NEW CHALLENGE TO ENFORCEABILITY OF COVENANTS NOT TO COMPETE
by
Smeeta S. Rishi
A case recently decided by a California Court of Appeals has a major impact on challenging the enforceability of covenants not to compete ("non-competes") contained in many shareholder buy-sell agreements, particularly non- competes typically adopted by shareholders of professional medical corporations.
It is common for shareholders of small and medium sized business corporations, including professional medical corporations, to enter into buy-sell agreements providing for the repurchase of a shareholder's stock upon the occurrence of certain specified events, such as a shareholder's death, disability or termination of employment with the employer corporation. California law renders covenants not to compete unenforceable unless they comply with Section 16600, et all, of the Business & Professions Code. Section 16601 states that a non-compete is enforceable in the context of the purchase of all of a shareholder's stock in a corporation, provided that the covenant is reasonable in terms of area and time. Non-competes are typically used in this context to prevent a shareholder whose shares are repurchased by the corporation from competing with the business of the corporation for the duration and in the geographic area specified in the non-compete.
The California Appeals Court held in Hill Medical Corp. v. Wycoff, decided on January 30, 2001, that a non-compete is not enforceable unless the purchase price for the departing shareholder's shares includes payment for the goodwill of the corporation. Specifically, the court requires a "clear indication that . . . the parties valued or considered goodwill as a component of the sales price." . The holding in Hill Medical is controversial, because arguably the plain language of Section 16601 does not support the Court's finding.
Hill Medical Corp. v. Wycoff involved the enforceability of a covenant not to compete by a shareholder whose shares were repurchased by his former employer, a professional medical corporation providing radiology services. Hill Medical Corporation sought to enforce a non-compete against a departing shareholder, stating that a shareholder whose shares were repurchased by the corporation would not compete within a 7.5-mile radius of any of the Corporation's facilities for a period of three years.
The share buy sell agreement in this instance, contained a purchase price formula for the value of shares based on the net book value of the corporation's assets and specifically excluded goodwill from being valued for purposes of the buy sell agreement. This case is particularly important to medical groups as the manner in which the purchase price was determined pursuant to the buy sell agreement between the Hill Medical Corporation and its shareholders is typical to the buy sell agreement amongst many medical groups, specially groups with specialty rather than primary care, practices.
The court did not provide a great deal of guidance on the manner goodwill should be valued to uphold the enforceability of the covenant not to compete. The court stated that it was not requiring a fair market value appraisal to sustain a non-compete. However, it is doubtful from the tone of the decision that placing a nominal value would have sufficed to make the covenant enforceable.
Corporations who place importance on the covenant not to compete need to take a close look at their buy-sell agreements. If the buy-out is for book value alone, then there is serious danger that the non-compete will be held to be unenforceable, at least if Hill Medical is followed in subsequent decisions. It is still to early after the case was published to predict what type of valuation of goodwill would satisfy a court. Accordingly, planning a response to Hill Medical involves a balancing approach that weighs the importance of securing an airtight non-compete against business considerations of paying the price for goodwill.
