INTERPRETATION OF RESTRICTIVE COVENANTS IN ARIZONA
By Ray K. Harris and Donald R. Gilbert
Contracts with technical
and professional employees (as well as sales and marketing employees)
often contain provisions restricting the employee's conduct after termination
of the employment relationship. These provisions (called "restrictive
covenants") can: prohibit disclosure of confidential information;
prohibit solicitation of clients, customers, vendors or other contacts
developed during the employment relationship; or prohibit competition
with the former employer. These restrictive covenants are enforceable
if they are "reasonable." As a general rule, any restraint greater
than necessary to protect the employer's legitimate interests is unreasonable.
See Restatement (Second) of Contracts, Section 188, Comment a (1981);
Restatement (Third) of Unfair Competition, Section 41, Comment d (1995).
Covenants contained in an employment contract that prohibit competition
are subject to the closest scrutiny. The prohibition against competition
must be reasonably limited in both geographic scope and duration. It is
not always possible to predict what a court will consider reasonable.
Therefore, restrictive
covenants are often accompanied by a contract term that allows unreasonable
provisions to be severed and ignored. The Arizona Supreme Court recently
provided guidance on how to interpret these contract provisions in Valley
Medical Specialists v. Farber, 298 Ariz. Adv. Rptr. 34 (June 18, 1999).
The Farber case expressly disapproved the approach adopted by the Arizona
Court of Appeals 10 years earlier in a similar case (Phoenix Orthopedic
Surgeons Ltd. v. Peairs, 164 Ariz. 54, 790 P.2d 752 (App. 1989)). The
Farber decision is especially significant because most restrictive covenants
involving Arizona medical practitioners have been patterned after the
restrictive covenants upheld in the Peairs case.
The Peairs Case
Dr. Peairs went to work in 1985. Dr. Peairs agreed (in his 1985 contract)
that he would not "practice orthopedic medicine and surgery"
for a period of 3 years after his termination within 5 miles of his firm's
offices. After 2 years Dr. Peairs terminated his employment. He was sued
for breach of the non-competition provision, and the trial court granted
an injunction that prohibited Dr. Peairs from maintaining an office in
the restricted area and from performing surgery at the three hospitals
within the area. The trial court allowed Dr. Peairs to serve as a volunteer
team physician at a Deer Valley High School because of the potential harm
to the high school if he was barred from that conduct. The trial court
also modified the injunction to allow Dr. Peairs to see patients "seeking
emergency care at a hospital within the restricted area." The court
allowed these modifications because the employment contract had a severability
clause stating "should any provision of this agreement be, or become,
unenforceable, the remaining provisions shall nevertheless be carried
into effect." The modification allowed Dr. Peairs to perform medical
services necessary "for the welfare of the public."
In 1989 the Arizona
Court of Appeals upheld the injunction enforcing the contract, affirming
that the restriction on practice within a 5-mile radius of his former
firm's offices was reasonable. The Court rejected an argument that all
restrictive covenants involving medical practitioners violate public policy
and adopted the trial court's modifications of the covenants because the
employment contract contained a severability clause.
The Farber Case
Like Dr. Peairs, Dr. Farber became employed in 1985. Unlike Dr. Peairs,
Dr. Farber was not subject to any restrictive covenant. After the decision
in the Peairs case, however, Dr. Farber became a shareholder in the practice
and agreed that he would not provide medical care and assistance for a
period of 3 years after his termination within 5 miles of his firm's offices.
Dr. Farber terminated his employment in 1994 and was sued for violating
the prohibition on competition. This time, however, the trial court held
the restrictions were unreasonable and could not be rewritten by the trial
to make them enforceable.
First, the trial court
found the geographic scope of the covenant unreasonable. Although it was
limited to the same 5 mile radius upheld in the Peairs case, the 3 offices
of Dr. Peairs' medical group were "clustered" in northwest Phoenix.
In contrast, the 3 offices of Dr. Farber's medical group were in Phoenix,
Scottsdale and Mesa. The total restricted area was 235 square miles and
the court considered this scope unreasonable. The Court further found
the geographic restriction to be unreasonable because it did not provide
an exception for emergency medical aid and was not limited to pulmonology.
Second, the trial
court found the duration of the covenant unreasonable. Although it was
limited to the same 3 year period upheld in the Peairs case, the court
found any pulmonary patient would consult their doctor at least every
6 months. After 6 months virtually all of the patients would have decided
which pulomonologist to consult. Thereafter further restrictions on Dr.
Farber were unnecessary.
Third, the trial court
ruled that the restrictive covenant violated public policy because it
did not allow emergency medical services to be performed within the restricted
area and also because the covenant not only prohibited Dr. Farber from
practicing his specialty (pulmonology and internal medicine) but also
extended to providing "medical care or assistance" generally.
The Arizona Court
of Appeals reversed the trial court and held that the restrictive covenant
was not void. The Court upheld the geographic scope and duration of the
covenant based upon similarities to the Peairs case. The Court overruled
Dr. Farber's public policy concerns and held that the trial court could
use the severability provisions of the employment contract to allow the
practice of emergency medicine and access to specialized medical equipment
inside the restricted area.
The Arizona Supreme
Court vacated the decision of the Court of Appeals, affirmed the trial
court judgment, and held that the Dr. Farber's restrictive covenant was
unenforceable. The Supreme Court ruled that the reasonableness of a restrictive
covenant involving a medical practitioner requires consideration of the
interests of not only the employer and the employee but also the interests
of patients and the public at large.
The Supreme Court
accepted the trial court's determinations that: 1) a three-year duration
was too long and that no more than six-months duration was necessary to
protect the employer's interest; 2) the geographic scope was too great
(235 square miles); 3) the failure to provide an express exception for
emergency medicine was unreasonable; 4) the failure to limit the restriction
to pulmonary medicine was unreasonable; and 5) the covenant violated public
policy by unreasonably interfering with the doctor-patient relationship.
The Court then considered
whether the severability provisions of the employment agreement would
allow the court to rewrite the restrictive covenant to make it reasonable
and therefore enforceable. The severance clause provided that the contract
would be "reformed and amended" to delete any invalid portion
and to enforce the scope of the prohibition "to the fullest extent
permissible." A severability clause will only allow the court to
eliminate "grammatically severable, unreasonable provisions."
"The court cannot create a new agreement for the parties to uphold
the contract." Otherwise employers could create onerous provisions
"knowing that it the words are challenged, courts will modify the
agreement to make it enforceable." Id.
Although we will tolerate
ignoring severable portions of a covenant to make it more reasonable,
we will not permit courts to add terms or rewrite provisions ...
We disapprove of the
portion of Peairs that permits courts to rewrite and create a restrictive
covenant significantly different from that created by the parties.
The court summarized
its methodology as follows:
The burden in on the party wishing to enforce the covenant to demonstrate
that the restraint is no greater than necessary to protect the employer's
legitimate interests, and that such interest is not outweighed by the
hardship to the employee and the likely injury to the public.
Lessons from the Farber
case
Restrictive covenants must be evaluated in each contract and may not be
enforced even if identical terms were enforced elsewhere. The Farber case
sends a clear message that overbroad restrictive covenants will not be
enforced, and that the Arizona courts will not rewrite restrictive covenants
to render them enforceable. Other states may allow judicial reformation
of contracts. See AN Deranger Inc. v. Strough, 103 F.3d 243 (2nd Cir.
1996) (Vermont law); Annotation 61 ALR.3rd 397 (enforceability, in so
far as restrictions would be reasonable, of contract containing restrictions
on competition). Arizona, however, does not allow a court to modify the
contract and enforce "reasonable" terms not agreed upon by the
parties. Restrictive covenants are strictly construed and such provisions
(and any associated severability clause) must be carefully and narrowly
drafted to avoid undue hardship on the employee. In deciding whether to
enforce restrictive covenants against providers of medical services, the
courts clearly will take into account whether enforcement will cause injury
to the public. The extent to which injury to the public will be a factor
in cases not involving medical care remains to be determined.