Scrutinize restrictive covenants

By Brian Wyatt, Esq.

They are illegal (with certain exceptions) in a few states, such as Delaware and Colorado, void as against public policy in others and looked upon with disfavor in most jurisdictions. Even the Judicial Council of the American Medical Association has gone on record against them. Nonetheless, restrictive covenants remain a fixture in physician employment contracts and also appear frequently in shareholders’ agreements executed when a physician acquires an ownership interest in a practice, and in asset purchase agreements executed in connection with the sale of a physician’s practice. Despite, or perhaps because of, their ubiquitous nature, physicians sometimes overlook these restrictive covenants. This may be because some physicians, quite naturally, focus on the terms of the ongoing relationship rather than on what will occur upon the perhaps seemingly unlikely termination of that relationship. In other cases, the physician may give little thought to the terms of a restrictive covenant based on the incorrect assumption that it would not be enforceable. However, in today’s ever-changing health care environment, physicians must be more attentive than ever to the nature and possible effect of the restrictive covenants in their agreements.

There are a number of issues which courts may consider when analyzing a restrictive covenant, and which physicians confronted with or trying to formulate a restrictive covenant should also keep in mind. These include the validity of the covenant, the reasonableness of its restrictions and the remedy for its breach. Most courts start their analysis from the perspective that, while restrictive covenants are disfavored and thus should be carefully scrutinized, they are generally enforceable to the extent that they are reasonable. Further, courts often attempt to balance the needs of the public and the interest of the physician-employee against the interests of the employer in protecting its goodwill, trade secrets, customer information and investment in training. In Pennsylvania, a restrictive employment covenant may be enforced if it is “ancillary to an employment agreement or a contract for the sale of a business” and “necessary to protect the legitimate interests of the employer or the purchaser of a business.”

Contractual Validity. The focus here is on whether there was adequate consideration given to the physician in exchange for entering into the restrictive covenant. In most cases, this is not an issue because either the hiring of the physician or the continuation of the physician’s employment is contingent upon the physician agreeing to be bound by the covenant. Similarly, restrictive covenants will usually be deemed validly entered into where the physician did so in connection with becoming a partner in or selling a practice, as in both instances the physician has received something of value, such as stock in the practice or payment for the physician’s ownership interest in exchange for entering into the covenant. However, adequate consideration may be lacking where a physician first enters into a restrictive covenant during an ongoing employment relationship without receiving in exchange any additional benefit.

Reasonableness of the Restriction. Two elements of a restrictive covenant which must be reasonable for the covenant to be enforceable are geographical area and duration. Courts have considerable flexibility in determining the reasonableness of the restrictions placed upon the physician and will look to a variety of factors in making this determination. For example, courts have often considered the ability of patients to secure treatment by a similarly qualified physician. Thus, where there is a shortage of physicians, courts have been more likely to read the restriction more narrowly. For example, in a leading Pennsylvania case, the court noted the shortage of orthopedic physicians in the restricted geographical area, as evidenced by significant delays in patients seeing the employer practice’s physicians. Accordingly, because “[t]he potential pool of clients far exceeds [the employer’s] ability to serve them,” the court held that the employer had failed to establish the element of irreparable injury required for a preliminary injunction to be issued. In cases not involving physician agreements, Pennsylvania courts have limited the geographical scope of the covenant to the area in which the employee worked and have held a covenant which was unlimited in duration invalid on its face.

Remedy. Restrictive covenants often contain a great deal of language about the employer’s recourse in the event the covenant is breached by the physician-employee. Breach of contract damages are always available to the extent that they can be proven. However, because of the often drawn out nature of the litigation process, employers include either or both of two remedies designed to prevent the physician from competing from the time of the physician’s employment is terminated or to compensate the employer if the physician does compete: a preliminary injunction and liquidated damages.

For a court to issue a preliminary injunction, the employer must meet a heavy burden. For example, under Pennsylvania law, the employer must show that:

• It is necessary to prevent immediate and irreparable harm which could not be compensated by damages.

• Greater injury would result by refusing it than by granting it.

• It properly restores the parties to their status as it existed immediately prior to the allegedly wrongful conduct.

Most restrictive covenants contain a recital in which the employee agrees that, in the event the covenant is breached, damages will not be sufficient and the employer will be entitled to injunctive relief. Judicial precedent establishes that merely making these statements do not make it so. The court will engage in its analysis of whether the injunction should be issued with the recital in the covenant providing, at best, evidence in the employer’s favor.

While liquidated damages clauses have been held per se unreasonable in some jurisdictions, most jurisdictions will enforce them. A liquidated damages clause will generally be enforceable so long as it is not a penalty or forfeiture clause and the liquidated damages are reasonably calculated. The “reasonably calculated” requirement means that the employer must make a reasonable effort to calculate what the economic damages to the practice will be if the physician breaches the covenant. In Pennsylvania, the courts will consider the intent of the parties, as demonstrated by the following criteria, to differentiate a valid liquidated damages clause from an invalid penalty or forfeiture provision:

• Whether damages are uncertain or very difficult of being ascertained.

• Whether the party is bound for a specific sum not to carry on a particular trade, profession or business within certain limits or for a certain period of time.

• Whether the sum is fixed as security for the performance of a number of contractual provisions, some of which are capable of accurate valuation.

• Whether the covenant relates to the performance or abstention from performing a certain act or acts which are not measurable by exact pecuniary standard and damages are stipulated as a sum for violating the covenant.

Thus, where the liquidated damages are reasonably calculated and not intended to punish, the provision will be enforceable.

Restrictive covenants continue to be used widely in physicians’ employment, shareholders’ and asset purchase agreements, and their provisions are generally enforceable in most jurisdictions. The issuance of a preliminary injunction or the enforcement of a liquidated damages clause would likely cause the physician-employee significant harm. Therefore, the prudent physician should read these provisions carefully and seek legal counsel regarding their potential effect.

Brian Wyatt, Esq., is an associate with the law firm Schnader Harrison Segal & Lewis in their Philadelphia office.