To Boost Economy, Reconsider Noncompete Clauses

“After you leave our company, you cannot work for a competitor.”

Many people must have been forced by an employer to sign such a statement when they joined or left a company. These documents are called a post-employment noncompete clause, or a noncompete.

As is well-known, in Japan entertainers have a hard time changing their talent agency, and there are restrictions on corporate-sponsored athletes changing their affiliation.

To a company, a rival poaching its staff could mean the theft of corporate information and a threat to its survival. In such a case, the company will end up getting nothing back on the investments it made in its employees and will even be helping its competitors.

If companies were allowed to poach as they pleased, they might just recruit skilled employees from others without bothering to educate and train staff on their own. Workers would then lose out on opportunities to develop and improve their skills.

Such justifications for noncompetes seem plausible at first glance, but think about it a little more and you might realize how strange the logic is.

When a company has employees who are too valuable to lose, it should treat them better, such as by providing them with a higher salary. If a worker whom the company has invested in is poached, that means that worker’s skills are valuable for a competitor.

Restrictions on workers’ freedom to change jobs in the form of noncompetes make it inevitable that they will miss opportunities to be paid better and, instead, be stuck in low-paying jobs. For people looking for a new job so they can make the most of their skills, the best workplace will likely be a competitor to their current employer. When a potential employer lures a worker with a higher salary, it means that the person is either likely to achieve higher productivity at the competing company or is currently paid a low salary that is not commensurate with their productivity.

There are cases in which a switch to a competitor entails a sharp salary increase. This is obvious when we look at professional baseball teams, for example.

When a pro baseball player gains the right to become a free agent, their salary tends to jump thanks to an attractive offer from their current team, which hopes to keep them from leaving. And if the player does become a free agent, baseball teams often offer large multiyear contracts to dissuade them from signing with other teams.

To date, the pros and cons of noncompete clauses have been discussed in relation to labor law. The debate centers on which is more important: allowing people to work where they like or protecting corporate secrets and the recovery of investment costs.

However, existing labor law has not necessarily been able to provide adequate solutions to the problems faced by workers such as freelancers, who work on a contract basis that is fairly close to regular employment.

The Japan Fair Trade Commission (JFTC) has started keeping a close eye on the matter. In February 2018, the expert Study Group on Human Resource and Competition Policy, for which the JFTC serves as the secretariat, released a report touching on the issue of noncompetes and acknowledging that the Antimonopoly Law had major implications for competition over human resources.

The issue of noncompetes has also been on the agenda of the Cabinet Office’s Council for Promotion of Regulatory Reform. On April 17, one of the council’s working groups held a hearing with officials of the JFTC, the Health, Labor and Welfare Ministry and the Economy, Trade and Industry Ministry, as well as private-sector experts.

The economy ministry pointed out that noncompetes themselves are valid provided that certain conditions are fulfilled. It said such conditions include setting the period to one year or less, limiting the types of work and occupations that will be covered, and introducing compensatory measures such as high salaries.

For its part, the health ministry said the validity of noncompetes should be decided on a case-by-case basis by the courts. Judicial involvement is inevitable as the clauses have both benefits and drawbacks, it said.

Indeed, relying on individual court rulings provides flexibility, but in practice, it is difficult to determine whether any given noncompete agreement is legal or illegal. It is also difficult to imagine workers having sufficient legal knowledge as contracting parties. To make individual judgements less ambiguous, guidelines might be adopted that list clearer legal requirements.

Bold move by U.S.

In the United States, there has been a notable trend on the issue. On April 23, the U.S. Federal Trade Commission (FTC) issued a rule banning noncompetes across the United States for the vast majority of workers. The rule is set to take effect on Sept. 4.

At the state level, California, North Dakota, Oklahoma and Minnesota earlier banned noncompetes, and the number of states with similar bans under certain conditions has been growing in recent years.

One factor behind the FTC’s bold decision was empirical analysis in the field of economics, which has evolved rapidly in recent years. In the past, there was a view that workers under noncompetes were receiving higher salaries. It was assumed that companies were offering higher salaries to encourage employees to sign these clauses.

Nonetheless, rigorous economic research conducted recently on the effects of noncompetes has revealed that the clauses have actually lowered salaries. Moreover, employers have been found to make workers in low-paying fields also sign noncompetes even though company secrets are not involved. Equally important, the same research found that noncompetes are suppressing innovation.

The FTC expects its ban on noncompetes to expand new business formation by 2.7% per year, and boost the average U.S. worker’s earnings by $524 per year.

The rule is also expected to help drive innovation, resulting in an estimated 17,000 to 29,000 more patents each year for the next 10 years.

Once the rule goes into effect, existing noncompetes will no longer be enforceable. Employers will have to notify workers that they will not be enforcing any noncompetes against them. The FTC has prepared a sample notice on which employers just need to fill in their name.

There is good reason for the FTC to decide on an across-the-board ban instead of leaving courts to decide on whether a noncompete is beneficial. That is, judicial outcomes tend to lead to an asymmetry of information between employers and employees.

Many workers were not aware of the fact that a noncompete could be illegal. In other words, noncompetes have been widely used in the United States even though the courts would not recognize them in many cases.

For example, packing workers on short-term contracts, who were earning about $10 an hour, were reportedly made to sign noncompetes. Even in California, where noncompetes are banned, many companies make every employee sign a noncompete.

The latest research shows that the drawbacks of noncompetes outweigh their merits. Despite many dissenting opinions, the FTC is pushing ahead to improve workers’ well-being and the benefits for society as a whole by removing restrictions on the labor market.

Meanwhile, in Japan, salaries have long been sluggish. One major reason for this is that workers have been restricted in their ability to change jobs for a long time.

A change in such practice would likely help Japan’s economy move on from the 30 years it has “lost.” I have high expectations for the JFTC’s future measures.

Fumio Ohtake

Ohtake is a specially appointed professor at the Center for Infectious Disease Education and Research (CiDER) at Osaka University, where he served as an executive vice president in 2013-15. He was president of the Japanese Economic Association in 2020-21.

The original article in Japanese appeared in the June 30 issue of The Yomiuri Shimbun.