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Status of Covenants Not to Compete and Liquidated Damages Provisions

August 28, 2023

Question: Are covenants not to compete and liquidated damages provisions in employment agreements still enforceable? I have seen news reports about the Federal Trade Commission and National Labor Relations Board being critical of these things, and even proposing banning them.

Answer: As discussed in this column a few months ago, the FTC issued a notice of Proposed Rulemaking on Jan. 5, 2023, that would ban covenants not to compete in employment agreements. On May 30, 2023, a National Labor Relations Board General Counsel memorandum was issued stating that covenants not to compete violate the National Labor Relations Act and are therefore an unlawful employment practice.

However, neither of these actions render covenants not to compete or liquidated damages provisions in employment agreements unenforceable. For this to be the case the Federal Trade Commission would have to complete the rule-making process, and its proposed rule would have to become final. A final rule would also have to survive anticipated legal challenges. It is questionable whether the NLRB General Counsel opinion would have any application to employed dentists, who would likely be deemed “supervisory” employees. The NLRB would have to adopt the opinion, and, like an FTC final rule, the opinion would have to survive legal challenges that will very likely be brought.

A covenant not to compete in Michigan is enforceable if it is reasonably limited both as to the restricted geographic area and its term. Generally, this means a term of two years or less and a restricted geographic area limited to encompass only where patients of the employer’s practice reside.

Employers often exceed what is reasonable both by including a term of more than two years and refusing to make a determination where their patients reside. Other ways employers typically make their covenants not to compete unreasonable and risk them not being enforced include:

  • Having multiple restricted geographic areas (one running from each office of the employer) when the employee will only work in one office.
  • Not including an exception applicable when a termination of the employment agreement occurs in the short term (such as the first year) and the employee is not yet any competitive threat to the employer.

Liquidated damages provisions included in employment agreements are almost always unenforceable. The purpose of a liquidated damages provision is for the parties to establish in advance what the damages will be deemed to be in the event of a breach. This is necessary when the damages from a breach are difficult to measure for some reason. This is usually not the case for a dental practice, where the lost profit on a dental service that has been provided in violation of a covenant not to compete is known. Liquidated damages amounts (such as $10,000 per patient treated or per day practiced in violation of a covenant not to compete) will be deemed unenforceable penalties. This is because the amount sought has nothing to do with the employer’s actual damages resulting from the former employee’s breach.

Be aware that requiring provisions in your employment agreement that are unreasonable and likely unenforceable will cost you the opportunity to hire quality employees. No one wants to work for an employer using intimidation and fear in the place of reasonableness and fact when running its business. The best practice is to study where your patients reside, so that you can demonstrate to the prospective employee (and a court of law when necessary) why your restricted geographic scope is what it is. If you are going to include a liquidated damages provision, the best practice is to study your profit margins on a procedure-by-procedure basis and ensure that the liquidated damages amount bears a reasonable relation to the profit you expect to lose if there is a breach.

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