You run a financial advisory shop with a roster of happy and satisfied clients. You think their loyalty is to your firm and that they’ll be unlikely to leave if any of your key employees depart and set up their own advisory business across town. You may be correct in this assumption, but only if you have protected your business. Here is the sorry tale of one advisor who didn’t, and a look at what he should have done to stave off trouble. While the case is hypothetical, it is based on several real-life stories.
Jack, a successful entrepreneur, is the sole shareholder of Jack’s Investment Management. Jack formed the firm in 1988, and had overseen the growth of its assets under management from $20 million in 1988 to more than $700 million by 2003. Over the years, Jack had also watched his firm grow from just himself and an administrative assistant to 17 employees, including two senior portfolio managers–Mark, who joined the firm in 1997; and Donna, who signed on in 1998–plus Bill, the chief operating officer and compliance officer, who was hired in 1999.
By 2002, Jack’s day-to-day involvement in investment management decisions, operations, and client relations had gradually passed to Mark, Donna, and Bill. Although they were well paid, all wanted to become owners in the firm. Mark, Donna, and Bill thought that ownership would demonstrate Jack’s commitment to them as well as their own commitment to the business.
Jack refused to budge. Since 2000, he been reading about acquisitions in the investment management industry and perceived that his firm might be a good takeover candidate.
By 2002 he was in his mid-50s and had begun to receive indications of interest in buying the firm from larger investment management and financial services firms. Mark, Donna, and Bill remained unaware of Jack’s interest in selling to outsiders and continued to express their desire to become owners.
In February 2003, Jack appeared to have a change of heart, indicating to the key employees that he would consider the sale of minority interests in Jack’s Investment Management at year end. But long before December rolled around, Jack received an attractive indication of interest from a larger investment advisory firm–let’s call it Successful Asset Management. Starting with Successful’s first feeler in May, discussions progressed in secret over the next few months. By mid-August, Jack had entered into a letter of intent to sell his shop, pending due diligence and execution of a final contract within 90 days, at a price that far exceeded his expectations.
A Sense of Betrayal
A few days after inking the letter, Jack advised Mark, Donna, and Bill of his plan to sell out. They felt betrayed: Mark, Donna, and Bill had been looking forward to becoming minority owners, with the hope that over time Jack would sell them his majority share. Over the following weekend, the trio met twice to discuss Jack’s news. They determined to form MDB Investment Consultants, their own registered investment advisor, and leave Jack’s firm by October 15.
During the next month, Mark, Donna, and Bill moved quickly: engaged competent securities legal counsel to register MDB as an investment advisor; made arrangements with a custodian; rented office space; and made other practical arrangements so as to be well prepared for their pending exit.
Fast forward to October 3. Mark, Donna, and Bill march into Jack’s office and announce that they are resigning from his firm that very day. They arrive at the new offices of MDB the same afternoon and begin calling clients they had served and socialized with while working for Jack, informing them that they had hung out their own shingle. Many of the clients tell Mark, Donna, or Bill to transfer their accounts to MDB. By the end of October, $300 million in assets has shifted from Jack’s to MDB.
Jack didn’t take the former employees’ raid on his business lightly. When he first received word that clients were moving to MDB, Jack asked his attorney to go to court immediately and stop Mark, Donna, and Bill from “stealing his clients” and “ruining his business.” But Jack was rebuffed. Moreover, Successful Asset Management indicated that it might not proceed with the purchase of Jack’s firm–and if it did, the deal would most definitely be on drastically less favorable terms to reflect Jack’s smaller asset base.
A Fatal Error
Did this train wreck occur because Jack failed to make Mark, Donna, and Bob shareholders of his firm? No. Jack’s fatal error was that he never required Mark, Donna, and Bill to sign a “restrictive covenant agreement.” Such an agreement would have prohibited or restricted the trio’s ability to divert client accounts from Jack’s to MDB either if their employment was terminated or they voluntarily decided to quit. Indeed, a restrictive covenant agreement could even have contained a provision requiring Mark, Donna, and Bill to pay monetary compensation to Jack’s in return for their ability to shift clients’ accounts to their new firm.