Non-compete employment agreements need to be reined in

Capitalism is all about efficiency, and free markets are its energy source. Non-compete employment agreements, though, have grown from covering a few key people in a firm to covering nearly everyone from the CEO to the cleanup crew. The transition took it from a reasonable practice to an abusive one.

This interfered with the labor market’s ability to allocate its resources freely, in the most efficient way. In the process these non-compete agreements had become a restriction on labor’s mobility, locking many workers into jobs in a modern form of serfdom.

In the Middle Ages, serfdom was an effective way to stabilize the agricultural workforce that the aristocracy depended on to supply their food as well as food for their military defense force. It did so, though, at the expense of labor market efficiency and quite possibly prolonged the impoverishment of so much of Europe’s population.

Labor market efficiency was not the principal factor in the recent awakening of state governments regarding non-compete agreements. Instead, it was complaints about what had clearly become an abusive practice. It didn’t seem fair.

For years, non-compete agreements were limited by the courts’ efforts to balance the interests of the employers and workers. Employers were entitled to a reasonable level of protection of their human resources from unlimited “poaching” of key people by rival firms. On the other hand, workers were entitled to a reasonable amount of freedom to seek the best level of compensation for their skills that they can.

The usual overload problems eventually arose because while “reasonable,” worked well it was not legally defined, and the courts were not equipped to withstand the geometric expansion in volume and scope of the new non-compete agreements. Businesses copied each other’s forms and expanding scope, of course, which effectively locked up markets for new job seekers. Especially in a recession or shrinking economic growth period, job opportunities became a “take it or leave it” world.

The extent of abusive practices can be seen in the kinds of non-compete agreements that state governments felt they had to stop. Washington state, for example, which passed its legislation in May of this year, includes a clause that states, “Noncompetition covenants longer than 18 months are presumptively unreasonable and unenforceable.” This new law will go into effect on January 1, 2020.

The need to ban non-compete agreements spanning over 18 months implies that employers were writing even longer ones – modern echoes of serfdom.

Taking its cue from other states, Washington’s new law will also exempt low income wage earners from non-compete agreements. The pursuit of labor stability, even down to the minimum wage, entry level workers, was the direct result of two economic factors: the record-low unemployment level; and the shrinkage in the illegal immigrant labor pool. But forcing minimum wage, entry level job seekers to sign a non-compete agreement is clearly abusive.

Individual states have different perspectives on economics, though, and while other states exempt minimum wage and low-income workers, Washington state’s law will exempt any individual earning less than $100,000 per year from enforceable non-compete agreements. That is the equivalent of $50 per hour, which is a wage level that at this time even labor unions could only dream of. It says something about the economic situation in the state, especially in the Seattle area, that the legislature set the threshold for low-income workers so high.

The good side of the Washington state law’s setting the exemption level so high is that it clearly rejects the effort to control the labor market and, instead, marks a return to the earlier, reasonable goal of protecting just a company’s interest in key personnel who would be very difficult to replace.

Some of those key people occupy important management positions, but there are also people who are “key” because of their knowledge of the technology, market strategy, or business plans that a firm doesn’t want its competitors to have. If a firm wants to protect its interests in these people with a non-complete agreement it must ensure that they qualify for an enforceable contract under the new law. And that might mean higher pay for the worker. It may help some firms to envision this key personnel decision as resembling the “key player” tag in the NFL. These designations come in several types, but generally they protect the team from losing the player to a competitor team if certain conditions are met, and it often means a boost in compensation.

Washington state’s new legislation won’t prohibit the use of on non-compete agreements but will restrict their widespread popularity with employers. It is an example of “nudge” economic policy. Free markets work with remarkable efficiency, but sometimes they need a nudge to keep them on track.