Business & Corporate Articles


Trade Secrets in the Securities Industry:  Four Key Issues Transitioning Financial Advisors Must Consider

Introduction

It is a scenario we encounter often.  A financial advisor approaches our firm in a panic.  While in the midst of transitioning their client accounts to a new firm — a significant undertaking on its own — they are sued for alleged misappropriation of trade secrets.  Worse still, a court may have issued a restraining order or preliminary injunction banning any further communications with their clients, who likely have no idea where their trusted financial advisor went or how to reach them.  The transitioning advisor is now facing a complicated legal battle while their business and livelihood hangs in the balance. 

When financial advisors move from one firm to another, there are many legal issues that should be considered.  Chief among them is determining the type of client information advisors are permitted to take upon leaving their prior firm — assuming they are permitted to take any information at all.  Equally important is evaluating when and how financial advisors may use that information to announce their new affiliation or solicit clients.  Despite many attempts to clarify and unify the rules governing an advisor’s use of client information during a transition — both by courts and financial firms — this remains a volatile area of the law and, in many cases, the legal battle rages on.

The fundamentally important, threshold issues a transitioning advisor should consider before making a transition include: (1) whether trade secrets laws could limit the type of information the advisor may take in connection with their transition; (2) the enforceability of any written agreements defining client information as a confidential “trade secret”; (3) the extent to which the departing broker may use client contact information in connection with their transition, if at all; and (4) how the interplay between Broker Protocol protections and applicable trade secret laws may impact the advisor’s ability to use client information. 

Applicable Law

In California, virtually everything that an employee acquires by virtue of his or her employment, other than compensation, belongs to the employer.  Cal. Labor Code § 2860.  This includes the employer’s trade secrets.  Trade secrets are governed by state laws and the recently enacted federal Defend Trade Secrets Act of 2016 (DTSA).  Forty-eight states, including California, have enacted some version of the Uniform Trade Secrets Act, while two states, Massachusetts and New York, rely on common law.

California’s trade secret laws are codified in the California Uniform Trade Secrets Act (CUTSA), which defines a trade secret as “a formula, pattern, compilation, program, device, method, technique, or process, that: . . . [d]erives independent economic value, actual or potential, from not being generally known to the public or to other persons who can obtain economic value from its disclosure or use.”  Cal. Civ. Code § 3426.1(d).  The DTSA defines trade secrets similarly, but before trade secret protections apply under federal law, there must be a finding that the information cannot be ascertained through alternative means, such as public sources.  18 USC § 1839(3)(B).

Trade secret protections are somewhat at odds with the laws of California and other states prohibiting “unreasonable restraints” on the practice of a lawful profession, trade or business.  See, e.g., Cal. Bus. and Prof. Code §16600, et seq.  As a result, the DTSA has safeguards in place to prevent conflicts with those laws.  For one, any injunctive relief under DTSA must comply with California’s “strong public policy against noncompetition agreements.”  18 U.S.C. § 1836(b)(3)(A)(i)(II); Advanced Bionics Corp. v. Medtronic, Inc., 29 Cal. 4th 697, 706 (2002).  California’s prohibition against noncompetition agreements, codified in Business and Professions Code section 16600, protects a person’s right to engage in their lawful profession.  Departing employees generally are free to compete against their former employers as long as they do not violate trade secret laws or engage in conduct tantamount to unfair competition. See, e.g., Henry Schein, Inc. v. Cook, No. 16-CV-03166-JST, 2016 WL 3418537 (N.D. Cal. June 22, 2016) (balancing trade secret protections with section 16600 in ruling on a preliminary injunction). 

The interplay between trade secret laws and California’s prohibition on non-compete agreements frequently creates a legal “gray area” which has led to conflicting legal precedent. Compare Dowell v. Biosense Webster, Inc., 179 Cal. App. 4th 564, 578 (2009), with Wanke, Indus., Commercial, Residential, Inc. v. Superior Court, 309 Cal. App. 4th 1151, 1176–80 (2012).  One of the seminal cases addressing the conflict between trade secret protections and non-compete laws is the The Retirement Group v. Galante.  In Galante, the court reasoned that while non-compete agreements are generally invalid in California, an employer may nevertheless seek to enjoin former employees from using the employer’s trade secrets to solicit clients as long as the employee’s actions were independently wrongful.   Retirement Grp. v. Galante, 176 Cal. App. 4th 1226, 1238 (2009). The case turned on whether the former employees misappropriated trade secret information, as defined by CUTSA — a showing that the departing advisors merely breached a contractual non-compete provision was not enough.  At least in California, an employer cannot rely on an illegal non-compete clause to prevent a prior employee from soliciting clients of the departing firm. 

Many broker-dealers and registered investment advisory firms require their employees to sign agreements which broadly define all client identities, contact information and account information as highly sensitive, proprietary “trade secrets.”  The fact this information is defined to constitute a “trade secret” does not, however, conclusively establish that the information is, in fact, entitled to trade secret protections.  The employer still has the burden of proving the information constitutes a legally protectable trade secret.  MAI Sys. Corp. v. Peak Computer, 991 F.2d 511, 522 (9th Cir. 1993); Am. Paper & Packaging Prod., Inc. v. Kirgan, 183 Cal. App. 3d 1318, 1325 (1986).

Client Lists as Trade Secrets

When a registered representative or investment advisor is contemplating a transition to a new firm, it is critical to determine at the outset whether client lists and other client information could constitute trade secrets.  This is a highly fact-based inquiry that depends on the nature of the advisor’s business; the history of the advisor’s interaction with his or her clients; the manner in which the advisor developed his or her book of business; and other, case specific facts that must be considered.  Reeves v. Hanlon, 33 Cal.4th 1140, 1155 (2004).  Generally, the more time and resources the employer expends to gather and protect the alleged trade secret information, the more likely a court will find such information constitutes a legally protected trade secret.  Morlife, Inc. v. Perry, 56 Cal. App. 4th 1514, 1522 (1997).  

In the financial services industry, customer lists containing unique client information that is not readily accessible to competitors or other third parties — such as those which identify clients with particular needs or characteristics — are more likely to be (but not always) considered trade secrets.  It is also important to consider how the employer stores client information, whether any third parties had access to it and whether other industry competitors have access to the same or similar data from another source. 

Client information need not be in written form to constitute a trade secret; it can exist solely in the employee’s memory. Morlife, Inc. v. Perry, 56 Cal. App. 4th 1514, 1522 (1997).  In other words, an advisor may be found to have misappropriated trade secrets merely by memorizing and using certain client contact and account information, assuming, of course, that such information constitutes a protectable trade secret in the first place. 

An employer must also show that its trade secrets have been misappropriated.  To prove misappropriation, the employer must show the former employee is currently using or has used trade secrets to solicit clients to leave the departing firm.  Richmond Techs., Inc. v. Aumtech Bus. Sols., 2011 WL 2607158, at *18 (N.D. Cal. July 1, 2011) (“[I]t is not the solicitation of the former employer's customers, but is instead the misuse of trade secret information, that may be enjoined.”).

Employers often seek to obtain temporary restraining orders and injunctions against former employees based on an alleged actual or threatened use of trade secret information to solicit clients from the departing firm.  These injunctions may prohibit any further contact between the advisor and his or her clients, though typically only those clients who have not yet transitioned their accounts to the advisor’s new firm.  As a result, firms typically pursue injunctive claims very soon after an advisor departs and the firm discovers he or she may have taken and begun using information that even arguably constitutes a legally protected trade secret.  As a worst case scenario, a transitioning advisor may be enjoined from contacting clients before transitioning any significant portion of their business to their new firm. 

Courts recognize the strong public policy favoring an investor’s right to choose their financial advisor and that “clients are free to come and go among . . . a myriad of [ ] financial advisors.” Smith Barney v. Burrow, 558 F. Supp. 2d 1066, 1082 (E.D. Cal. 2008); see also FINRA Rule 2140 (prohibiting FINRA member firms from interfering with a customer’s request to ransfer his or her account in connection with the change in employment of the customer’s registered representative).  And when considering requests for injunctive relief in this area, courts are instructed to avoid infringing on the investor’s right to take their business wherever they choose. See StrikePoint Trading, LLC v. Sabolyk, 2009 WL 10659684, at *6 (C.D. Cal. Aug. 18, 2009). Injunctions and orders that infringe on a clients’ right to “seek out new advisors of their choosing, especially if they wish to take business to [the advisor] because the clients prefer [the advisor’s] services,” are improper.   StrikePoint Trading, LLC, 2009 WL 10659684, at *6. Indeed, “the public interest is better served with open competition in the securities field and access to advisors of clients' choice.” Barney v. Burrow, 558 F. Supp. 2d 1066, 1084 (E.D. Cal. 2008).

Financial firms may also face an uphill battle establishing the “irreparable injury” requirement for injunctive relief.  If the firm’s alleged damage can be quantified and remedied by an award of money damages, there is no “irreparable injury” and no grounds for injunctive relief.  Smith Barney v. Burrow, 558 F. Supp. 2d 1066, 1083 (E.D. Cal. 2008).  In the financial industry, it is often fairly simple to calculate the revenue the firm will lose when a client leaves.  In that case, the damages are quantifiable and, by the time the firm seeks injunctive relief, may have already occurred thereby rendering injunctive relief improper as a matter of law.  Merrill Lynch, Pierce, Fenner & Smith Inc. v. Callahan, 265 F. Supp. 2d 440, 443–44 (D. Vt. 2003).  “The real loss which might be suffered by Merrill Lynch comes in the form of commission revenue generated by the Defendant from former Merrill Lynch customers, and that can readily be calculated from the commissions her and her new firm derive from the old Merrill Lynch Customers.” Merrill Lynch v. McCullen, 1995 WL 799537, at *3 (S.D. Fla. 1995).

Announcements vs. Solicitations In The Financial Industry

Under California law, even when client contact information constitutes a trade secret, departing advisors may still be able to use certain client contact information to “announce” their new affiliation.  While an individual may violate CUTSA by using a former employer’s confidential client list to solicit clients, CUTSA generally does not forbid an individual from announcingtheir change of employment, even to clients whose identities may constitute trade secrets.  Reeves v. Hanlon, 33 Cal.4th 1140, 1156 (2004). This is, however, a fact specific determination, and it is critically important to consult with experienced counsel to assess the potential risks involved. 

Confusion remains as to what constitutes an “announcement” versus a potentially prohibited “solicitation.”  Bare bones “announcements” may actually be held to constitute solicitations if they petition, invite or otherwise encourage customers to call or contact the person for information about their new firm or otherwise touts the new firm as being superior or offering better services than the prior firm.  If an announcement asks former firm clients to continue to do business with the advisor at their new firm, moreover, it will generally be considered a solicitation.  UBS Financial Svcs. Inc., v. Fiore, No. 17-CV-993-VAB, 2017 WL 3167321, at *14, (D. Conn. July 24, 2017). 

Finally, the CUTSA does not restrict an advisor from passively accepting business from former clients, as long as the advisor does not use trade secret information to do so.  Thus, assuming the advisor has not previously engaged in improper solicitation or misappropriated trade secrets, the advisor is generally free to accept calls or meetings with prior clients and follow their directives. 

Impact of The Broker Protocol

A final important factor to consider is whether the advisor’s transition is covered by the Protocol for Broker Recruiting (“Broker Protocol”).  The Protocol is an agreement among brokerage firms, RIAs and other financial firms setting forth certain ground rules that apply when an advisor transitions from one Protocol firm to another.  The Protocol’s “principal goal . . . is to further the clients’ interests of privacy and freedom of choice” when their chosen advisor moves from one firm to another.  In a Protocol transition, advisors have the ability to take and use client contact information to solicit clients to join their new firm, even if that information would otherwise be considered a trade secret. 

When an advisor leaves a Protocol firm and joins another Protocol firm, the advisor and hiring firm shall have “no monetary or other liability” to the prior firm as long as they “substantially comply” with the Protocol.  Substantial compliance generally means that the transitioning advisor and firm comply with the terms of the Protocol in good faith, do not take more client information than expressly permitted by the Protocol (e.g., nothing more than client names, account titles, addresses, phone numbers and e-mail addresses, if any) and do not solicit clients prior to the advisor’s resignation.  UBS Financial Svcs. Inc., v. Fiore, No. 17-CV-993-VAB, 2017 WL 3167321, at *15-*17 (D. Conn. July 24, 2017).  Notwithstanding Protocol protections, firms and transitioning advisors must comply with industry rules and regulations governing the use and safekeeping of client data, including those set forth in Regulation S-P. 

Many hiring firms encourage advisors to bring client contact information with them when they join.  At the same time, those firms may threaten legal action when other advisors depart and use client information to solicit clients.  Courts have criticized firms for what amounts to a “heads I win, tails you lose” recruitment strategy.  Morgan Stanley v. Frisby, 163 F.Supp.2d 1371, 1378 (N.D. Ga. 2001).  As the Court reasoned in Morgan Stanley v. Frisby, “[e]quity stops Morgan Stanley from challenging Defendants’ transition to PaineWebber because Morgan Stanley actively hires brokers from competitors and encourages them to use their client information to solicit account transfers.” Morgan Stanley DW, Inc. v. Frisby, 163 F. Supp. 2d 1371, 1377 (N.D. Ga. 2001).

The mere fact that a firm is a signatory to the Protocol can also factor into a Court’s determination of whether client contact information constitutes a trade secret.  As the Court articulated in Smith Barney v. Burrow, “Smith Barney cannot have it both ways — it cannot declare this information to be confidential and, at the same time, permit the information freely to be taken to 38 other financial institutions by departing advisors.” Smith Barney v. Burrow, 558 F. Supp. 2d 1066, 1080 (E.D. Cal. 2008).  “Given the Protocol, plaintiff is hard pressed to convince this Court that the information regarding clients whom defendants served qualify as plaintiff’s confidential trade secrets.”  Id. at 1081.  Courts are similarly hesitant to find that a client list constitutes the employer’s trade secret when the individual advisor has built their clientele through their own efforts and referrals.

For financial advisors who are contemplating or embarking on a transition, it is extremely important to consult with experienced counsel to minimize the significant risks of litigation.  The potential consequences of a temporary restraining order or injunction are severe and could result in the loss or destruction of all or a significant portion of an advisor’s book of business.

-- George Miller and Katherine Bowles 

**This article is for information purposes only and does not contain or convey legal advice.  The information herein should not be relied upon in regard to any particular facts or circumstances without first consulting an attorney. Any views expressed are those of the author only and not of the SDCBA or its Business & Corporate Law Section.**