More On Legal & Compliancefrom The Advisor's Professional Library
- The Few and the Proud: Chief Compliance Officers CCOs make significant contributions to success of an RIA, designing and implementing compliance programs that prevent, detect and correct securities law violations. When major compliance problems occur at firms, CCOs will likely receive regulatory consequences.
- Risk-Based Oversight of Investment Advisors Even if the SEC had a larger budget and more resources, it is doubtful that the Commission would have the resources to regularly examine all RIAs. Therefore, the SEC is likely to continue relying on risk-based oversight to fulfill its mission of protecting investors.
Because of the "greying" of the investment advisory industry, it is becoming increasingly more important for investment advisory firms to consider succession planning issues, whether via prospective internal succession or an external acquisition or sale.
For an internal succession, it makes sense to execute a well-drafted shareholders' agreement or operating agreement that addresses the terms and conditions for the disposition/succession of ownership interests (i.e., stock, membership interests, etc.) upon the occurrence of various events, including admitting new owners, regulatory disqualification, death, disability, retirement, and termination of employment. For an external succession, a firm should have a well-drafted purchase/sale/merger/joint venture agreement that adequately protects the respective parties' interests before and after the transaction. However, whether the transition will be internal or external, critical to any potential successful succession is having the appropriate underlying documents in place to protect the firm's proprietary interests in its client relationships; specifically, a firm's needs restrictive covenant agreements.
While many principals of investment advisory firms think about the day that they may sell their largest asset, their firm, too many firms do not adequately protect their most important asset, their client relationships. It is imperative for every firm to make sure that it has taken appropriate steps to protect its client relationships relative to firm employees (generally, the firm's investment advisor representatives) that may service those relationships. Without doing so, the firm is exposed to the unfortunate consequence of losing client relationships to departing employees. How does the firm avoid this unfortunate consequence? Require each employee who is responsible for establishing or serving clients to execute a restrictive covenant agreement. Although it is a relatively simple process, too many firms have either not done so, or have agreements in place that do not protect the firm for a variety of reasons, including poor drafting or lack of consideration.
Generally, there are two types of restrictive covenant agreements that an investment advisory firm can require its employees to execute:
- Non-Competition: Under this agreement, the firm generally seeks to prohibit the employee from accepting employment in the investment advisory/financial services industry for a certain period of time. In addition to a time limit restriction, non-competition covenants can be modified to limit the restriction by geography. For example, an agreement can include a stipulation that the employee cannot accept employment for a period of two years in a specific state, or within a one hundred mile radius of the firm's offices.
- Non-Solicitation: Under this type of restrictive covenant, the firm does not seek to prohibit the employee from accepting employment in the same or similar industry, but rather seeks to prohibit the employee for a certain period of time from soliciting to render or rendering services to firm clients wherever located. The non-solicitation covenant can be modified to limit or expand the client prohibition to past and current clients, and prospective clients reasonably identified by the firm prior to the employee's termination.
The Particular Benefits Of Non-Solicitation Agreements
Both types of restrictive covenants are intended to protect the company's legitimate business interests, most important among them being its client relationships. The primary difference is whether the employee will be prohibited from seeking or accepting gainful employment in the same industry as that of the firm (i.e. non-competition), or the employee will be permitted to become employed in the same industry, but not with the benefit of the firm's clients or employees (i.e. non-solicitation).
I favor the non-solicitation covenant. Certain states generally tend to look unfavorably upon or prohibit non-competition covenants based upon the principal that it is contrary to public policy to prohibit an individual from making a living in his/her chosen profession. Thus, if the enforceability and/or reasonableness of the non-competition covenant could potentially be challenged, the firm is much better off seeking a reasonable non-solicitation covenant that is generally enforceable.
In addition to the type of restrictive covenant, a properly drafted agreement should also include a confidentiality provision under which the employee covenants to maintain as confidential all firm information (e.g. client information, proprietary investment processes or technology, etc.), and not to use any of the firm's confidential information for any purpose other than for the benefit of the firm. In addition, the confidentiality covenant should also require that, to the extent that the employee maintains or has access to any firm confidential information outside of the firm's offices (whether in hard copy or electronic form), to immediately return all such information to the firm.
Finally, the agreement should provide the firm with adequate legal recourse against the employee if he violates the non-solicitation covenant or confidentiality provisions, including, but not limited to, the ability to immediately request that a court enjoin the former employee from violating the agreement (i.e., a restraining order) or to recover monetary damages.
When Is the Best Time To Execute These Covenants?
The optimal time to have an employee execute the agreement is immediately prior to or simultaneously upon commencing employment. What if the new employee will not execute the agreement? Do not hire that person! A properly prepared agreement with reasonably drafted non-solicitation and confidentiality covenants only asks the new employee, at the inception of the employment relationship, to agree not to "steal" from the firm by recognizing the firm's legitimate proprietary interest in protecting its client relationships and business operations. For a new employee who brings clients with him upon the inception of employment, it is not unusual to exclude those pre-existing client accounts--as specifically identified on a schedule to the agreement--from the non-solicitation covenant. However, unless there are unusual circumstances, the agreement should also make clear that any new clients (that is, other than the non-pre-existing clients specifically identified on the schedule) that the new employee subsequently brings into the firm are the firm's clients, and are subject to the non-solicitation covenant.
Even if you did not execute a restrictive covenant when the new employee begins, you may have other options (see "What if the Horse Has Left the Barn?" sidebar).
If you do have a restrictive covenant, there are other considerations. For example, there is the issue of liquidated damages, or what is sometimes referred to as "transition compensation." In some agreements, the firm may want to consider a provision that requires the departing employee to compensate the firm in the event that clients decide to terminate their relationship with the firm and engage the departing employee and/or his new employer. This type of provision must be carefully drafted so as to not permit, among other unfortunate consequences, the employee to violate his restrictive covenant obligations and negate the firm's legal remedies, including its ability to seek injunctive relief.
The bottom line is this: If you do not have a restrictive covenant agreement in place, get one. If you do have one, but are concerned about its enforceability, have it reviewed by your attorney. If you accomplish this relatively simple task, you will be in a much better position to ensure that your employees will not leave the firm with your most important asset, your client relationships.
Finally: what if you are hiring a new investment professional who is expected to transfer existing client accounts? Whenever an advisory firm is in the process of hiring a new investment professional who is expected to transfer her existing client accounts to the new firm (whether it be an investment advisory representative of another advisory firm or a registered representative of a broker/dealer), the prospective employer should inquire as to whether that individual is currently subject to any agreement with her current employer restricting the contemplated transfer of accounts. Unfortunately, all too often the prospective employee cannot recall if she is subject to such an agreement. We will address this and related issues in my next column in the June issue with the help of two of my partners who are recognized authorities in this area.
Thomas D. Giachetti is chairman of the Securities Practice Group of Stark & Stark, a firm with offices in Princeton, New York, and Philadelphia representing investment advisors, financial planners, broker/dealers, CPA firms, registered reps, and investment companies throughout the U.S. He can be reached at firstname.lastname@example.org.