Law Firm's New Approach to Restrictive Covenant Ruled Valid by N.C. Supreme Court

GREENVILLE, N.C. (January 6, 2003) - An innovative "cost sharing" style of restrictive covenant contained in a physician employment contract was upheld as valid by the North Carolina Supreme Court in a landmark case of first impression. The visionary agreement, drafted by Ward and Smith, P.A. to protect a medical practice's investment in its new employee, resulted in a doctor's liability for damages in excess of $100,000 to her former employer, a multi-specialty medical practice.

On December 20, 2002, the NC Supreme Court upheld a May 7, 2002 ruling of the North Carolina Court of Appeals, affirming a 2-1 opinion that the doctor must pay damages to her former employer under the cost sharing agreement she signed. The ruling marks the first time that both courts have ruled in favor of validity in an area that up until now has been uncertain: what medical practices can do to protect their often substantial commitment of capital and related investments undertaken on behalf of employees.

Ward and Smith attorney J. Troy Smith, Jr. drafted the precedent-setting agreement, whose language is likely to become standard in the legal field. Ward and Smith attorney A. Charles Ellis represented the medical group before both the N.C. Court of Appeals and the N.C. Supreme Court.

"The court has reconfirmed that this is an enforceable liquidated damages clause," said Attorney Ellis. Unlike penalty clauses, the general rule holds that liquidated damages clauses which are reasonable are enforceable as part of a contract and are collectible.

Attorney Smith foresaw that a traditional covenant "not to compete" would leave the medical group vulnerable to losing money spent for training and development of new employees. The firm devised an alternative cost sharing agreement, which contained a formula to calculate damages that would become effective if the physician practiced in a three-county area in the year after employment ended. The terms of the agreement effectively circumvented the issues often encountered in enforcing noncompete agreements in the health care field. The agreement did not prohibit practicing medicine after termination of employment, but instead provided that the physician would pay a cost share to the practice for damages which it had suffered.

Appeals Court Judge John Tyson called Smith's formula for determining the cost share "very precise." The terms below describe the cost share formula for computing damages:

• The total operating expense of the medical group in the year preceding the termination would be divided by the number of full-time physicians in that time period.
• That quotient would then be multiplied by 25 percent, with the product being the cost share amount.

Tyson said that the damages the doctor is required to pay are only 3 percent of the $3.5 million she produced for the medical group in one year. He noted that the use of mathematical formulas to compute liquidated damages had been approved by the state Supreme Court.

The Court of Appeals ruled the cost sharing agreement valid, stating that it "was not a covenant not to compete," and that the doctor breached the contract when she opened her office within the specified geographic area. Thus, she became liable for a share of her former employer's employee training and development costs as well as overhead costs.

The Court of Appeals stated specifically: "We hold that the cost sharing provision is not a covenant not to compete and we do not subject it to the strict scrutiny as to reasonableness and public policy required with a covenant not to compete. The cost sharing provision at issue here is designed to protect plaintiff against competition by defendant within the three counties described. The contract does not prohibit defendant from engaging in the practice of her profession, but only provides that if she does so within the described three county area, she will pay a certain sum for making this choice."

The ruling is exciting for medical practices and other health care companies. The clear language of the agreement drafted by Ward and Smith will allow practices to move forward confidently with hiring practices and invest in their employees without fear of financial loss when employment contracts are breached or terminated.

Ward and Smith, P.A. is the largest law firm based in eastern North Carolina and serves as counsel for more mid- and large-sized businesses in the region than any other firm. More than 50 attorneys serve clients locally, regionally, nationally, and internationally from offices in Greenville, New Bern, Raleigh, and Wilmington. Ward and Smith is rated as one of America's Greatest Places to Work with a Law Degree by Harcourt Brace. The firm is home to 11 attorneys included in the publication, The Best Lawyers in America, and six attorneys selected as "Legal Elite" from peer-review surveys published by Business North Carolina.