The last decade has seen a tidal wave of advisors leaving traditional brokerage firms and even advisory firms to launch their own independent advisory firms that will allow them to serve their clients better and to meet their own professional and personal goals. Whether it’s the opportunity to give clients more investment and service options, achieve more professional and personal freedom, access better practice management tools, grow their client base, or increase their compensation, the number of advisors making a transition to independence continues to grow.
The path to independence often requires significant preparation and planning, particularly given the length of time that it takes to form an advisory firm, retain service providers, and register as an investment advisor with the SEC or one or more states. Advisors typically want to hit the ground running when they resign from their firms and solicit and onboard clients as soon as possible, which often means that advisors choose to take certain transition steps while still employed by their current employer.
Nonetheless, there are numerous legal and regulatory challenges to consider in executing a transition, and navigating the landmines that can sink a transition requires preparation, knowledge, and expert advice.
In this article, we will provide a high-level roadmap for advisors pursuing a path to independence designed to shed light on the challenges faced by many advisors in the course of the transition process. First, we will discuss common contractual and legal obligations can impact an advisor’s path to independence including reviewing non-competition and non-solicitation restrictions, an advisor’s various confidentiality obligations, and an advisor’s legal duties owed to its current employer. Second, we will then explore how the Protocol for Broker Recruiting (“Broker Protocol”) impacts an advisor’s path to independence and what advisors should consider when planning a transition without the benefit of the Broker Protocol. Third, we will discuss common mistakes that advisors make when executing a transition. Fourth, we will discuss what can happen if a transition is botched and how that can negatively impact a transitioning advisor.
What Are the Contractual and Legal Obligations Commonly Owed
by Transitioning Advisors?
Contractual Obligations
In most cases, financial advisors working for a brokerage or advisory firm will sign at least one employment agreement with their employer, and depending on the circumstances, advisors may sign other agreements that contain important provisions that will impact any transition the advisor desires to make. Such agreements can include compensation agreements relating to forgivable loans or grants of equity-based compensation. These agreements are often one-sided and rarely negotiated by employees. Such agreements typically contain many provisions designed to protect the firm’s trade secrets and client base. Yet, employees typically expend significant amount of their professional time and resources cultivating expertise and business relationships which benefit the firm, and they desire to utilizes such resources upon their departure from the firm. Below we highlight some of the most common provisions in employment and related agreements that can impact the path that an advisor can take when planning a transition.
Provisions Prohibiting Competition With The employer
Noncompetition clauses (also known as noncompete agreements) are contractual provisions that limit an employee’s ability to engage in specified activities during their employment and afterwards. These clauses are commonly included in employment contracts or separate agreements signed by employees during the course of their employment. The purpose behind these clauses is to safeguard a company’s proprietary information, trade secrets, customer relationships, and other business interests. Yet, these provisions are often drafted in a manner that can broadly restrict an employee’s ability to earn a living after leaving a firm. For instance, non-competition clauses from brokerage or advisory firms can prohibit a financial advisor from providing brokerage or investment advisory services altogether following their departure from an employer. They can also restrict an employee’s ability to take an ownership stake in a financial services firm. Advisors commonly mistake non-competition clauses with covenants not to solicit clients (which we will discuss below), but non-competition clauses can (and typically do) prohibit activities beyond soliciting clients after an advisor’s employment ends.
Because non-competition clauses can drastically impair an employee’s ability to pursue employment and business ownership opportunities post-termination, states typically require that these non-competition clauses be limited in terms of the activities that can be restricted, the geographical area where the employee is prohibited from competing with the employer, and the duration of the non-competition restriction after termination of employment in order to be considered enforceable.
Unfortunately, determining the enforceability of non-competition clauses is not an exact science given that most guidance concerning the enforceability of noncompetition clauses comes from judicial decisions applying state law which governs such contracts. Determining the enforceability of a noncompetition clause depends not only on the scope of the restrictions outlined in the noncompete clause, but also the guidance handed down by courts in the applicable state.
As such, it’s vital for advisors to seek experienced counsel who can help them interpret the specific non-compete clauses in their employment agreements and to help them evaluate whether such provisions are likely to be enforceable.
It’s important for advisors to remember that preparing to compete with the advisor’s current employer prior to resigning (including preparation to launch a new advisory firm) does not, in and of itself, constitute competing with the employer; provided that the advisor takes appropriate precautions and appropriately restricts its activities so as to not violate any legal obligations owed to the employer.
Provisions Prohibiting Solicitation of Clients
When most advisors think of post-employment restrictions, they mostly think of restrictions on the ability to take clients with them after they depart from their current employer. What constitutes “solicitation” varies depending on the specific language of an advisor’s employment agreement, but in general, solicitation refers to the act of encouraging, inducing, or enticing clients to discontinue their current business relationship with the advisor’s employer and/or to move with the advisor to their new firm to receive services. Solicitation can also refer to encouraging prospective clients considering joining the advisor’s former employer not to retain such firm and to hire the advisor’s new firm for services instead. Solicitation can take various forms including direct communications through physical mail or email, phone calls, or advertisements but may also occur indirectly through communications initiated by intermediaries or advertisements.
To avoid violation of restrictions on the non-solicitation of clients, sometimes departing advisors publish generic “wedding style”; or “tombstone”; type announcements (through local newspapers or billboards) that simply notify the audience of the departing advisor’s change in employment and provide them with the advisor’s new contact information. In certain circumstances these types of advertisements have been found not to violate restrictions on the solicitation of clients. However, some courts have held that such advertisements could nonetheless violate a departing advisor’s obligations not to solicit clients if the audience targeted by such an advertisement is too narrow and targeted.
Sometimes, non-solicitation provisions can be drafted even more broadly to prohibit an advisor from accepting a client from their previous firm, even if there was no active solicitation of such clients. Other non-solicitation provisions that are even more restrictive flatly prohibit an advisor from rendering services to any client of their previous employer following departure from the firm, which equates to a tantamount non-competition clause with respect to such clients. These can be some of the more difficult provisions for departing advisors because of the breadth of activities that would constitute solicitation. Employers often include this within the definition of solicitation because of the evidentiary challenges often associated with proving that a client was solicited by the departing advisor.
The exact language of a provision restricting the solicitation of clients goes a long way towards determining the type of communication that a departing advisor can have with a client. In some instances, advisors may have scripts prepared by counsel to ensure they do not say things that could violate the applicable restrictions on the solicitation of clients.
As with non-competition clauses, the enforceability of restrictions on the solicitation of clients will vary widely depending on the situation and specific language of the restriction, but broadly speaking, restrictions on the solicitation of clients are more likely to be enforced than non-competition restrictions. As with non-compete clauses, restrictions on the solicitation of clients are more likely to be enforceable if they are limited in scope and duration. Yet, as with non-competition clauses, the enforceability of such provisions will vary from state to state as each state’s courts will have different perspectives on the enforceability of such provisions.
Provisions Prohibiting the Solicitation of Employees
Employers often include in employment agreements restrictions on the ability of advisors to take employees with them to their new firm because of the time and resources devoted to training such employees and the value created through such efforts. As with restrictions on soliciting clients, the term “solicit” generally means any effort designed to encourage, induce, or convince a person (in this case an employee) to leave the advisor’s current firm. In some cases, the term “solicit” is defined even more broadly to include the simple act of hiring an employee from the advisor’s former firm, whether or not it can be shown that there was actual active solicitation of the employee from the former firm.
In general, employers are more likely to take action against a departing advisor that solicits employees where the solicited employee is particularly valuable to the former employer. In the financial services context, this could hold true particularly for wealth managers, portfolio managers, and other employees that have specialized skills that are valuable to the former employer.
As with restrictions on competition and solicitation of clients, the enforceability of restrictions on the solicitation of employees varies depending on the language of the restrictions as well as the courts of the state whose laws govern the employment agreement.
It’s important to note that, even in the absence of contractual restrictions prohibiting the solicitation of employees, an advisor could nonetheless be liable to their former employer if they engage in “raiding” of employees. In general, Raiding refers to deliberate and coordinated efforts to unfairly lure employees from an advisor’s former firm to join the advisor’s new firm. These cases are not based on the violation of an advisor’s employment agreement, but rather on the common law principle that an advisor cannot unfairly interfere with the former employer’s legitimate business relationships with its employees. In general, these claims are much less common in the investment advisory arena nowadays but can still arise where an advisor takes a large number or percentage of a former employer’s employees to join the new firm.
Provisions From Loan Forgiveness Programs
Advisors that receive loans that can be forgiven over time as a component of their compensation package when joining a firm may encounter certain challenges that could impact their transition path.
When financial advisors decide to transition to a new firm, the loan forgiveness terms agreed upon with their current employer can have a significant impact on their decision-making process and financial obligations. Among other things, advisors who have not met the loan forgiveness criteria at the time of their departure may be required to repay the outstanding loan balance to their former employer. This obligation can create financial strain and influence the advisor’s decision to transition if they anticipate difficulties in repaying the loan. Advisors who are contemplating a transition may also be subject to retention bonuses tied to the loan forgiveness terms. These bonuses are designed to incentivize advisors to remain with their current firm until the loan is forgiven. If advisors leave before the specified period, they may be required to repay a portion or the entirety of the retention bonus.
Because the conditions tied to loan forgiveness arrangements can vary widely, it’s important for advisors to closely review with counsel the terms of these arrangements including the conditions that must be satisfied prior to departure.
Other Employment Agreement Restrictions
Although less prominent, other provisions in employment agreements must be reviewed carefully to ensure that the advisor does not breach the agreement during the transition process.
For instance, certain employment agreements require that advisors provide a specified amount of notice to the employer (e. g., thirty days prior notice) prior to departing from the firm. Such provisions, if enforced, could put the advisor at a disadvantage when competing with their current employer for clients because departing advisors are not typically permitted to solicit clients until after their departure date (while the employer can immediately begin contacting the advisor’s clients before the advisor’s departure date).
Therefore, advisors must review provisions in employment agreements requiring them to give advance notice of termination and consult with counsel as to the best path forward for addressing their obligations with respect to such provisions.
Confidentiality Obligations
When conducting their transitions, advisors typically owe several obligations pertaining to the disclosure and use of proprietary information, which arise out of their employment agreements as well as rules and regulations governing the privacy of client information.
For starters, advisors typically owe their current employer an obligation to refrain from disclosing confidential information of the employer and to refrain from using confidential information in a way that is detrimental to the interests of the employer. These obligations typically arise out of the advisor’s employment agreement and can apply long after an advisor has terminated its relationship with the employer. In most instances, employers require departing advisors to return all confidential information to the firm upon their departure, and the failure to return such information could result in liability for the departing advisor.
It’s vital that advisors review any confidentiality obligations in their existing employment agreements to determine what information is considered by the employer to be “confidential information” (which definition typically includes information not only about the employer, but also about its clients) and what responsibilities they have with respect to such confidential information during and after their employment.
Second, independent of any restrictions contained in employment agreements, advisors typically owe obligations imposed by law to safeguard client nonpublic information from theft or loss. More specifically, Regulation S-P under the Gramm Leach Bliley Act (which governs the activities of SEC-registered broker-dealers and investment advisors) aims to protect the privacy of individuals’ nonpublic information. For purposes of Regulation S-P, nonpublic information includes any data that can identify or be traced back to an individual, such as names, addresses, social security numbers, account numbers, and investment history. Advisors planning a transition must navigate the regulatory requirements to safeguard clients’; information in compliance with Regulation S-P. Among other things, Regulation S-P requires advisors to obtain written consent from clients before transferring their nonpublic information to a new firm. This consent is typically obtained through a “Change of Brokerage”; or similar form, ensuring clients are fully informed about the transition and granting permission for their information to be shared with the new firm.
In light of these confidentiality obligations, advisors must be careful about what information they use and how they use it during the transition process as well as with whom they can share such information.
It is important to note that, despite contractual and legal confidentiality obligations owed to employers and clients, advisors may still gather information that is publicly available (including contact information for their clients), which is typically excluded from the definition of confidential information or the restrictions on the use and disclosure of confidential information.
The Duty of Loyalty
Advisors owe certain legal duties to their employers, even if such duties are not spelled out in employment agreements. Among other things, a fundamental principle that governs the relationship between employers and employees is the duty of loyalty. This duty requires employees to act in the best interests of their employers (including performing their duties faithfully, diligently, and honestly), refraining from engaging in self-dealing and properly handling conflicts of interest, and maintaining confidentiality of (and avoiding misappropriation of) the employer’s information.
As a result, advisors must refrain from engaging in conduct that is designed to interfere with an employer’s legitimate business interests even during the transition process, or the employer could file suit for violation of the duty of loyalty.
What Is the Broker Protocol and How Does It Impact an Advisor’s Transition Path?
What is the Broker Protocol?
The Broker Protocol is an agreement originally signed in August 2004 between three major wirehouses, Smith Barney (now Morgan Stanley), Merrill Lynch, and UBS, designed to reduce the amount of litigation that was occurring in the aftermath of employee departures from one firm to join another firm. Prior to the adoption of the Broker Protocol, it was common for an employee’s former firm to file suit against the new firm for violations of noncompetition, non-solicitation, and/or confidentiality obligations imposed on the transitioning employee. Two decades later, many broker-dealers and investment advisory firms have joined the Broker Protocol, and this has significantly reduced the amount of litigation following the departure of advisors from brokerage or advisory firms.
Provided that the requirements of the Broker Protocol are satisfied, a departing employee can take five pieces of information with them to the new firm without violating any employment agreement provisions restricting competition with the advisor’s employer, restrictions on the solicitation of clients from the advisor’s employer that the advisor serviced, and confidentiality obligations owed to clients under Regulation S-P. The five pieces of information that a departing advisor can take with them include the names, addresses, phone numbers, email addresses, and account titles for the clients that they serviced while working for their employer. Departing advisors are prohibited from taking any other information including, without limitation, account numbers, account statements, and client files.
What Requirements Must Be Satisfied for An Advisor to Vail Itself of the Protections of the Broker Protocol?
A number of conditions must be satisfied for advisors to avail themselves of the protections of the Broker Protocol. For starters, both the firm from which the advisor is departing as well as the firm that the advisor is launching must be a member of the Broker Protocol. Second, the advisor can only take the information specified above. Third, the advisor can only solicit those clients of the employer served by the advisor while employed at the firm. Fourth, advisors must submit their resignation in writing, and their resignation letter must include a full list of the exact client information being taken as well as a second list containing the account numbers associated with those client accounts, so that the firm can verify which accounts are protected by the Broker Protocol. If the firm from which the advisor is departing disagrees with the list, the advisor will not be found to have violated the requirements of the Broker Protocol as long as the advisor exercised good faith in compiling the list and substantially complied with the requirement that only delineated Client Information related to clients the advisor served while at the firm be taken with the advisor upon departure.
How Can An Advisor Use Client Information Taken In Reliance on the Broker Protocol?
After switching firms, the Broker Protocol permits the broker to use the transferred client contact information only to solicit clients to join the advisor at its new firm. The advisor cannot utilize such information in any other way without the client’s permission. To ensure that there are no Regulation S-P violations from further use of the client information, the transitioning advisor typically request that clients sign an authorization to release account-specific information to the custodian/broker that will serve as the custodian for the new advisory firm which then allows the advisor to utilize the client’s nonpublic information going forward to provide services to the client.
The advisor’s former firm is obligated to forward to the new firm the client’s account number(s) and/or most recent account statement(s) or information concerning the account’s current positions within one business day, if possible, but, in any event, within two business days, of its receipt of the signed authorization. This information should be transmitted electronically or by facsimile. Sometimes, an advisor’s former firm may not comply with the requirements to transmit client information in a timely manner, and so the advisor or its counsel may need to intervene to remind the former employer of this obligation.
Exceptions from the Broker Protocol
There are certain circumstances where the Broker Protocol will not apply as described above. For starters, advisors who seek to solicit clients in advance of submitting their resignation will not be afforded the protections of the Broker Protocol. Second, the Broker Protocol requires advisors to adhere, in good faith, to the requirements of the Broker Protocol, meaning that attempts to mislead the firm from which they are departing (for example, changing account numbers to prevent the firm from being able to identify and contact clients the advisor desires to solicit) could cause an advisor to lose the protections afforded by the Broker Protocol.
Additionally, in certain circumstances, the Broker Protocol may not allow an advisor to solicit clients that they served while at the firm. For instance, where the advisor was a member of a team that served the client, and the entire team does not transition to the new firm, the terms of the agreement entered into by the team will govern which clients the advisor will be permitted to solicit after departure from the firm. In the absence of a team agreement, the universe of clients that the advisor can solicit depends on how long the advisor has been a member of the team in a producing capacity. If the advisor has been a member of the team for less than four years, the advisor may only solicit those clients that the advisor brought to the team. If the advisor Has been a member of the team for at least four years, the departing advisor may take the Client Information for all clients serviced by the team and may solicit those clients to move their accounts to the new firm.
Next, if the advisor acquired the clients as a result of an agreement with a retiring advisor where the advisor continues to pay a trail to the retiring advisor in exchange for transferring such clients to the advisor, the agreement entered into by the advisor, the retiring advisor, and the firm at which they are employed will govern whether the advisor can solicit such clients upon departure – not the Broker Protocol.
Common Misconceptions About the Broker Protocol
There are several common misunderstandings about the Broker Protocol we see from departing advisors. For instance, some advisors mistakenly believe that the Protocol for Broker Recruiting prevents their former employer from competing with them for clients they are looking to take to their new firm. In fact, the Protocol does not prohibit such solicitation of clients by the advisor’s former employer, which is why it is vital for advisors to carefully plan their transition to maximize their ability to expeditiously solicit clients immediately upon departure if permissible.
Second, advisors sometimes believe that the Broker Protocol gives them freedom to solicit employees from the firm from which they are departing. The Broker Protocol does not absolve an advisor for responsibility for complying with any restrictions on the solicitation of employees imposed by their current firm. The Broker Protocol also does not absolve an advisor for violation of applicable laws (such as Regulation S-P) or its common law duties owed to the employer (including the duty of loyalty).
How Can Advisors Navigate A Transition Without the Protections of the Broker Protocol?
Undoubtedly, advisors face more risks when attempting a transition without the benefits of the Broker Protocol because any non-competition and non-solicitation restrictions found in an advisor’s employment agreements remain in full force and effect. Yet, advisors routinely make transitions without the protections of the Broker Protocol. However, in such circumstances, it’s even more pivotal to have expert counsel to evaluate the best path for an advisor in light of the specific contractual provisions found in their employment agreements and how likely the courts of the state whose laws govern the employment agreement will enforce the restrictions imposed on the departing advisor. Often, attorneys working with advisors making a non-Broker Protocol transition can negotiate with the advisor’s employer to clearly delineate the terms of the advisor’s separation from the firm.
Common Mistakes Made by Advisors When Executing a Transition
The most common mistakes seen when advisors attempt a transition arise out of a lack of adequate knowledge and preparation and the failure to consult experienced counsel to guide the advisor through the transition process. Below, we highlight four specific common mistakes we see advisors make when navigating the transition process.
The first common mistake is the failure to pay attention to small details, which can have a significant impact on the advisor’s transition. An example of this is advisors that assume that all Broker Protocol transitions are the same when, in fact, they may not be. Contrary to what some believe, a firm that is signatory to the Broker Protocol can define how the Broker Protocol will apply to their organization. Advisors may neglect to read the Joinder Agreement of the firm from which they are departing to understand if the firm has enumerated any exceptions from the Broker Protocol that are conditions of their joinder to the Broker Protocol. For instance, some firms may exclude certain of their affiliates from the coverage of the Broker Protocol. Advisors that fail to understand this may miscalculate what steps they may take when soliciting clients from those affiliates that are not deemed to be participating in the Broker Protocol.
A second common mistake occurs when advisors form their own entities to launch their own advisory firm while still employed without adequately reviewing employment agreements and employer policies to determine if such action is permissible. Often non-competition clauses as well as an employer’s duty of loyalty preclude an advisor from owning an entity that is designed to compete with the advisor’s current employer. While it could be argued there is no actual competition without onboarding any clients, advisors that nonetheless take these steps are very likely violating firm policies that require pre-approval of outside business activities, including owning other business entities, which could potentially result in termination for cause if discovered by the employer.
A third common mistake occurs when advisors underestimate their employer’s ability to detect when they are engaging in activities that could violate the advisor’s obligations to the employer. For instance, advisors may believe that their employers cannot track their activities including the sending and downloading of information that is helpful to the advisor in the transition process when, in fact, many financial institutions have forensic capabilities that can be utilized to determine when an advisor is inappropriately sending or downloading information that should not be used in the transition process, including determining when emails are being sent to personal accounts and when information is being downloaded to personal devices. An employer that detects unusual activity and subsequently conducts and investigation may discover an advisor’s plans to leave the firm, which could result in the firm prematurely terminating the advisor before the advisor has adequate time to execute its transition plan. This could leave advisors scrambling and, even worse, could potentially stymy an advisor’s attempts to execute the transition as desired.
A fourth common mistake occurs when advisors prematurely tell clients and/or employees of their plans for transition without having first consulted with experienced counsel. Such communications could result in violations of provisions prohibiting the solicitation of clients and/or employees. In general, communicating with potential clients and, especially employees, prior to resignation also increases the risk that the employer will discover the advisor’s plans and terminate the advisor before the advisor has an opportunity to fully implement the transition plan. Therefore, while advisors are enthusiastic to share their plans with their clients and fellow employees, they should generally tread cautiously in this area for both legal and practical reasons.
What Happens When a Transition Plan Goes Awry?
While the vast majority of advisor transitions are executed without a hitch, some transitions have resulted in significant reputational and financial harm to transitioning advisors.
Where an employer suspects that an advisor has failed to satisfy its obligations owed to the employer, typically the employer will first file to obtain a temporary restraining order (“TRO”) against the advisor, which can, at least for a few weeks and perhaps more, prohibit an advisor from executing the transition plan including prohibiting the advisor from utilizing confidential information during the transition process, soliciting clients or employees to join the advisor’s new firm, or, in some circumstances, competing against the employer altogether.
Whether a court decides to enter a TRO is fact-specific and depends on, among other things, the nature of the departing advisor’s conduct as well as the state in which the TRO is being sought. An employer that succeeds in obtaining a TRO can gain a competitive advantage against an advisor in its attempts to retain clients that could otherwise sever their relationship with the employer, which is why it is such a powerful tool in the hands of an employer.
This is why many transitioning advisors typically wait until late Friday afternoon in order to submit their resignation because this makes it much less likely that the employer will be able to file for a TRO and have a hearing on the matter before the weekend when the advisor can begin reaching out to clients to introduce clients to the new firm and begin the account transfer process if the client desires to join the advisor’s new firm.
In order to minimize the likelihood of an employer obtaining a TRO, advisors should carefully map out their transition plan to ensure they satisfy their obligations to the employer or, at the very least, minimize the likelihood that the employer will reach out if they fail to completely satisfy such obligations to the employer.
Even if an employer is not successful at obtaining a TRO, if it can demonstrate during the subsequent FINRA arbitration that it suffered damages as a result of improper conduct by the departing advisor, the advisor could nonetheless be liable for monetary damages payable to the advisor’s former firm.
Conclusion
Planning a transition can be daunting for an advisor, and it can involve many legal pitfalls to navigate, but many transitions have been executed smoothly, and the vast majority of advisors that transition to independence say that it’s the best move they’ve made in their career.
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