FTC Proposed Non-Compete Ban: Impact on Nonprofit Hospitals and Nonprofit Affiliates

As has been extensively reported, on January 5 the Federal Trade Commission (“FTC”) proposed a rule (the “Proposed Rule”) that would, with only limited exceptions, prohibit employers from using non-compete clauses. More specifically, the FTC’s new rule would make it illegal for an employer to:

• enter into or attempt to enter into a non-compete with a worker
• maintain a non-compete with a worker
• represent to a worker, under certain circumstances, that the worker is subject to a non-compete

The Proposed Rule would also require employers to rescind existing non-competes and actively inform workers that they are no longer in effect.

If finalized in its current form, the Proposed Rule would obviously have a profound and dramatic impact on employers in every line of business, including the health care industry. That said, a critical threshold question with respect to the Proposed Rule and its impact on health care employers is whether and to what extent the rule is applicable to nonprofit health care organizations, and, in particular, organizations that have been recognized by the IRS as tax-exempt organizations under Section 501(c)(3) of the Internal Revenue Code (“Code”).

While this question is not specifically addressed in the Proposed Rule, there is language there that supports the conclusion that the rule, if finalized in its present form, will not apply to many, if not most, of these organizations.

The starting point is language in Section V of the Proposed Rule in which the FTC describes each section of the rule on a section-by-section basis.

In subsection I(c) of Section V, the FTC states that the “[r]ule would apply only to non-compete clauses between employers and workers.” For this purpose, an “employer” would include any “person” that hires or contracts with a worker to work for the person, and a “person” would be defined as any natural person, partnership, corporation, association or other legal entity. On its face, this would of course be broad enough to result in Section 501(c)(3) organizations being considered employers. However, the FTC goes on to state that:

“Some entities that would otherwise be employers may not be subject to the [r]ule to the extent that they are exempted from coverage under the FTC Act. These entities include … an entity that is not ‘organized to carry on business for its own profit or that of its members.’” [emphasis supplied]

Health care organizations that have qualified as Section 501(c)(3) organizations must be organized and operated exclusively for exempt purposes as set forth in Section 501(c)(3) of the Code and none of their earnings may inure to any private shareholder or individual. While a Section 501(c)(3) organization (e.g., a tax-exempt hospital) may have net earnings from the carrying on of its exempt purposes, those net earnings must be exclusively used/dedicated to exempt purposes. Accordingly, such net earnings should not be considered as having arisen from the carrying on of a business for profit and the Section 501(c)(3) organization should not be considered an “employer” subject to the prohibition on non-competes.

This result should not change on account of the fact that, as is often the case, a Section 501(c)(3) health care organization, such as a tax-exempt hospital, has a member that is itself a Section 501(c)(3) organization (typically a parent-type entity whose Section 501(c)(3) status derives from its being a “supporting organization”). Nor should the fact that the Section 501(c)(3) subsidiary makes contributions or transfers assets to the parent, provided they are used for Section 501(c)(3) purposes, affect the nonprofit status. In such cases, the Section 501(c)(3) continues to be an entity not organized to carry on business for its own profit or that of its members.

The analysis may become more complicated where the Section 501(c)(3) organization also conducts activities that constitute an unrelated trade or business. Assuming the conduct of the unrelated trade or business does not impair the tax-exempt status of the Section 501(c)(3) organization, that any net earnings are used exclusively for Section 501(c)(3) purposes, and that any member is itself a Section 501(c)(3), it can certainly be asserted that, notwithstanding the unrelated trade or business, the Section 501(c)(3) remains an entity not organized to carry on business for its own profit or the profit of its members. That said, the FTC may assert that the receipt of unrelated business income, irrespective of its amount relative to the exempt purpose income, results in the organization no longer being considered an entity “not organized to carry on business for its own profit.” Under such circumstances, the Section 501(c)(3) would not enjoy the exemption and could be an “employer” for purposes of triggering the proposed prohibition on non-competes.

The issues presented take on an even greater degree of complexity in various other circumstances. Among others, for example, does a Section 501(c)(3) nonprofit become an “employer” for purposes of the prohibition on non-competes where it has an ownership interest in a for-profit entity (e.g., a for-profit subsidiary) whose business activities it does not itself conduct but from whom it receives dividend or rental income? What about a Section 501(c)(3) organization that derives exempt function income from its participation in a joint venture with for-profit partners? What about a Section 501(c)(3) organization that wishes to employ physicians in a state where corporate practice of medicine rules require it to be organized as a professional corporation (i.e., instead of a nonprofit), but the governing instruments do include the organizational and operational language required to obtain tax-exempt status?

In a subsequent blog post we will review some previously issued FTC advisory opinions and several court cases that provide some useful guidance in addressing these issues and related issues. We will also delve into the applicability of the proposed non-compete ban on for-profit health care institutions as well as the parameters of the exemption as it applies to non-competes entered into in connection with mergers and acquisitions.