Back From the Future: Recent Morgan Stanley Loss/Win Underscores Need to Plan Transition
Preview
Leaving firms never has been easy for financial advisors. Brokerage firms often object to their former employees taking “their” clients. Likewise, brokers need their clients, with whom they fostered relationships, in many cases, for decades. As a result, before 2004, courts were filled to the brim with lawsuits and motions for temporary restraining orders filed against brokers by their former employers. The primary goal of those filings was to prevent brokers from taking any client information and using it to solicit and move the clients to a new home.
This regime proved unworkable for all the parties involved. It was too expensive for brokerage firms to file lawsuits, and most ended with a short “time out” and/or a monetary payment. Depending
The relief came in 2004 when the leading brokerage firms decided to ease the situation by creating a mechanism where brokers and firms could part their ways without judicial involvement. The framework was dubbed the Protocol for Broker Recruiting. Merrill Lynch, Morgan Stanley, Smith Barney, and UBS were the founding members and the original signatories of the Protocol. Around 1,700 firms are currently participating in this mechanism. Although recently some major players, including Morgan Stanley, have left the Protocol, it remains one of the major documents that regulate the relationship among the financial industry players. Issues, however, still exist, including those involving interpretation of the Protocol. As the fight for clients becomes more and more competitive with the advance of technological progress and informational technology and with some leading firms exiting the Protocol, more legal battles should be expected. Thus, an entirely new framework might be necessary.
A case of Kevin M. Clouse is one of the more recent examples of the tension that is building up in the industry. At the break of 2017, one Kevin M. Clouse of Seattle, Washington, a broker, decided to leave his employer at the time – Morgan Stanley Smith Barney, LLC – and bring some of the clients with him to his new firm, RBC Capital Markets, LLC. What happened next will probably be a starting point for a new reality in the financial industry. The situation that unfolded was somewhat reminiscent of the pre-Protocol years, as Morgan Stanley filed a complaint and a motion for injunctive relief in a federal court requesting a temporary restraining order. Somewhat surprisingly, in a very brief order, the court denied the request. Nonetheless, when the case proceeded to arbitration, the panel of arbitrators ruled for Morgan Stanley.
What follows is an analysis of those divergent opinions that will provide some guidance as to what the future holds for the financial industry and how reps should approach their transition.
Facts
The stage is set in Washington where Morgan Stanley has one of its offices and where Kevin M. Clouse lives. Clouse started working in the Seattle branch in June 2009 as a result of Morgan Stanley-Smith Barney merger. Before the merger, Clouse worked at Smith Barney first as a sales assistant and then – since 2005 – as a financial consultant trainee. In both roles at Smith Barney, Clouse worked with Gary Magnuson who was an experienced financial advisor. On May 26, 2015, Clouse, Magnuson, and Magnuson’s daughter entered into a joint production agreement, and they worked together until Clouse resigned.
Clouse left Morgan Stanley on January 30, 2017. According to Morgan Stanley, the resignation followed a meeting of Clouse with Magnuson on January 27, 2017, before Magnuson’s four-week departure to Vietnam. Magnuson’s daughter was not present because she was sick. There was no mention of his resignation during the meeting. When Clouse resigned on Monday, he left Morgan Stanley a list of 105 clients he intended to solicit. Clouse immediately began working for his new firm from where he instantly sent a mass mailing to all clients on the list to bring them into his new firm. Morgan Stanley took an issue with such a development and filed a complaint and a motion for injunctive relief in the federal court and an arbitration claim with FINRA. Parties’ arguments, in this case, reflect the incredible complexity of the issue; already intricate legal arguments must adhere to established precedents, yet they cannot ignore the reality where decimation and transfer of volumes of information have become as easy as a click of a computer key. Moreover, in many instances, the information itself is readily available from an almost unlimited number of sources. The court, in this case, seemed to take this reality into account whereas the FINRA arbitration panel clung tightly to the pre-Protocol tradition.
Disposition of the Matter in the District Court
Morgan Stanley filed its complaint
The District Court sided with Clouse, denying Morgan Stanley’s motion for a temporary restraining order. Emphasizing that a temporary restraining order is an “extraordinary remedy,” the Court stated that Morgan Stanley “has not carried its burden to establish” the elements of the remedy. The court, in particular, highlighted that Morgan Stanley has not shown “a likelihood of success on the merits, irreparable harm in the absence of TRO, or that the balance of equities tips in its favor.” Since the court was silent on whether the injunction was in public interest, another element of an injunctive relief claim, an assumption that Morgan Stanley satisfied it is reasonable. The bitterness of this loss for Morgan Stanley was sweetened by the FINRA panel’s award just a few weeks later.
Arbitration Award
On February 14, 2017, Morgan Stanley filed a claim under FINRA Rules to recover damages resulting from Clouse’s departure. It brought this claim eight days after the District Court’s decision, asking for injunctive relief as well as asserting a breach of contract, misappropriation of trade secrets, conversion, and breach of fiduciary duty causes of action. It also alleged two additional claims – aiding and abetting breach of fiduciary duty and intentional interference with contractual relations – against Clouse’s new employer. Except for the monetary damages, the relief requested in the arbitration mirrored the relief sought in the District Court. Thus, by way of injunctive relief, Morgan Stanley asked for the return of all documents, records, and information taken by Clouse. Oddly, it included in this list financial information of the clients. Morgan Stanley also asked the arbitration panel to prohibit Clouse from using, disclosing or transmitting those documents and information for any purpose, including solicitation, excepting 13 clients it identified as Clouse’s friends and family. Morgan Stanley also asked for a prohibition on solicitation of all clients for whom Magnuson was the “Designated Joint Producer/Lead FA,” again, excepting the 13 clients. Finally, Morgan Stanley asked to place a prohibition on destroying or making unavailable for further legal proceedings any records or documents in Clouse’s possession or control obtained from or containing information derived from Morgan Stanley’s records. Besides this injunctive relief, Morgan Stanley asked for compensatory damages in an unspecified amount, attorney’s fees, and other relief that the panel sees appropriate.
At the conclusion of the arbitration, the panel returned an award for Morgan Stanley. Although not all requests were satisfied, the panel awarded $311,000 in compensatory damages and $164,000 in attorney’s fees. The arbitrators also granted injunctive relief, ordering Clouse and his new firm to return to Morgan Stanley all client information that Morgan Stanley produced to Clouse and his new firm during the arbitration, including two specific documents – New Accounts Per Year and Draft Protocol List. Clouse and his new firm also had to confirm, in writing, that they possessed no Morgan Stanley client information obtained by Clouse other than information permitted by the Protocol, giving them 20 days to comply. The panel and the court came to different conclusions although the law they operated under was the same. A careful look at the details of this case may help understand such an unusual divergence of opinions.
Injunctive Relief
Elements
To understand this case, some background information on injunctive relief is necessary. Injunctive relief is an important remedy granted by courts when an award of monetary damages is not sufficient to make a person whole. An injunction either orders a person to affirmatively do something, such as requiring a party to perform a contract, or demands a person to stop doing something, such as prohibiting a financial advisor from soliciting his former clients. Injunctive relief is available in three forms: a temporary restraining order, a preliminary injunction, and a permanent injunction. A temporary restraining order is the most limited remedy with its primary purpose to give the court time to decide whether a preliminary injunction is justified. A preliminary injunction is granted before trial to prevent significant damage that could occur by the time the trial is concluded. Naturally, a court enters a permanent injunction after it considers the merits of the case. Because the first two kinds of injunctive relief are placing burdens on a person before a court examines the merits of the case, courts are reluctant to grant them. Therefore, when courts decide whether to issue injunctive relief, they weigh various factors to determine whether injunctive relief is justified. One of such factors is whether the party requesting this remedy will succeed on the claims it advances against the opposing party. A court, therefore, has a difficult task of deciding the issue without prejudging the case only based on the pleadings without any discovery. Thus, a party asking for injunctive relief also must defend the merits of the substantive claims.
The test for both a preliminary injunction and a temporary restraining order is the same, except a temporary restraining order is granted only in the emergency circumstances when preservation of status quo is necessary to avoid damages. Since both remedies are “extraordinary,” a very demanding test must be satisfied. There must be a “clear showing” that a party requesting such relief is entitled to it. The party, therefore, must persuade a court that (1) it is likely to succeed on the merits; (2) it is likely to suffer irreparable harm in the absence of the relief; (3) the balance of equities tips in its favor; and (4) an injunction is in the public interest. In the Ninth Circuit, which includes the State of Washington, courts also grant injunctive relief when a party demonstrates that serious questions going to the merits were raised and the balance of hardships tips sharply in favor of the party requesting the relief. Like the main test above, this test also requires a showing that there is a likelihood of irreparable harm and that the injunction is in the public interest. Success on the merits is a necessary element because it affects the balancing of relative harms. The moving party need only show that it is likely to succeed on one claim. As part of the irreparable harm analysis, courts also must decide if there is no adequate remedy at law for the plaintiff. Once either of those tests is satisfied, the court will grant a temporary restraining order. The court, in this case, did not believe that that there was a need for such relief.
Likelihood of Success on the Merits: Breach of Contract
The first element of the test –
To show the likelihood of success on, arguably, its most viable breach of contract claim, Morgan Stanley cited all agreements signed by Clouse whether relevant or not. The first agreement mentioned was a nondisclosure agreement, signed in 2005 when Clouse was promoted by Smith Barney to a Financial Consultant Trainee, as well as confirmations of the conditions of this agreement throughout his employment with Morgan Stanley, as they were articulated in Morgan Stanley’s Code of Conduct. Morgan Stanley also cited a one-year non-solicitation agreement signed in 2005. Although all these documents repeatedly appeared in the pleadings, Morgan Stanley mostly relied on what was called a joint production agreement.
A joint production agreement was a collection of terms and conditions that regulated the work of a financial advisor team at Morgan Stanley. Clouse entered into such an arrangement with Magnuson and Magnuson’s daughter on May 26, 2015. It consisted of two separate documents: (1) the Joint Production Memorandum Agreement; and (2) the Joint Production Schedule A (Client List). The Memorandum required all signatories to abide by Morgan Stanley’s Joint Production Agreement Policy (the “Policy”) that mandated each teammate to identify the clients for whom they are responsible by designating themselves as a “lead” financial advisor for that particular client. Schedule A reflected this assignment of each client to his or her respective financial advisor. Schedule A also provided for a new Schedule A if any information on the list changed. In this case, Schedule A listed Magnuson as the “lead” financial advisor for all the clients. Finally, the Policy incorporated some employment and post-employment restrictions, including a one-year non-solicitation provision and a prohibition on the retention of client information. It also stated that the Broker Protocol was not applicable. These documents coupled with the language in the Broker Protocol excluding teams and partnerships from its scope were the crux of Morgan Stanley’s argument.
Because Morgan Stanley stated that the Broker Protocol did not apply to team agreements, it based its claim for breach of contract on the Team Agreement and the Policy that restricted Clouse as to solicitation and disclosure of customer information. Morgan Stanley argued that Clouse had agreed to the Team Agreement, he never contested the designation of Magnuson as a “lead” financial advisor for all team clients, and he also agreed to the Policy that prohibited solicitation for one year. According to Morgan Stanley, taking the list of clients and contacting them through mass mailing, was a breach of the agreements. Morgan Stanley argued that the agreements were enforceable as to Clouse under Washington law because they were entered into when the employee was first hired as a financial advisor. Anticipating the argument to the contrary, Morgan Stanley stated that when Clouse signed the Team Agreement, he “received substantial monetary benefits and access to more Morgan Stanley accounts,” which was additional “consideration” to bind Clouse. Finally, Morgan Stanley argued that the one-year restriction on solicitation was reasonable under Washington law.
In response, Clouse’s central defense was his following the Broker Protocol. He insisted that even if any contracts he signed were enforceable, the Protocol applied. Additionally, he stated that the team agreement was not binding because there was no independent “consideration” when Clouse signed it. He finally argued that, in cases where the Protocol was not closely followed, money damages should be a proper remedy, not an injunction, because the damages were readily calculated. Clouse concluded that an injunction would “serve no purpose” because he already contacted all 105 clients. Thus, there was “nothing to enjoin” and “nothing to return,” as Clouse did not take anything else but the list of clients, a copy of which he left for Morgan Stanley. Clouse also argued that an injunction would harm the members of the public who are “free to select whichever provider of financial services they please without the kind of improper interference Morgan Stanley seeks to impose on them.” He then proceeded to present facts and arguments in support of his reply.
Clouse emphasized
Because one of Morgan Stanley’s principal arguments was non-applicability of the Protocol to teams of financial advisors, Clouse addressed this argument first. He pointed out that the general rule that the Protocol established for teams was that a “financial advisor who has been a member of a team for four years or more may solicit any client serviced by the team.” He further added that the Protocol allowed signatories to be more restrictive, but the additional restrictions may not “be construed or enforced to preclude [financial advisors] from taking the Client Information for those clients whom [they] introduced to the team . . . or from soliciting such clients.” Clouse stated that he had been performing the majority of work for the team’s clients and was a primary contact for more than 280 clients. He estimated that he introduced about 40% of the clients. In contrast, Magnuson’s primary focus was portfolio management with minimal client contact while his daughter was a primary client contact for only a few clients. To that point, Clouse stated
Clouse also stated that the designation of Magnuson as an originator of all 310 clients was a sham and the agreement itself was unenforceable. He pointed out that those designations are divorced from reality because even Clouse’s friends and family members were listed as if Magnuson brought them. A different conclusion would have to assume that in 10 years of service, Clouse had not originated a single client on that list. Moreover, Clouse argued that the Team Agreement itself was unenforceable because it was not supported by independent “consideration.” As an example, he stated that before he entered into the agreement he already was an employee, his compensation did not change as the result of the agreement nor did his share – 33% – of clients change, and the agreement did not recite any additional consideration. When presented with the agreement, he contended, “he felt he had to sign [it] if he wanted to keep his job.” Furthermore, Clouse was not allowed to change his designation to a “lead.”
Lastly, Clouse also advanced an argument that the team agreement was unenforceable because it was an unreasonably restrictive employment covenant. He said that it was not reasonably necessary to protect the employer’s interests or goodwill by restricting Clouse from engaging in business with any of his team’s clients because, if Magnuson decided to leave, Magnuson could have taken all 100% of the client information and attempted to solicit all of the clients. The agreement allowed Magnuson to dominate all clients, which is not a reasonable measure to protect the employer’s business. Moreover, Clouse argued that the restrictions were in violation of public policy because they denied the clients their freedom of choice.
Likelihood of Success on the Merits: Misappropriation of Trade Secrets
Morgan Stanley also argued that it would succeed on the misappropriation of trade secrets claim by stating that the confidential client list and the contact information fell within the meaning of a protected trade secret. Morgan Stanley observed that the law in Washington recognized that a confidential customer list was a trade secret. It argued that the “economic value” of the information that Clouse took was “substantial,” as the list contained “nearly one hundred client contacts” with hundreds of client accounts and around $110 million in client assets that generated “significant commissions.” Morgan Stanley added that this information – clients’ assets, investment plans, holdings, and similar confidential information – was not “generally known to, or readily ascertainable by, any of Morgan Stanley’s competitors” who “can obtain economic value from its disclosure or use.” Morgan Stanley also stated that it instituted procedures to maintain customer information confidentiality, having expended “substantial financial and human resources to develop” and protect this information through classifying it “confidential” and requiring confidentiality agreements.
Clouse countered that Morgan Stanley would not prevail because there was no trade secret and no misappropriation. He cited court opinions stating that a customer list was not a trade secret if it was readily ascertainable from a public source. Clouse observed that a knowledgeable financial advisor could easily compile from publicly available sources the client information he took from Morgan Stanley. Clouse argued that he did not “utilize improper means to acquire the information and . . . he was under no duty to limit its use for the purposes specified in the Protocol.” Clouse’s arguments are compelling, especially in light of the shrinking scope of privacy in the social media era.
Likelihood of Success on the Merits: Conversion and Breach of Fiduciary Duty
Although Morgan Stanley asserted claims for conversion and breach of fiduciary duty in the complaint, it did not pursue those arguments in its motion for a temporary restraining order. In the complaint, however, Morgan Stanley stated that the “conduct of [Clouse] constitutes a conversion of . . . proprietary and trade secrets rights and interests, for which Morgan Stanley is entitled to exclusive use.” It alleged nothing else except that Clouse was its employee. In this capacity, Morgan Stanley argued, he owed the firm a fiduciary duty of trust and loyalty, requiring him to “maintain Morgan Stanley’s trade secret and other confidential and other proprietary business and customer information.” Because Clouse took the confidential information in violation of his agreements and the Protocol, he breached this duty of loyalty.
Addressing both of these claims, Clouse retorted that Morgan Stanley could not sustain any of them. Because the information Clouse took was not “property” of Morgan Stanley and because Clouse was entitled to it, there was no conversion. Similarly, because Clouse was not under any duty to refrain from taking the information, he did not breach his fiduciary duty to Morgan Stanley. Here, too, Clouse’s arguments were more compelling because, in part, of the nature of the information Clouse took and its availability to the public.
Irreparable Harm
In its complaint, Morgan Stanley argued that irreparable harm would result due to: (1) disclosure of trade secrets, customer lists, and other confidential information; (2) loss of confidentiality of clients’ records and financial dealings, loss of confidence and trust, loss of goodwill, and loss of business reputation; (3) loss of personnel and damage to office morale and stability; and (4) present economic loss that was unascertainable at the time of complaint and future economic loss that was not subject to calculation at the time of the proceeding. To prevent this harm, Morgan Stanley asked the court to enjoin Clouse form further solicitation of clients and from using and disclosing confidential customer information; it also asked the court to order Clouse to return all information he took when he resigned, except for the 13 clients that Morgan Stanley determined were Clouse’s friends and family. Morgan Stanley added there could not be an adequate remedy at law because losses from misappropriation of trade secrets and the loss of goodwill, trust, and confidence would be difficult to calculate.
Clouse countered that Morgan Stanley could not show irreparable harm. First, Clouse left the company by following the Protocol, that is, by taking the information allowed by the Protocol. Further, Clouse argued that Morgan Stanley waited ten full days before it filed the suit. When Clouse contacted the clients on the day he left, the purported harm to Morgan Stanley occurred on that very day because “customers cannot be unsolicited.” Therefore, even if Morgan Stanley could show that valid agreements restricted Clouse, the temporary restraining order entered ten days after the solicitation had occurred would have no “meaningful impact on preventing any irreparable harm.” Again, it is tough to argue against this point.
Balance of Equities
Finally, Morgan Stanley argued that the equities related to the granting of injunctive relief outweighed a denial of injunctive relief. Morgan Stanley explained that an injunction would protect its “goodwill, business reputation, trade secrets, and contractual rights.” It offered that an injunction would not bar Clouse from earning a leaving as a financial advisor because he would be “free to develop his own client relationships.” Morgan Stanley further observed that Clouse would be able to “solicit business from any person or household in the entirety of King County . . .
Conversely, Clouse argued that the balance of equities tipped in his favor and that an injunction would not be in public interest. From the equities perspective, granting an injunction would “hamper [his] ability to earn a living and compromise his ability to support his wife and two daughters.” Also, it would interfere with customers’ “informed decision from whom they receive financial services.” He suggested that the loss to Morgan Stanley would be minimal: a small number of clients. Clouse further contended that the public interest would be harmed by the injunction because it will deprive the clients of the “freedom to learn about and choose their financial advisor,” especially being able to choose an individual who had served them for 17 years, in some cases.
Clouse’s arguments were compelling enough for the District Court to deny Morgan Stanley’s request for a temporary restraining order as the court had to conclude that Morgan Stanley was not likely to succeed on the merits of any of its claims under Washington law. Inexplicably, however, the arbitration panel, operating under the same law, came to a different conclusion. Notwithstanding the panel’s decision, the District Court’s denial shows that the judiciary could be becoming more receptive to financial advisors’ arguments. This is an important development as the judiciary is the first stage of the proceedings in suits against brokers by their former firms, as a motion for a temporary restraining order must be filed in court. Well-reasoned responses to such motions may sway more courts in this direction, putting pressure on arbitration panels to follow suit.
Conclusion
Every financial advisor who is contemplating leaving his or her firm must plan for months on how best to approach and plan the transition. A competent securities attorney familiar with financial services employment law is a must in these situations. Only such a holistic, long-term approach will allow for a smooth transition with
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