There are lots of reasons to be skeptical about what many courts still call “covenants not to compete,” nowadays often known as NCAs. To begin with, they restrict the fundamental right of all individuals to sell their labor to the highest bidder. Some theorists — the matter is contested — argue that they limit innovation.

Three states, including California, ban them entirely; several others are considering whether to follow suit. For opponents, the fact that the clauses show up so often in the contracts of low-wage workers is a particular concern. (Just the other day, NPR ran a story about the difficulties they pose for yoga instructors.)

But before we jump on the bandwagon, let’s consider the matter a bit more closely. In particular, let’s try to figure out whether there are any circumstances in which covenants not to compete might be valuable to low-wage employees.

Noncompete clauses have become ubiquitous. A February 2021 study in the Journal of Law and Economics found that 18% of U.S. employees are bound by noncompete agreements. One-third did not learn of the requirement until after they’d accepted the job. 

It’s odious to add significant contract provisions during onboarding. The bargaining power of brand-new employees is relatively low because they have turned down other offers. (This concern applies well beyond noncompetes.)

The more important finding — consistent with other research — is that noncompetes are common across industries, and without regard to income and education. Some 13% of workers earning less than $40,000 a year and 14% of workers without a bachelor’s degree were bound by the agreements.

Most observers find it easy to understand why high-wage workers would be asked to sign noncompetes. That’s why many proposed laws — including the one just enacted in Illinois — extend protections mainly to those at the lower end of the wage scale. The underlying intuition is straightforward: In the absence of the restrictions imposed by a noncompete clause, the employer will be forced to pay a higher wage to induce the employee to stay.

But is the intuition correct? If a worker can leave at any time and sell her expertise on the market, the employer might be inclined to invest less in training. The result could easily be a less productive worker who earns a lower wage. Or if the employer does fully train the worker, a lower wage might compensate the company for the risk that the worker will take all that training across the street.

Still, this explanation doesn’t suffice to explain why noncompete agreements have become so common. No potential employee begins negotiations hoping to bargain for a noncompete clause. The inability to sell one’s skills for a higher wage is a cost, not a benefit. 

In a perfectly competitive labor market, therefore, we would expect compensation for the clause; that is, the employer would purchase the employee’s freedom to leave by paying a higher wage. This expectation explains why, even in the many states where noncompetes are allowed, courts are less likely to enforce them when employers are unable to show that they gave their employees something of value in exchange.

When jobs are few, however, the employer might impose an NCA as a tool for extracting surplus from the employee without offering a higher wage. A 2020 study by the economists Matthew S. Johnson and Michael Lipsitz confirms this instinct. By measuring the increase in noncompetes among low-wage employees during the Great Recession, when jobs were relatively scarce, Johnson and Lipsitz find exactly this result. Thus there’s good reason for the brouhaha.

But the Great Recession turns out not to be the end of the story. As part of the same analysis, Johnson and Lipsitz hypothesize that when the minimum wage rises, employers of low-wage labor will recoup some of their losses by expanding the use of noncompete clauses. They confirm the hypothesis through a study of the beauty salon industry. The clauses are more common in states that mandate higher wages.

The authors also make another useful discovery. The biggest debate in the minimum-wage literature revolves around how an increase affects employment. Johnson and Lipsitz find that the effect varies, depending on the enforceability of covenants not to compete. In states that enforce the clauses, they report, a rising minimum wage has no measurable effect on employment among low-wage workers. In states that don’t enforce the clauses, the effect is negative — that is, low-wage employment falls.

If these findings are correct — always a big “if” for an unexpected effect — employers may be using noncompetes to recover some of the surplus they’ve transferred to employees in the form of the legally mandated higher wage. Prohibiting the clauses for low-wage workers, despite its allure, might drive employers to find other means to recoup their losses; they might even, as the study of the salon industry implies, just employ fewer people.

None of this is to say that minimum wage increases are bad, or that covenants not to compete are good. What the findings do suggest is that banning noncompetes can raise the cost to the employer of low-wage labor. 

This suggests in turn, as the authors note, that any regulatory response to the conundrum of post-employment restrictions on labor ought to be nuanced. We don’t do nuance well these days — but, if regulators are cautious, Biden’s executive order might give them the chance to try.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Stephen L. Carter is a Bloomberg Opinion columnist. He is a professor of law at Yale University and was a clerk to U.S. Supreme Court Justice Thurgood Marshall. His novels include “The Emperor of Ocean Park,” and his latest nonfiction book is “Invisible: The Forgotten Story of the Black Woman Lawyer Who Took Down America's Most Powerful Mobster.”

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