Introduction
A covenant not to compete (a.k.a. a non-compete agreement) is a contract or clause in a contract specifying that an employee or contractor (often through a professional services agreement) must not enter into competition with their employer or client. This agreement is for a specified period of time after the employment or service contract is over. The covenant not to compete may be in the context of other restrictive covenants, such as confidentiality covenants that prohibit the employee or contractor from revealing proprietary information or secrets to any other parties during or after their employment or contract.
Covenants not to compete, as well as certain other forms of restrictive covenants, are receiving more criticism and we are observing limited enforceability in a growing number of states. Critics have argued that non-compete agreements in healthcare may reduce market efficiency, contribute to labor shortages in areas for which it is difficult to recruit, and ultimately hurt patients and consumers. During the last several years, in which the healthcare industry has experienced intense and troublesome staffing shortages, several states have narrowed or even banned enforcement of non-compete agreements with physicians and other types of healthcare providers. In some cases, the bans allow for civil and/or criminal penalties against a party requesting or seeking to enforce a non-compete agreement. Due to changes or risk with application, it may be time to consider alternative structures to better contract provider alignment, continuity, and tenure.
Background
As early as the 19th century, non-compete agreements were used to protect valuable and confidential information, particularly in trade. By the 1950s, non-compete agreements were regularly used to prevent employees from taking sensitive information and training practices to competitors.
In the 1980s and 1990s, hospitals and their affiliated physician groups began requiring physicians to sign non-compete agreements as a condition for employment and service contracts to protect financial interests and investments related to the costs of recruiting, relocating, training, and marketing of physicians. They remain common features of employment and professional services agreements.
However, despite their current prevalence, non-compete agreements are of limited enforceability in a growing number of states. They have historically been criticized for restricting employee freedom of movement in ways that are anti-competitive. Critics have argued that non-compete agreements in healthcare reduce market efficiency, contribute to labor shortages in areas for which it is difficult to recruit, and ultimately hurt patients and consumers. During the last several years, in which the healthcare industry has experienced intense and troublesome professional staffing shortages, several states have narrowed or even banned the creation and enforcement of non-compete agreements with physicians. In some cases, the bans allow for civil and/or criminal penalties against a party requesting or seeking to enforce a non-compete agreement.
The scope and enforcement of non-compete agreements has historically been governed by state law – including both state statutes and case law – and therefore vary by state. Although the specifics vary, the general principles from state to state are similar. To be enforceable, non-compete agreements generally must be of reasonable geography, scope, and duration; must protect a legitimate business interest, such as trade secrets; and must be supported by proper consideration. In states that permit non-compete agreements, statutes and common law vary with respect to what constitutes reasonable geography, scope duration, legitimate business interest, and/or “consideration.”
There are various reasons to proceed carefully with non-compete agreements. Some of the components that parties must carefully consider in a non-compete agreement include the following:
- Duration: Non-compete agreements cover specific time frames, such as six months or one year. Longer-term agreements are prohibitively restrictive under the laws of certain states.
- Geography: The geographic scope may be important to both the enforceability and validity of the non-compete covenant in the relevant state or states.
- Scope of Services: Non-compete agreements must specify the type of work or services that a current or former employee cannot provide. Depending on the jurisdiction, they may need to specify information, techniques, procedures, and practices that are unique to the business or otherwise proprietary.
- Business Interest Protected by the Non-Compete Agreement: In many cases, it is important to document at the outset the interests that make the non-compete agreement necessary.
- Competitors: The competition must be defined in the agreement. The company does not need to list them all, but it should give a general idea of the industry and types of businesses the employee agrees to not work.
- Consideration: Generally, enforceability of a non-compete agreement depends on adequate consideration and the consideration is identified under the terms of the non-compete agreement.
- Damages: Enforcing parties define the damages they are entitled to if an employee breaches the agreement.
Comments on Valuation
Traditionally, the value of a non-compete agreement is represented by the present value of the cash flows that would be lost if the departing person were to compete, adjusted for the effective probability that the person will compete, and compete successfully.
The most common approach is to utilize a method of the Income Approach, termed the Lost Income Method (more commonly referred to as the “with and without” method). The Lost Income Method utilizes the same basic methodology as the Discounted Cash Flow Method (i.e., projecting distributable cash flow and discounting future cash flow to estimate present value); however, the Lost Income Method utilizes distributable cash flow assumptions that reflect the economic reality of competition by the person.
In contexts that implicates healthcare laws and regulations – the Stark Law, Antikickback Statute and parallel state laws, for example – valuation approach and methodology may need to be carefully considered to ensure they do not inappropriately take into consideration cash flows or market data reflecting physician referrals (we recommend reviewing the Bradford Regional Medical Center Case – 2010). This need for caution may complicate discussions and negotiations about compensation, contracting and buy-outs, and may significantly diminish or even defeat the risk mitigation purposes of non-compete agreements.
Changes on the Horizon
On January 5, 2023, The Federal Trade Commission (FTC) proposed a national ban on non-compete agreements. The Federal rule banning non-compete agreements, if finalized, will apply to employees and independent contractors, paid and unpaid. It will require employers “to rescind existing non-compete agreements and actively inform workers that they are no longer in effect.”
In its commentary on the issue, the FTC has argued that non-compete agreements “constitute an unfair method of competition and therefore violate Section 5 of the Federal Trade Commission Act.” Additionally, FTC Chair Lina M. Khan has noted that “non-compete [agreements] block workers from freely switching jobs, depriving them of higher wages and better working conditions, and depriving businesses of a talent pool that they need to build and expand. By ending this practice, the FTC’s proposed rule would promote greater dynamism, innovation, and healthy competition.”
The FTC’s proposed rule would prohibit employers from (1) entering new non-compete agreements with workers, and (2) maintaining most extant non-compete agreements with current staff. The proposed rule would generally not apply to other types of employment restrictions, like non-disclosure agreements. However, other types of employment restrictions could be subject to the rule if they are so broad in scope that they function as non-compete agreements.
Non-compete agreements remain relatively common in the healthcare sector for now, specifically in the provider space. It is common to see large institutions place affiliated/contracted physicians under non-compete agreements that restrict provision of clinical services within a certain geography for a certain period following the end of the employment or contractual relationship.
In a vacuum, one could promote that because a non-compete agreement has value and it is woven into a compensation offer, total physician compensation will decrease if non-compete agreements are eliminated. However, we suggest that other market dynamics, including but not limited to, supply and demand, inflation, technology, efficiencies, changes in reimbursement models, other offers from direct or indirect competitors for access to provider expertise, could all influence whether compensation increases or decreases following the elimination of non-compete agreements. Data from states that currently ban physician non-compete agreements don’t tell a consistent story. Eliminating non-compete agreements in a specific market affects competition in that market and may lead to an increase in compensation. In this context, compensation offers could increase significantly in the event of a ban on non-compete agreements (these offers would still need to be supported by fair market value).
Closing Comments
From a strategic perspective, contemplating other options to create better alignment may be a worthwhile endeavor. Several options that come to mind include creating deferred compensation pools or retention bonus allocations, enhanced non-solicitation arrangements, and alternative benefit arrangements (quality of life services) that accrue based on tenure with the employer or contracting organization. Compensation plans can significantly impact alignment with the provider community by creating opportunities to better align culture, satisfaction, performance, and retention of physicians through updates to compensation plans.
Whether or not there is a new Federal rule banning non-compete agreements, physician non-compete agreements may be increasingly disfavored for reasons related to state law and local market dynamics. Regardless of the Federal rulemaking process, this may be a good time to evaluate alternative options for aligning physicians and their employers through compensation plan design.
About the Authors – David White, Carlo Duaban, and Chris Louis are professionals within Pinnacle Healthcare Consulting, a nationally recognized healthcare advisory firm. David is based in the Denver office, while Carlo and Chris are based in the St. Louis office.
