Restrictive covenants

In November 2010, the State of Michigan Court of Appeals upheld a Circuit Court Judgment that confirmed an arbitration award that ordered the selling dentist to pay a total of 80% of the purchase price in damages plus attorney’s fees and investigating expenses because he violated a restrictive covenant. (Case No 293996 Oakland Circuit Court LC No. 2009-098520-CK)

The defendant (seller) in this case entered into an agreement in which he sold his practice and agreed to not practice dentistry within a 25 mile radius of the practice he sold, or to solicit patients from the practice.

A restrictive covenant is usually a very straight forward and common provision (or separate contract) seen in most purchase and sale agreements, the intent of which is, to protect the purchaser in a transaction.

Information taken from the court decision indicates that the purchase and sale agreement contained several provisions that were considered by the arbitration, supported by the Circuit Court and ultimately upheld by the State of Michigan Court of Appeals:

-As is common, a certain amount of the purchase price was allocated to “Goodwill”.  In this case that amount was 80% of the purchase price.  

-The restrictive covenant provided that the seller would not practice dentistry within a 25 mile radius for a period of five years.

-The seller would not solicit patients from the practice for a period of five years.

-The contract contained a liquidated damages clause that provided that if the seller breached the restrictive covenant the purchasers would be entitled to 80% (the goodwill value) of the purchase price.

-The prevailing party would receive legal fees and costs.

In spite of, or perhaps in ignorance to, the restrictive covenant provisions, the seller opened a new practice in a community within the agreed upon 25 mile radius from the practice he sold to the buyers. Though in a different town, the new practice was still within the restricted area and he solicited patients from his previous practice.  Only about 100 patients actually transferred, which represented a small percentage of the active patient base at the time of the sale. Even so, the awarded damages amounted to 80% of the purchase price ($1,488,520) plus over $42,000 in legal fees, a total amount of $1,530,635!  This does not include the legal fees incurred by the seller to defend himself.

The question, then, can certainly be answered in the affirmative, at least in Michigan, Restrictive Covenants are enforceable!

The only state where there are statutory prohibitions against restrictive covenants is Alabama.  Other states have “reasonableness” restrictions which provide that a restrictive covenant has to be reasonable to be enforceable.  The reasonableness restrictions can apply to time as well as distance and are written to protect the purchaser without unreasonably restricting the seller from practicing his or her profession.  

Each state will have either statutory guidelines or case law that has established what is reasonable and enforceable.  Essentially, the restriction on the geographic area is situational and jurisdictional – it depends on where you live and what you are restricting.

Usually, the standard is, the restrictions have to be “reasonable.” If unreasonable, the court may disregard the restrictions set out in the contract and define what, in its belief, is reasonable. This decision is usually based on:

1. Protecting the employer, buyer or remaining partner from damage that could be caused to the practice by a violation of the restriction and;

2. Protecting the employee, seller or departing partner from undue restrictions of the practice of their chosen profession.

Generally speaking, highly populated areas will generally allow restrictions of smaller geographic areas whereas sparsely populated areas will have larger geographic areas of restriction.  There may also be different standards that apply to specialties that draw patients and referrals from larger geographic areas.

The amount of time a restriction can remain in force and effect is also determined by statute or case law, but is usually reasonable in nature.  A ten year restrictive covenant would most likely be held to be unreasonable if challenged in court.

One specific note about the case cited above is that there were specific contractual provisions for liquidated damages in the event of a breach.  The Michigan Circuit Court upheld the contractual provisions that were agreed to by the buyer and the seller and imposed the damages that were contained in the contract.  

In the event there is no liquidated damages provision in a contract, the court will decide on the damages incurred by a breach if any.  Most jurisdictions will try to determine actual damages and will not impose punitive damages, however these decisions are made by the court and the decisions are often dependent on intent and how egregious the breach was.

In many jurisdictions an injunction can be obtained from the court to prohibit the continued violation of a restrictive covenant and the court most likely will not consider any individual economic or other hardship that might be caused by an injunction or the penalty for violating a restrictive covenant.

It also should be noted that in the above case, the prevailing party was awarded attorney fees and costs.  This may or may not be the standard unless the “prevailing party” language is specifically included in the contract.

The bottom line: Restrictive Covenants are, in most states, enforceable and can be very expensive if violated. That said, restrictive covenants that are unreasonable will most likely not be enforced by the courts.

Having an experienced professional who works with dental practice sales on a regular basis and an attorney who knows the statutes and case law in your state are a must and could prove to be invaluable, whether you are buying or selling a dental practice.