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April 15, 2014

Using Covenants Not to Compete in the Health Care Industry Part 1 – Understand the Basics

Covenants not to compete, and their “sister” covenants not to hire or solicit employees, and not to use or disclose trade secrets, are important protections that hospitals, medical practices, and other health care providers should always consider including in their agreements with key employees.  Although in some circumstances such covenants might not be enforceable, those circumstances are relatively uncommon, and these covenants can protect a health care entity from serious economic damages resulting from immediate competition by former employees.  The basic rules governing these covenants seem simple, but courts examine them closely because they are restraints on trade and competition. To understand the use of covenants for any particular employer-employee situation, first it is important to understand the basic rules themselves. 

  1. The covenant must be in writing and signed by the person to be bound.  This seems obvious, but too often an employer will include such covenants as part of unsigned policies and procedures and not as part of written employment agreements signed by the employee.  To be enforceable, a covenant not to compete must be in writing and be signed by the employee. 

  2. The covenant must be supported by valuable consideration.  In North Carolina, if a covenant is a condition of the initial employment (if the employee is advised that signing a covenant not to compete is a condition of employment), then the employment itself is the valuable consideration for the covenant.  The problem arises when an employer wants to start using covenants not to compete with existing key employees.  For such covenants to be enforceable, new consideration must be offered to the employee in exchange for the employee’s agreement to the covenant.  The new consideration can be a promotion – but it must be a bona fide promotion, with true additional responsibilities and true additional potential for increased income.  It can be a raise, but not a raise offered to all employees, including those who are not signing covenants.  It can be a one-time payment – that payment must be material, something of real value  For example, if a doctor makes $500,000 a year, offering $1,000 as consideration for signing an amendment to his employment contract to add a covenant not to compete might be viewed as inadequate consideration.  Unfortunately, there is no bright line defining what constitutes adequate consideration, and in each case, the particular facts involving that employee and employer are critical in determining the new consideration to offer.  

  3. The scope of the covenant must be limited so that it protects a legitimate business interest of the employer.  This rule is a bit more complicated. There are two primary considerations – the business activities of the employer while the employee is employed, and the involvement of the employee in those business activities.  For example, a hospital system would have a legitimate business interest in protecting against competition by former physician employees only in the practice areas and specialties offered by the hospital.  If the hospital did not offer in-patient psychiatric services, then there would be serious doubt that the hospital could enforce a covenant to prevent a former employee from being employed by a different hospital system for the purpose of offering in-patient psychiatric services.  But the rule goes further than merely looking at the services offered by the employer.  To be enforceable, the covenant cannot restrict an ex-employee from engaging in activities that he was not involved in (or substantially exposed to) during the term of employment.  Consider the employee hired for hospital management with responsibility over that hospital system’s owned or managed medical practices.  After four years, that employee leaves to work with a competitor, but in a position primarily involving a different area of hospital management – for example, overseeing applications for governmental grants and funding for clinical trial programs.  Can the former employer enjoin the ex-employee from accepting (or continuing in) this somewhat different position with a competitor? It will depend upon the facts.  If the new employer does not permit the ex-employee to be involved in the management, recruitment, or other activities related to that competitor’s owned or managed medical practices, does not permit him or her to disclose to the new employer any trade secret information, and otherwise ensures that the ex-employee does not violate the terms of the covenant in his or her new position with the competitor, the covenant may not be enforceable, because the ex-employee is engaged in an activity in which he or she was not involved in the former position.  Conversely, if the evidence shows that the ex-employee is assisting the new employer with aspects related to the new employer’s medical practices, then the covenant would be enforceable. 

  4. Finally, the limitation that a covenant protect legitimate business interests is also applied to prevent covenants from being enforced against employees who, if they became employed by a competitor, would not realistically pose a threat of material damage.  Covenants not to compete are likely to be unenforceable against employees who are not key providers of services (such as physicians, physician extenders, and management employees) and who otherwise do not have material involvement with or access to information regarding patients, referral sources, financial information, confidential IT systems, business plans, management activities, or other confidential or trade secret information.

  5. The covenant must be reasonable as to time and territory.  In the traditional employer-employee setting, and absent extraordinary circumstances, a covenant not to compete should generally not have a duration longer than two years.  In addition, the territory in which the covenant applies not only must be limited to the territory in which the employer conducts its business, but also will likely be limited to the territory in which the employee was actually involved in providing services.  Imagine a health care employer with locations scattered across North Carolina.  If an employee is hired to manage or provide physician services in one specific geographic area for this health care entity, then the covenant can prevent competition within that geographic area.  The harder questions arise when the employer wants the territory to include the entire state of North Carolina or all states where the employer has locations.  To enforce a covenant broader than the territory in which the employee’s day-to-day activities are conducted requires a case-by-case factual determination.  For example, if the employee was involved in or materially exposed to information about the employer’s business activities, patients, referral sources, or other activities over a statewide or larger region, then the covenant may be enforced in this broader territory.  Conversely, if the employee had little actual involvement in the activities of the employer’s locations outside of the city or other geographic area in which he or she performed services, a court is unlikely to enforce the covenant to prevent competition outside of that city or geographic region. 

  6. Enforcement of the covenant must not be against public policy.  This final rule is particularly applicable in the health care industry.  It has most often been applied when a medical practice attempted to enforce a covenant to prevent a physician from competing in a highly specialized practice area or in an area underserved by physicians.  In essence, even if a covenant would be enforceable under all the other rules, it nonetheless will not be enforced if doing so would pose a risk to the public health or safety by denying the residents of a community adequate access to necessary health care professionals. Thus, if a rural community had only two orthopedic surgeons who practiced together and one left to form his own practice, it is highly unlikely that the orthopedic surgeon remaining with the original practice could enforce a covenant not to compete to prevent the other one from opening his own separate practice.

These are the basic rules.  In another issue, we will examine techniques for drafting covenants to maximize enforceability and deterring employees from leaving to compete against the employer.

© 2014 Poyner Spruill LLP. All rights reserved.

About the Author

Lee A. Spinks, Commercial Litigation Attorney, Poyner Spruill Law Firm
Partner

Lee's practice areas include Commercial Litigation, Business and Commercial Law, and Health Care Law.  He represents clients in state and federal courts, before administrative agencies, and in ADR proceedings including arbitration, mediation, and summary jury trials. He focuses his litigation practice on matters involving alleged accounting malpractice, "balance sheet" and reps and warranties disputes between buyers and sellers of businesses, claims made against banks, and other corporate, commercial, and banking litigation matters involving accounting issues...

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