In recent years, legislators, regulators and judges have shown increased focus on and interest in pushing back against restrictive covenants found in employee contracts, looking to strike a balance between the legitimate needs of businesses and those of employees that move on. These concerns are often echoed by participants in the overall labor market. I touched on restrictive covenants in a previous editorial, and here will describe the current climate in-depth, with a focus on financial advisors.
Resistance to imposing restrictions on an exiting employee by contract is nothing new. In fact, some states have had laws on the books addressing this dating back to the 1800s. But a rising sentiment against restrictive covenants is shifting the landscape for wealth management firms as the covenants can have major impacts on clients’ ability to follow advisors to a new firm.
Depending on the specifics of the contract and the situation at hand, financial advisors often face the dilemma of abandoning longstanding client relationships despite a client’s demand or continuing them under threat of a dispute with their former employer.
Types Of Restrictive Covenants
There are four types of restrictive covenants:
Non-competition covenants restrict the exiting employee from opening a competing business or joining a competitor. These almost always have limitations; either an expiration date (e.g., six, 12 or 18 months after the employment terminates) or a geographic radius (e.g., no place of business within a 250 mile radius of the corporate headquarters).
Non-solicitation covenants restrict the exiting employee from soliciting the firm’s clients or employees to join them after they leave the firm. This can have significant implications for transferring an advisor’s clients to a new firm. This provision often limits the restriction to an employee initiating contact with the former client for purposes of the solicitation.
Non-acceptance covenants prevent the exiting employee from accepting the firm’s clients, who formerly had the relationship with that employee, regardless of whether the employee has contacted the client since departing their prior firm – a very strict restriction for exiting advisors. Sometimes, the non-acceptance provision is coupled with a liquidated damages provision that essentially establishes a predetermined price for the employee to acquire the client from the former firm.
Garden leave covenants cause the exiting employee to give notice of their departure at a predetermined amount of time in advance (e.g., 90 days) during which the employee may not be obligated to report to work but is restricted in their interactions with the clients. Though the reason given is often the orderly passage of duties and transfer of obligations, these covenants often effectively amount to a blackout period in which the exiting employee has no communication with the clients.
FTC Rule Stalls But A Path To Federal Action Remains
On April 23, the Federal Trade Commission (FTC) issued a rule banning non-competition clauses in contracts nationwide, with enforcement to begin on Sept. 4, but a federal district judge in Texas set the rule aside shortly before enforcement, meaning it did not come to be. The rule is currently in limbo, and the FTC may appeal. Other courts could weigh in as well.
Firms cannot simply put new employment contracts on hold while awaiting clarity.
Though federal action on non-competition clauses have stalled, business goes on. Firms cannot simply put new employment contracts on hold while awaiting clarity. Adding to the confusion are the firms that acted ahead of the rule’s planned enforcement date by communicating to employees that the non-competition clauses in their contracts were no longer valid. Those companies are now left to decide whether to rescind those statements and what the legal implications could be.
Firms must make decisions relevant to their own facts and circumstances, and the circumstances of the wealth management industry are somewhat unique because the advisor-client relationship is very personal and pertains to highly guarded confidential information. The best part to the run-up to the anticipated enforcement of the FTC rule is that it gave firms the impetus to review their contracts and procedures regarding restrictive covenants as the battleground shifts from federal to state courts.
State Battlegrounds
With federal rulemaking stalled, the battles at the state level are likely to intensify.
The states have already been a major battleground for restrictive covenants for years, and with federal rulemaking stalled, the battles at the state level are likely to intensify. North Dakota and Oklahoma have recently reiterated their centuries-long stances. New York, Minnesota and Massachusetts have all made recent moves to push back on the enforcement of restrictive covenants. California has gone so far as to impose its law on restrictive covenants even when out-of-state contracts come in front of its courts, regardless of the choice of law specified in the contract.
This leaves firms and advisors engaged in battles across states, requiring attention not only to each state’s laws and courts, but also how another state’s courts or laws may interpret or reject the laws of the state designated in the contract. Adding to the complexity is the post-pandemic nomadic fluidity of the labor market. Each case hinges on the wording of the restriction and – to even a greater extent –the facts and circumstances surrounding the employment and termination for the advisor and their clients. There is simply no easy answer for advisors or firm leaders who say, “Just tell me what I need to do.” Like a wealth management strategy itself, the solution must be tailored to each individual situation.
Avoiding Litigation
Many firms recognize the hazards inherent in pursuing a case against a recently departed financial advisor. If a firm loses in court, other advisors may read the publicly available decision, essentially notifying those advisors that their covenants may also be unenforceable (though their own facts and circumstances may vary). Firms may face public scrutiny from disgruntled clients who feel like the firm is intruding on their right to work with the financial advisor of their choice. Litigation expenses can also consume precious budget resources.
Firms may face public scrutiny from disgruntled clients.
In light of these concerns, leading firms have turned to a multifaceted solution that includes an age-old private sector solution. Wealth management firms are expanding and diversifying their breadth of services and they are deploying a deeper bench of advisors and relationship managers to serve each client. Firms are building more complex systems that departing advisors find difficult to replicate. Companies are spending more time at the onset of an employment arrangement to get the employment terms right; sometimes going as far as structuring the hire as an acquisition to improve the likelihood of enforcing these covenants. And when a dispute ensues, these firms are pursuing confidential settlements with exiting advisors to maintain discretion.
As this issue continues to evolve, firms and their advisors will have to keep up with legal and regulatory changes on the enforcement of restrictive covenants and account for their own evolving circumstances in order to ensure that their contracts stand for what they think they do. But the best firms aren’t waiting for lawmakers or regulators and actively implementing strategies to ensure that their company is protected under any circumstances.
Brian Hamburger is Founder, President and CEO of MarketCounsel Consulting and Founder and Chief Counsel of the Hamburger Law Firm.
