Close Close

Regulation and Compliance > Federal Regulation

Difference of Opinion

Your article was successfully shared with the contacts you provided.

Knut Rostad is the compliance officer for Rembert Pendleton Jackson, an independent advisory firm in Falls Church, Virginia, with $700 million in AUM. Over the past three years, his firm twice has been involved in the issues surrounding departing advisors. I referenced one of these instances in my blog at last June, and in subsequent entries and phone conversations with Rostad, explored the myriad ramifications of the issues involved in this sensitive and timely topic. Without delving into the details of the suit itself, he graciously agreed to share his thoughts with me for a fuller treatment of the subject in this column.

The lawsuit first came to my attention last spring, when Rostad called to talk about the broader industry issues involved with advisors leaving a firm and to get my opinion. It’s possible that he was expecting a different reaction (I get that a lot). It struck me much the same as the record companies suing the now-defunct Napster for enabling free electronic downloads of music, and I told him why: In both cases, we’re dealing with knee-jerk reactions to inevitable and unstoppable realities, making the plaintiffs look self-serving and possibly vindictive.

For RPJ, I suggested a suit over this all-too-common occurrence in the independent advisory industry is based on the illusion of a primary relationship between client and firm, and would neither bring back the clients, nor the renegade advisor, and makes the firm appear more interesting in its own economics than the well-being of its clients.

As you might expect, Rostad was not entirely swayed by my analysis and our ensuing discussions along with some responses to my blogs illuminate the issues that advisory firms must wrestle with when deciding how to handle defecting advisors who leave the firm, taking clients with them.

Clark: I’m still not sure what your firm wanted to accomplish. Seems the Chinese proverb that if you have to resort to violence you’ve already lost, applies here: filing suit is a no-win for anyone.

Rostad: We are a small business that’s in many respects operated like a family. Naturally we aren’t happy when anyone leaves us. It causes a break in the family. Our primary concern in any departure is that 1) the client’s interests are protected, and 2) laws and regulations are upheld. Our firm is legally responsible for the confidentiality of client information. Federal law here is clear. The personal nonpublic information that clients entrust to a firm may not be transferred outside that firm without client permission.

Clark: Frankly, it sounds to me that the partners were mad, and found a legal excuse to file suit. I understand the files were the property of the old firm. But if her exclusive clients in all likelihood would continue working with her, then for the welfare of the clients, wouldn’t it behoove the old firm to just give her the files to ensure a continuity of good advice?

Rostad: Legally, as you point out, the information is property of the firm. A departing advisor needed to have certain forms executed before lawfully removing client files. The business issue is quite simple. The marketplace is competitive and any client is essentially free to choose where to seek investment advice. Contrived barriers that seek only to negate this reality are plainly wrong. However, I don’t believe that federal privacy law is a contrived barrier, aiming to distort the free market.

Clark: You’re right, of course, in an ideal world. Yet, that solution strikes me as totally unrealistic. Think of the timing: The leaving advisor would approach the owners of the firm and announce her intention to leave at some future date, taking the clients with whom she works directly with her. Either she would already have their transfer authorization forms signed (which could raise questions about breaching her responsibility to the firm while on its payroll), or plan to get them signed in short order. Is it really unreasonable for her to expect that the firm owners might react in a hostile manner, either by physically throwing her out of the office, getting a legal injunction against her, dragging out the file transfer process, or some combination of these? Point is, because she can’t trust the owners to act professionally, she has little choice but to act the way she did.

Rostad: I see your point about the reality of the situation, but I don’t think that justifies what’s tantamount to stealing the client files. What’s more, while no one would argue that the clients themselves aren’t free to choose any advisor they wish, don’t you think the leaving advisor has a responsibility to their former firm and the clients to not break the law? If you think about it, this is not a very high standard.

That said, you raise another key point. A firm owner and firm employee don’t come to the table with the same cards. The owner has a legal advantage that’s significant; the employee may have a business advantage (in the client relationship) that can be significant. Each may have legitimate claims; you would have to see how the hands are played each and every time to resolve the issues raised in a departure. For example, the owner in the firm has invested significantly in training, attracting the clients, launching the firm to begin with, and all the myriad risks, liabilities, and responsibilities of firm ownership.

Clark: While I would argue about relevance of the responsibility to the firm and owner’s “investment” you’re raising, I don’t doubt for a moment that most advisory firm owners believe strongly in both. I suspect that it’s because firm owners feel so strongly about them, that this is such an emotional issue. And because it is so emotional, I’m not sure that firm owners are really thinking clearly about it.

In my view, the primary responsibility of an advisory firm is for the financial well being of their clients. That’s its fiduciary duty. And in the case of clients who wish to continue to work with an advisor who’s leaving the firm, it seems to me the first obligation of the firm is act according to those wishes by ensuring a smooth and orderly transition of client services and records. By allowing their emotions to take over, and act in the interest of the firm and/or the owners by trying to protect its economic interests, or mitigate its liability by acting contrary to its clients’ wishes is violating its professional fiduciary duty.

Rostad: I understand your point, here, and agree to a point. But I don’t think you give enough credence to the value that firm owners add, the principal-agent relationship, and employees’ responsibilities to the firm. You can’t separate those factors from this situation. However, I do think that this entire issue quickly may become moot with the widespread use of non-compete agreements in advisory firms these days.

Clark: Again, this is exactly the problem. You’re suggesting another “solution” for the firm to keep the clients. We know from a long history of financial advice that clients don’t have relationships with “firms.” They have relationships with advisors. By refusing to face this reality, owner advisors fail to create career tracks, partnership opportunities, underpay employee advisors, and end up losing the clients (if not to leaving advisors, then to another outside advisor). The solution is not to keep trying in vain to tie the advisors to the firm, but create a situation where the lead advisors with the client relationships want to stay at the firm.

What’s more, it’s hard for me to believe that non-competes and non-solicitations will be very effective. For one thing, they’re hard for courts to enforce when the clients clearly want to work with the leaving advisor.

Rostad: Yes, non-competes and non-solicitation agreements are more and more difficult to enforce. The challenge, as you point out, is these agreements were originally designed for salesmen selling widgets in a geographic territory–not advisors providing “consulting services” in an “open” territory.

There’s another issue here that needs examination. Your premise seems to be that all or most investment advisors seek to become a true firm–one that grows beyond the founder or initial partners. I question this premise, and wonder how many advisors are able to make the leap. The fact that these one- and two-man shops are not willing to give up control or ownership share, may not necessarily be connected to the high turnover rate of their professional employees. I’m not sure how may advisers intended to build a firm in the first place.

Clark: If advisors don’t “intend” to build a firm, then they shouldn’t hire or promote lead advisors and turn their clients over to them. Once you’ve done that, you have a firm, whether you like it or not.

The one thing we do agree on is the need for industry standards for transferring clients that will enable the wishes of the client to be respected, while protecting the firm against securities and privacy liability. It seems to us that a scenario in which the advisory firm–when notified that an advisor is leaving–would take responsibility to contact that advisor’s clients, notify them of her imminent departure, and of their option to stay with the firm or go with the advisor, along with the forms to authorize that transition. That way, the firms would clearly be looking out for the clients’ best interest, covering their own liabilities, and acting as true professionals.

Bob Clark, former editor of this magazine, surveys the advisory landscape from his home in Santa Fe, New Mexico. He can be reached at [email protected].


© 2024 ALM Global, LLC, All Rights Reserved. Request academic re-use from All other uses, submit a request to [email protected]. For more information visit Asset & Logo Licensing.