Earlier this month, the Federal Trade Commission (FTC) announced a proposed ban on non-compete agreements in employment contracts.  If enacted, the proposed ban would prohibit a common provision of employment agreements that employers use to limit employees’ ability to compete.

As the RIA industry has grown and matured, non-competes and other restrictive covenants have become part of the industry lexicon.  Accelerating deal activity and a proliferation of outside capital have certainly contributed to the prevalence of restrictive covenants, as virtually any transaction will involve a seller non-compete to protect the buyer’s investment.

The FTC’s proposed ban would have certain exceptions

The FTC’s proposed ban would have certain exceptions, including allowing non-competes in transaction scenarios and for individuals owning greater than 25% of the firm.  For the RIA industry, we suspect that these exceptions would cover the majority of the scenarios in which the protected party would seek to enforce a non-compete.

While common in transaction scenarios, non-competes are less common for ordinary employees at wealth management firms.  More common is the non-solicit agreement, which would still be allowed under the proposed FTC rule.  In contrast to non-competes—which broadly restrict employees from engaging in competing business—non-solicit agreements restrict an employee’s ability to contact and attempt to recruit clients if they leave their current firm.

From an RIA’s perspective, solicitation of clients is often the primary threat posed by a departing employee.  Particularly for client-facing advisors, clients may see their relationship as being with that advisor, not the firm.  In such situations, solicitation of the client base by a departing advisor can be devastating to the firm.  Non-solicits target this threat directly, and—because of their narrower scope—they’re generally more enforceable than non-competes.

Non-competes can serve as a credible threat to dissuade competition

Currently, the enforceability of non-competes is a state-by-state issue, with several states already approaching an outright ban.  Still, even in states where they’re difficult to enforce, non-competes can serve as a credible threat to dissuade competition.  Few desire to be involved in costly litigation, even if they come out on the “winning” side.  Even with non-solicits still in play, an outright ban on non-competes would, at the margin, reduce some of the frictional costs associated with transferring firms, making employees more mobile.

From the firm’s perspective, increased employee mobility has the potential to cut both ways.  Firms have a higher risk of employees being poached but also an easier time recruiting advisors from other firms.  Firms that can offer an attractive value proposition to employees—including incentive compensation structures and long-term equity incentives—could have a competitive advantage in terms of recruiting.

Restrictive agreements are the stick used to achieve employee retention, but compensation is the carrot.  In many instances, a well-structured compensation plan can contribute to employee retention as well or better than restrictive agreements.  By limiting employers’ use of non-compete agreements, the FTC’s proposed ban heightens the importance of a well-structured comp plan.  See Compensation Structures for RIAs Part 1 and Part 2.

The FTC is seeking public comment on the proposed rule.  As currently drafted, we anticipate a minimal impact on the RIA industry, given the available alternatives to non-competes.  But, for firms relying on non-competes to retain employees, the proposed rule is cause to explore alternative strategies for employee retention, whether through alternative restrictive agreements or compensation structure.

About Mercer Capital

We are a valuation firm that is organized according to industry specialization.  Our Investment Management Team provides valuation, transaction, litigation, and related services to a client base consisting of asset managers, wealth managers, independent trust companies, broker-dealers, PE firms and alternative managers, and related investment consultancies.