What Duty of Loyalty is Owed to the Client?

What Duty of Loyalty is Owed to the Client? 

Since 2011, the SEC has advocated for a uniform fiduciary standard in order to clear up the confusion in the minds of many investors regarding the scope of the duties owed to them by their advisors.

Brian J. Sommer
bjs@muslaw.com

Currently, the law in many jurisdictions makes a distinction between the extent of the duty of loyalty owed by investment advisors and financial advisors employed by broker dealers. Generally speaking, investment advisors owe their clients an ongoing duty of loyalty whereas financial advisors do not. The problem is that most investors believe that they are owed an ongoing duty of loyalty regardless of whether they are dealing with an investment advisor or financial advisor. Consequently, the SEC is advocating for clearer guidance regarding the duty of loyalty and its ongoing nature.

But until such time as Congress accepts the SEC’s recommendations, it is best practice for advisors to clearly spell out in their client agreements the scope of their obligations to their clients so as to avoid confusion and in order to make clear the boundaries of the services offered.

Such guidance is welcome because Pennsylvania law on the matter is actually unclear and perhaps even contradictory.  For starters, under Pennsylvania law, the advisor is the agent of the client and as such the relationship is a fiduciary one. Consequently, the advisor is subject to a duty of loyalty to act only for the client’s benefit.  See Basile v. HR Block, 761 A2d 1115, 1120 (Pa. 2000). Unless otherwise agreed, this duty of loyalty subjects the advisor not to act or agree to act during the period of their agency for other parties whose interests conflict with those of their client in matters in which the advisor is employed. See Restatement (Second) of Agency, §394. Consequently, given the ongoing nature of advisor-client relationships, the duty of loyalty arguably remains even after the transaction or transactions are completed.

Interestingly, the duty of loyalty is defined to include, but is not limited to, the duty to disclose to the client all relevant information. Basile, 761 A2d at 1120. This, however, is where the ongoing nature of the duty owed becomes muddled. Within the specific context of the securities industry, courts have stated that this duty to provide clients information includes but may not be limited to information which is relevant to the affairs entrusted to the advisor, which the advisor has notice of, which the client would desire to have, and which can be communicated without violating a superior duty to a third person. Merrill Lynch v. Perrelle, 514 A2d 552, 561 (Pa. Super. 1986). Thus, Perrelle suggests that these duties are limited to each transaction and end thereafter which arguably contradicts the more general standard under which, as discussed above, the duty of loyalty is ongoing throughout the client-advisor relationship.

This tension illustrates the need for a uniform fiduciary standard as proposed by the SEC. Indeed, currently, without a clear showing of the parties’ intent, much is left open for interpretation by a tribunal as to the ongoing nature of the duty of loyalty owed to a client. Thus, and until such time as Congress adopts the SEC’s proposed uniform fiduciary standard, it is prudent for client agreements to be reviewed in order to determine whether or not there are any limits on the duty of loyalty.

Brian Sommer is an attorney at Pittsburgh-based law firm Meyer, Unkovic & Scott. His practice is focused on commercial litigation, particularly securities litigation, intellectual property disputes, Marcellus Shale litigation, and shareholder rights. Brian can be reached at bjs@muslaw.com or 412.456.2887.

This material is for informational purposes only. It is not and should not be solely relied on as legal advice in dealing with any specific situation.

The Alternative Option for Expunging CRD Records

It is incorrect for financial advisors to assume that the expunging of disclosure events from their Central Registration Depository ("CRD") records can only happen at the conclusion of an arbitration and only if the panel finds (a) that the customer's claims, allegations, or information is factually impossible or clearly erroneous, (b) that the advisors were not involved in the alleged misconduct, and/or (c) that the claim, allegation, or information is false. To the contrary, an alternative and independent route exists through the courts. Moreover, with a standard developing that courts can use when determining whether or not to grant expungement, courts are particularly well suited for expunging disclosure events (a) that are years, sometimes decades, old or (b) in situations where an arbitration panel has not made any findings of falsity or non-involvement as mentioned above.

Such a standard for the courts is necessary because FINRA's Rule 2080 governing expungements is surprisingly silent on how courts should go about determining whether or not to grant an expungement. See Reinking v. FINRA, 2011 U.S. Dist. LEXIS 5611 (W.D. Tx. 2011) and Bridge v. E*Trade, 2012 U.S. Dist. LEXIS 110693 (N.D. Ca. 2012). Indeed, as the Reinking court observed, the majority of Rule 2080's focus is on the standard to be used when determining whether or not FINRA may waive the obligation to be named as a party to the court proceedings. Reinking at *9. This is not, as Reinking observes, the standard courts are to use, or should use, when deciding to grant expungement as it is too exacting for a merits determination, since its purpose is to govern when FINRA will oppose an expungement not whether expungement should ultimately be granted. Reinking at *12.

Consequently, Reinking looked for guidance from the SEC's commentary on Rule 2080's predecessor, NASD Rule 2130. That commentary emphasizes striking the appropriate balance between the ability to remove information from the CRD that holds no regulatory value, while simultaneously preserving information in CRD that is valuable to investors and regulators. Reinking at *11. Accordingly, Reinking held that it too should weigh the regulatory value of the information to be expunged when weighing whether or not to grant expungement.

This Reinking standard, subsequently adopted and endorsed by Bridge, is also in keeping with other existing legal tenets that balance an individual's rights against society's interests, such as those governing the expungement of a criminal record wherein the harm to the individual must be balanced against the government's interest in preserving such records. cfn. Com. v. Wexler, 431 A2d 877 (Pa. 1981).

Practically speaking, and unlike the balance of Rule 2080, it allows a court to decide in a fair and balanced manner the oftentimes critical question - how long is too long for an event to remain an advisor's CRD report when the value of a prior event for investors and regulators arguably diminishes with each additional year. Accordingly, the Reinking standard allows a court to properly weigh an advisor's desire to remove a disclosure event that is behind them and to which they have responded with positive changes in practice against the regulatory value of keeping that same event in the CRD.

Consequently, expungement through the courts is possible thanks to Reinking's guidance.

This material is for informational purposes only. It is not and should not be solely relied on as legal advice in dealing with any specific situation.

Non-Compete Agreements: When Can They Be Enforced Against Advisors?

Brian J. Sommer

Although departing financial advisors who comply with the Protocol for Broker Recruiting (the "Protocol") are, generally speaking, free to solicit customers that they serviced at their former firms after they join their new firms regardless of any non-compete agreement they may have signed with their former employer, rightly or wrongly they may nevertheless find themselves having to defend a lawsuit alleging that they have breached any such agreement if there is any question regarding the departing advisor soliciting customers to move their accounts before he or she has left their former firm.

Under such circumstances, the departing advisor is left with no real option but to defend the claim because the alternative, whether by choice or by court order, will require the advisor to not contact or service their clients. Fortunately, and aside from any factual arguments over whether or not there is a breach of the Protocol, there are circumstances under which a non-compete can be determined to be unenforceable.

First, a non-compete is unenforceable if it lacks adequate consideration. Consideration is something of value given by both parties to a contract that induces them to enter into the agreement to exchange mutual performances. While generally speaking courts do not examine the adequacy of the consideration when determining the validity of a contract, non-competes are the exceptions to that rule. If the consideration is not adequate then the non-compete will not be enforced. Examples of adequate consideration include a new job, additional benefits, a bonus, a raise, and/or a promotion. Recently, the Pennsylvania Superior Court affirmed this rule and further held a mere recital in a non-compete agreement that the parties intend to be legally bound to the terms is insufficient consideration. Consequently, any non-compete agreement containing such language and nothing more is unenforceable. See Socko v. Mid-Atlantic Systems, 2014 Pa. Super. LEXIS 702 (Pa. Super. 2014). Interestingly, Socko refutes a decision by a Pennsylvania federal court that held the opposite in a case involving a financial advisor and a non-compete with their former employer. See Latuszewski v. Valic Financial Advisors, 2007 WL 4462739 (W.D. Pa. 2007).

Second, and even if the court finds there is adequate consideration, it may nevertheless decline to enforce the non-compete if it finds the burdens placed upon the departing advisor are too great and burdensome. For example, courts have more recently begun to consider the employee's specific circumstances and in particular the negative impact enforcing the non-compete will have on them. Thus, courts may be less inclined to enforce a non-compete on a highly specialized 60 year-old who is unlikely to start anew in another industry, or on employees who are the sole means of income for their family. See Shepherd v. Pittsburgh Glass Works, LLC, 25 A.3d 1233 (Pa. Super. 2011).

While Socko and Shepherd are the law of Pennsylvania, many non-compete agreements have clauses requiring interpretation and enforcement pursuant to another state's laws. While parties are free to choose what law is to be applied, there is nevertheless a question as to whether or not an agreement otherwise unenforceable under Pennsylvania law will still be enforced due to the governing law of the chosen state. Under such circumstances, Pennsylvania courts will enforce a choice of law provision unless (a) the chosen state has no substantial relationship to the parties or transactions and there is no reasonable basis for the parties' choice, or (b) application of the law of the chosen state would be contrary to a fundamental policy of Pennsylvania which has a materially greater interest than the chosen state in the determination of the particular issue and which would be the state of the applicable law in the absence of an effective choice of law by the parties. See Miller v. Allstate Ins., 763 A.2d 401, 403 (Pa. Super. 2000).

Prior to Socko, Pennsylvania courts enforced non-compete agreements that under Pennsylvania law lacked adequate consideration, but did not under the governing law of the chosen state, reasoning that the existence of consideration did not result in an application contrary to a fundamental Pennsylvania policy. cfn. Perma-Liner v. US Sewer & Drain, 630 F.Supp.2d 516, 522-523 (E.D. Pa. 2008). However, Socko's emphasis that, unlike other contracts, the adequacy of consideration is critically important to enforcing a non-compete agreement suggests that adequate consideration for non-compete agreements is indeed a fundamental Pennsylvania policy. Consequently, pre-Socko decisions enforcing non-compete agreements that lacked consideration merely on the basis of another's states laws as chosen by the parties may no longer be good law. Similarly, Shepherd's holding may also rise to the level of fundamental policy thereby requiring the application of Pennsylvania law notwithstanding a choice of law clause involving the application of another state's laws.

For all these reasons it is important for advisors to consult with counsel before changing firms in order to, among other things, prepare for any lawsuit over existing non-compete agreements.

This material is for informational purposes only.  It is not and should not be solely relied on as legal advice in dealing with any specific situation.