NSIGHTS. KSDB Health Law. Misappropriation of trade secrets. 3 Establishing. Autumn In this issue. The facts. Trade secret claim

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1 Autumn 2005 In this issue 3 Establishing your practice s value 4 Group practice document check-up 6 An instructive restrictive covenant case KSDB Health Law NSIGHTS Vasilios J. Kalogredis, J.D., CHBC, CFP bkalogredis@ksdbhealthlaw.com Jeffrey B. Sansweet, J.D., LL.M. jsansweet@ksdbhealthlaw.com David R. Dearden, J.D. ddearden@ksdbhealthlaw.com Michael R. Burke, J.D. mburke@ksdbhealthlaw.com Susan Harmon, J.D., LL.M., Of Counsel Leif C. Beck, J.D., CHBC, Of Counsel lbeck@ksdbhealthlaw.com Front row: Leif, Bill Back row: Dave, Mike, Susan, Jeff Kalogredis, Sansweet, Dearden and Burke, Ltd. Misappropriation of trade secrets By Vasilios J. Kalogredis, J.D., C.H.B.C., C.F.P. Andrew Pollack, M.D. d/b/a Philadelphia Institute of Dermatology v. Skinsmart Dermatology and Aesthetic Center, P.C., et al, arose in the Court of Common Pleas of Philadelphia County, Commerce Case Management Program on October 5, The facts Dr. Pollack, the Plaintiff, was the sole owner of a dermatology practice known as Philadelphia Institute of Dermatology ( PID ), for which Dr. Shawe worked as a dermatologist and Dr. Badawy as a surgeon. They had worked as PID independent contractors for several years until they left PID and formed their own new practice, called Skinsmart. PID s patient files and information were maintained in its office s computer system. Only certain PID employees could access the system in its entirety. In late 2001, Dr. Pollack had opened negotiations with Drs. Shawe and Badawy about possibly selling part of PID to them. Although the parties reached a tentative agreement in June of 2002, the two doctors presented resignation letters to Dr. Pollack on August 5, Before that they asked PID staff members to make copies of PID s appointment books and to print out portions of the database (the Patient List ). Skinsmart opened its doors on September 3, 2002, under a lease that they had signed before their final day at PID. While still affiliated with PID they offered employment to Ms. Wilson, a PID employee who had served as Dr. Pollack s medical assistant for many years. The Court found that Ms. Wilson used the Patient List to call scheduled PID patients and try to reschedule them with Skinsmart. Drs. Shawe and Badawy also called patients and sent out a mailing. A substantial number of Skinsmart s patients came from the Patient List and resulted in approximately $700,000 of revenue. Trade secret claim Dr. Pollock asserted a claim for misappropriation of trade secrets. The Court said that to prevail the Plaintiff continued on page 2

2 Misappropriation of trade secrets continued from page 1 must show: (1) the existence of a trade secret; (2) that it was of value to him and important in the conduct of his business; (3) that by reason of ownership, he had the right to the use and enjoyment of the secret; and (4) that the defendants obtained the secret while they were in a position of trust and confidence under circumstances making it inequitable and unjust for them to disclose it to others or make use of it themselves, to the prejudice of the plaintiff. The Court listed several factors helping determine whether certain information is a trade secret: (1) the extent to which the information is known outside of the owner s business; (2) the extent to which it is known by employees and others involved in the owner s business; (3) the extent of measures taken by the owner to guard the information s secrecy; (4) the information s value to the owner and to his competitors; (5) how much effort or money the owner spent in developing the information; and (6) how easily others could properly acquire the information. The 20,000 name Patient List was indeed a trade secret worthy of protection; it had been compiled over many years by PID s substantial efforts; PID spent money on computers, software and employees to keep and maintain it; the information was not universally known or accessible; PID sought to protect the information s secrecy; and the Patient List was indeed valuable and important to PID, being a core component of the practice. Dr. Pollack was the sole owner of PID and thus he owned the Patient List. The Court said that a duty not to disclose trade secrets may arise from either a restrictive covenant or a confidential employment relationship. While the parties had no written contracts guiding them in this case, the defendant doctors were found to have a confidential relationship while working at PID. They violated it by having defendant Ms. Wilson copy the Patient List and use it call to patients to reschedule them for Skinsmart. The Court granted Partial Summary Judgment to the Plaintiff against the individual defendants, leaving to a jury the amount of damages to be awarded. Unjust enrichment Dr. Pollack also claimed that the defendants were unjustly enriched. The Court found that the Patient List, taken from PID without compensation, definitely benefited the defendants in setting up Skinsmart. Thus, it determined that it would be inequitable for the Defendants to retain the benefits without paying PID for the value. The Court granted Summary Judgment to Dr. Pollack and left to a jury what the amount of damages should be. Duty of loyalty The Plaintiff also claimed a breach of the implied duty of loyalty. Since loyalty is a component duty within the agent-principal relationship, the Court had to find that the defendants were indeed agents of PID. The three elements establishing an agency relationship are: (1) the principal s manifestation that the agent acts for him; (2) the agent s acceptance of the undertaking; and (3) the parties understanding that the principal is to be in control of the parties. Ms. Wilson s position as a PID employee established her agency status. Though no written contract existed, the defendant doctors were found to be under an agency relationship because they treated The individual defendants unauthorized use of the Patient List was a clear breach of their duty of loyalty to PID. patients at PID, because PID managed the billing and paid all the overhead for all patients they saw there, and because PID paid them for their services. The Court found that the individual defendants unauthorized use of the Patient List to establish Skinsmart was a clear breach of their duty of loyalty to PID. The Court also granted Summary Judgment to Dr. Pollack and left to the jury the matter of damages. Settled out In the end, the parties agreed to a $400,000 settlement. Bill Kalogredis named a Pennsylvania Super Lawyer We are pleased to report that Bill was listed in the June 2005 issues of Philadelphia Magazine and Pennsylvania Super Lawyers magazine as a Pennsylvania Super Lawyer. The honorees were selected by Pennsylvania attorneys. Only 5 percent of Pennsylvania attorneys received this distinction. 2

3 Establishing your practice s value By Leif C. Beck, J.D., CHBC Doctors do not often think of their practice as a valuable asset, but rather as a means of providing service and producing income. Still, most practices really have a substantial capital value. The value may be little more than what your equipment and accounts receivable are worth, or as much as millions of dollars, with an intangible value being part of the equation. Having served as expert advisors (and sometimes witnesses) about health care practice values, we can safely say that doctors, and their advisors, are often poorly informed on this subject. The valuation issue comes up in a wide variety of situations, including: Arranging for a new doctor to become a partner ; Setting a fair pay-out to a partner upon his or her retirement, death, disability or other departure; Selling one s practice; Negotiating with a hospital to sell one s practice, or upon a hospital s effort to sell back a practice it had previously purchased; KSDB Health Law NSIGHTS is published semi-annually by Kalogredis, Sansweet, Dearden and Burke, Ltd. Address: 987 Old Eagle School Road, Suite 704 Wayne, PA Telephone: Fax: Kalogredis, Sansweet, Dearden and Burke, Ltd Copyright strictly reserved. This newsletter may not be reproduced in whole or part without the written permission of Kalogredis, Sansweet, Dearden and Burke, Ltd. Buying a practice to augment or protect your market share in your service area; A merger of practices; Determining a large group s capacity to obtain favorable financing; Allocation of assets between doctor and non-doctor spouse in divorce; In a lawsuit between ex-partners. Capitalizing earnings While most of those situations are reasonably collaborative, we ve been involved in a variety of legal actions in which appraisers have provided outlandish valuations. That s largely because lawyers for non-doctor spouses and other plaintiffs sometimes rely on a valuation approach broadly known as capitalization of earnings. It is a common method for valuing commercial businesses and a staple in determining stock market values. It can create havoc for a defending doctor. A solo physician works very hard to produce a $200,000 annual income. An aggressive lawyer obtains a business valuation expert to say that 6 times earnings is a fair value for the business, thus finding the practice worth to be $1,200,000. We in the healthcare profession, know that his practice just cannot sell for that sort of price. That s because the business has to pay a fair wage to an excellent doctor to generate its revenue. Subtracting $200,000 (the median income in that doctor s specialty) leaves zero earnings to capitalize. The issue particularly arises in divorce cases involving a doctor with inordinately high earnings. We recall a case of a very successful specialty surgeon with a sterling reputation and a huge case load. He worked exceptionally long hours and his income was nearing seven figures. His divorcing wife s lawyer asserted that the practice s goodwill value was $5,000,000. In truth, the practice had almost no goodwill value because no buyer could have stepped into that surgeon s shoes. The goodwill was personal to the surgeon, due to his unique personal capacities and his personally devoting far more hours than even physicians would consider normal. Hence it was not due to the practice, and it was not a quantifiable, transferable asset. The goodwill issue was rejected as it deserved to be. Group documents rule While someone might claim that the group is worth millions of dollars, they run into what the partners themselves, acting at arms length with each other, have agreed to in their shareholders or partnership agreement. What better indicator of value is there, than what has been agreed at arms length among individuals having conflicting interests in the issue? Furthermore, how can the group be worth more if no member is free to sell his or her interest in it except back to the group at the contracted price? Unfortunately, some courts have not accepted this argument. 3

4 We routinely urge our group clients to be sure their buy-out agreements are in place and are realistic. Having seen too many agreements left intact for ten, twenty and even more years, we fear that some groups may be headed for trouble if and when someone leaves and the documents calling for an unrealistic buyout are in place. Goodwill as one asset Notice one essential difference between calculating a value on the capitalization of earnings method and the way actual medical and dental practice buy-ins and pay-outs are handled. When capitalizing earnings, the resulting figure represents all the practice s assets, wrapping cash, equipment and furniture, accounts receivable and goodwill value into one number. Group documents, on the other hand, look at each asset category as a separate part of the overall value. Valuing cash, furniture, fixtures and accounts receivable (less outstanding debts) doesn t usually result in huge variations, so the question typically comes down to realistically valuing that amorphous and often contentious item goodwill. Many practices do indeed have some goodwill value. The best indicator of intangible value is what a buyer and a seller, acting independently and at arms length, would pay and receive essentially, what would happen in the marketplace. Based on their work experience, consultants and attorneys involved in medical and dental practice matters deal regularly with such pricing issues and can fairly well predict where the parties will come out. Group practice document check-up By Jeffrey B. Sansweet, J.D., LL.M.* Most physicians in group practice entity. If the practice is a profes- understand the need to have sional corporation, the documents their internal arrangements documented would include Employment in writing. If no agreements Agreements for the shareholders, are in place, a junior physician could a Buy-Sell or Shareholders leave with no advance notice without Agreement and Bylaws. If the a restrictive covenant. A senior practice is a partnership, there physician could retire or die with would be a Partnership Agreement. no entitlement to a buy-out. Even And finally, if the practice if documents do exist, they may be is a limited liability company, an outdated in light of the current legal Operating Agreement would be and economic environment. the governing document. Thus, it is very important to examine your practice inter-doctor docu- The most obvious and impor- Buy-out ments periodically to see if any tant issue that needs to be looked changes, additions or deletions are at in light of the difficult healthcare environment in the greater warranted. The form of the documents will Philadelphia area is the buy-out. vary depending upon the type of If the buy-out is a set dollar *Reprinted as adapted with permission from Physician s News Digest, Not great prices Doctors hoping to reap great sums by selling out are likely to be disappointed. They are usually better off financially by working another year. The heady days when hospitals and PPMCs bought medical practices for big dollars are long gone. Still, while a myriad of factors dictate a practice s value, we and our peers tend to find values ranging from zero (in surprisingly many situations) up to 50% of the most recent year s practice revenue and sometimes considerably more in a few isolated situations. Such values aren t to be sneezed at, but they re far short of what so-called experts find by loosely applying capitalization of earnings methods. amount that was agreed to in better days, it should be reduced to a more realistic value. If the buyout is expressed as a percentage of the gross receipts for a period prior to termination (e.g., an annual average over the prior two calendar years), the percentage may be too high since the overhead is almost certainly higher than in the past due to skyrocketing malpractice insurance rates and steady increases in health insurance premiums. If the buy-out is expressed as a percentage of the net income or W-2 compensation of the departing doctor for a period prior to termination, an adjustment may not be necessary 4

5 as that figure would self-adjust depending on the bottom line finances of the practice. In some buy-out arrangements, practice debt is not factored in, perhaps because there was no debt at the time the documents were entered into. Clearly, times have changed, and any practice debt should reduce a departing doctor s buy-out. On the other hand, when a physician retires, he or she should not remain as a personal guarantor or surety on any outstanding practice loans. Thus, the governing documents should provide that the remaining physicians shall use their best efforts to have the creditor bank remove the retired physician as a guarantor or surety, although ultimately that is up to the bank. Another issue relating to the buy-out that should be reexamined is the required notice of termination. Since for many specialties it is very difficult to recruit a new physician, a physician who retires or leaves voluntarily perhaps should be required to give six-to-twelve months notice to the group, instead of what may ordinarily be three or four months notice. In order to put some teeth into this notice requirement, the documents should provide for a reduction in the buy-out to the extent such notice is not given. Malpractice insurance Adjustments to the buy-out should also be considered due to the changes in the malpractice insurance industry. When the existing documents were drafted the practice may have had occurrence coverage for all the physicians. If the practice could no longer obtain or afford such coverage and instead now maintains claims made coverage, the issue then arises as to which party becomes responsible for the tail payment, the practice or the physician. It could be all one party s responsibility in any situation, split equally, or dependent upon the reasons for departure and subsequent practice, if any. In addition, since in Pennsylvania the MCARE Fund has provided for premium abatements in certain situations, a physician who does not stay in practice in Pennsylvania for the entire subsequent year may be assessed with the abated premiums plus administrative and legal costs. Thus, in order to avoid litigation, all contracts should now address the issue of the responsibility for any tail premium and MCARE assessment. A reasonable approach for an owner-physician would be to have the practice pay them and reduce the departing doctor s buy-out by such payments. Don t put it off Of course, the sooner one or more of the owners are likely to be affected by a change in the documents, the more difficult it will be to reach agreement on any changes. For example, if a physician is very close to retirement, he will be less open to a reduction in the buy-out formula. Alternatively, a younger physician who may be contemplating moving out-of-state may be less open to a longer notice period or a reduction in the buy-out for the malpractice tail and MCARE assessment. However, it is important to try to reach a consensus for the betterment of the group as a whole. I represented an anesthe- sia group that carried forward a much higher than reasonable buyout formula each time a new owner was brought in. When the senior physician died and another left with significant buy-out entitlements, the group dissolved and lost its hospital contract, all of which could have been avoided if the group had been willing to step back and reevaluate its buyout structure. Given how difficult it is to convince physicians not to leave Pennsylvania, another variation to consider in buy-out formulas is to reward long-term employment. For example, if the buy-out entitlement is one hundred percent of annual average W-2 compensation over the previous two calendar years, perhaps a physician should need to be with the practice for 20 or 30 years to reach that level, with a sliding scale for each year below that. It is also important to make sure the practice buy-out ties into any affiliated entities. For example, if there is a separate entity that owns the practice real estate or an ambulatory surgery center, most of the time when a physician leaves the practice he must withdraw from the real estate and surgery center entities as well. Semi-retirement Another matter to consider addressing in the practice documents is semi-retirement or cutback options. Many practices do not address these matters unless and until one of the owners wishes to cutback, but others have a set methodology in place ahead of time. Issues to be dealt with include the length of notice to be 5

6 given, an age and/or year of service requirement to be eligible, a minimum number of sessions to be worked, the extent of call, if any, a compensation formula, the length of the cutback arrangement before forced retirement, the impact on co-ownership status, and the effect on the buy-out. Net income division The practice s compensation methodology and the documentation thereof also should be examined periodically. Besides consideration of actual changes to the methodology (e.g., shifting or redistributing between equality and productivity based formula; whether productivity should be measured by collections, charges or RVUs; a different allocation of fixed and variable overhead; an administrative fee to one of the owners), it is important to ensure compliance with the Stark/Fraud & Abuse laws and regulations (e.g., not giving credit for designated health services that are not personally performed by the doctor or incident to such services) as well as the Internal Revenue Code and related regulations (e.g., with a C Corporation, trying to avoid a recharacterization of bonuses as non-deductible dividends). New partner When it is time to bring in a new owner, don t just assume you can use the same documents and buy-in arrangements as used previously. I represent a gastroenterology practice which, because it was so difficult to attract an associate, brought in an associate as a partner a year earlier than promised and waived the buy-in altogether. We did, however, provide that the new owner s buy-out would be nominal for several years so as to disincentivize him from leaving. When a new owner is brought in, the voting dynamic should be addressed. If the ownership is going from one to two, what will happen upon a deadlock? If you are going from two to three, should there be a unanimous vote required in order to take certain actions such as the sale of the practice, purchase of a practice, hiring a physician, or a new office location? Should the senior doctor be able to be outvoted 2 to 1 on any matter? When there are several owners, do you want to require a majority vote on certain items, and a supermajority (e.g., 75 or 80%) vote for certain critical decisions? Should the President or managing partner have certain unilateral powers? In this ever-changing, challenging, heavily regulated business of practicing medicine, it is important to review your practice s internal documentation periodically with your attorney to make sure it is still fair and legal. An instructive restrictive covenant case By Vasilios J. Kalogredis, J.D., C.H.B.C., C.F.P. The Pennsylvania Superior Court decided WellSpan Health v. Bayliss earlier this year. The facts In 1993, WellSpan, a nonprofit health care system based in York, Pennsylvania, recruited Philip Bayliss, M.D., a perinatologist, to its York Hospital. Dr. Bayliss signed a contract that included a promise not to engage in the practice of perinatology in York County or its four named contiguous counties (Lancaster, Dauphin, Cumberland and Adams) for two years after his employment terminated. Under Dr. Bayliss, York Hospital expanded its Maternal Fetal Medicine Division to include two additional physicians and considerable new equipment. WellSpan marketed Dr. Bayliss and maternal fetal medicine extensively. Strong referral linkages were forged both with its own physicians at York Hospital and with doctors in at least three nearby hospitals in York and Adams Counties. WellSpan and Dr. Bayliss contemplated as early as 1999 some type of expansion into neighboring Lancaster County, about 26 miles away, but things bogged down before they ever created a physical presence there. In mid-2001 Lancaster General Hospital opened a new Women and Babies Hospital (WBH) of its own. In February of 2003, Dr. Bayliss announced his resignation from WellSpan and his intention to establish a maternal fetal medicine practice at WBH on July 1, Trial court proceeding WellSpan filed a Motion for Preliminary Injunction seeking to enforce the restrictive covenant. The trial court upheld the restrictive covenant as to York and Adams counties. However, concluding that WellSpan did not compete for perinatology patients 6

7 in Lancaster, Dauphin or Cumberland Counties, the lower court refused to enforce the covenant as to them. The trial judge s decision was appealed, particularly as it related to Lancaster County, to Pennsylvania s Superior Court. The rest of this article concerns that appellate court s written opinion. Protectable interests As a threshold requirement for a court to enforce it a non-competition or restrictive covenant, it must be reasonably related to protecting a legitimate business interest. Among the types of protectable interests are trade secrets and confidential information, unique or extraordinary skills, customer goodwill and investments in employee specialized training programs. Merely seeking to prevent a departing employee from competing so the former employer will have an economic advantage is not a legally protectable interest. Courts have applied the customer goodwill concept to patient relationships as a protectable interest. Significantly, the Court also recognized that a medical practice s patient referral base was a legitimate, protectable interest. Confidential information and trade secrets are also protectable interests. They may include a compilation of names and data used to a business s advantage over competitors. If, however, a competitor could obtain that information by legitimate means, it is not protectable as a trade secret. A balancing act Having determined that Well- Span s covenant satisfied the threshold requirement of protecting a legitimate business interest, the Court proceeded to a balancing of interests. First, it weighed the employer s protectable business interest against that of the physician-employee. Then it evaluated the interests of both employer and employee visa-vis those of the public. In weighing the employer s and employee s competing interests, the Court recognized that the covenant must be reasonably necessary to protect the employer. It considered whether the temporal and geographical restrictions on the ex-employee were reasonable. These determinations of reasonableness are factual and a covenant that fails them will not be enforced. The Court also recognized that the public s interests are of paramount importance. Courts will give close judicial scrutiny to non-competition covenants involving physicians because medical services are so important to the public. If, for instance, patients experience long delays in getting appointments for particular services in a geographic area, a court may find a shortage and decide not to enforce a restriction. Conversely, if a court finds no evidence of a shortage in the specialty, it will more likely grant an injunction. The decision Dr. Bayliss became the only perinatologist in Lancaster County. The Court determined that the County needed perinatology service and inferred that the doctor would be fully involved caring just for patients there. The fact that York County, less populous than Lancaster County, provided enough work for more than one perinatolgist certainly helped support that inference. Further, the Court agreed that a non-competition covenant is unreasonable if it extends to an area where the employer does not compete. WellSpan did not compete with WBH and Dr. Bayliss in Lancaster County, nor did Well- Span have any offices or provide maternal fetal medicine services there. No more than 1% of WellSpan s new maternal fetal medicine patients came from Lancaster County, while less than 2% of OB patients treated at WBH came from York County. All these facts more than adequately supported the conclusions that the restriction was geographically unreasonable as to Lancaster County. The trial court s blue-lining the covenant, enforcing it as to York and Adams Counties but rejecting it as to Lancaster County was affirmed. KSDB Health Law Insights available via You may now obtain KSDB Health Law Insights through the convenience of electronic mail. If you or someone you know is interested in delivery of our Newsletter, please complete this form and fax it to (610) or provide us with the required information at dlotka@ksdbhealthlaw.com. Name: Title: Organization: Address: Telephone Number: Fax Number: 7

8 KSDB Health Law NSIGHTS Kalogredis Sansweet Dearden and Burke Ltd. Suite 704, Door C 987 Old Eagle School Road Wayne, PA PRST STD U.S. POSTAGE PAID LANSDALE, PA PERMIT NO. 177 Return Service Requested NEWSLETTER AUTUMN 2005 Speaking and Writing Information and Website We have extensive experience in speaking and writing on topics of interest to healthcare practitioners. Whether it be your local, state or national society; a group of residents/fellows; or a study group, we would be interested in talking to you about speaking and/or writing opportunities. You are encouraged to visit our Website at for more information on our areas of expertise and articles we have written and talks we have given. Among the national meetings at which we will be speaking over the next few months are: Jeffrey B. Sansweet at the American Academy of Ophthalmology Annual Meeting in Chicago on October 16-18, 2005 on Employment Contracts, Partnership Buy-Ins and Choice of Practice Entity. Michael R. Burke at the American Academy of Physical Medicine and Rehabilitation Annual Assembly in Philadelphia on October 28, 2005 on Stark and Fraud and Abuse Issues and Entering and Leaving a Group Practice. Vasilios J. Kalogredis at the American Academy of Dermatology Annual Meeting in San Francisco on March 2, 2005 on Employment Agreements and Personnel Management. In addition, Leif C. Beck recently spoke on an HCPro, Inc. audioconference to physicians and administrators on the subject, Physician Mergers: Strategies for Evaluating Opportunities and Avoiding Pitfalls. Please contact us if you would like to explore the possibilities.