Securities Fraud Lawyer Blog
Offering bonuses in the form of employee forgivable loans (EFLs) is common in the financial industry, but these so-called bonuses can result in a trap for unsuspecting brokers (see our website here). While there are a variety of defenses (LINK) available to brokers when a brokerage firm seeks to enforce these EFLs in a FINRA action, the fact is that arbitrators seem to rule against brokers in these matters almost reflexively. But a couple of novel theories might offer new alternatives.
The Uniform Commercial Code
One potential new defense to an arbitration proceeding to enforce a promissory note is based on the Uniform Commercial Code (UCC). The UCC is a model law adopted by states throughout the country to insure that certain financial instruments are subject to the same legal requirements nationwide. The relevant provisions of the UCC for our purposes apply to negotiable instruments, which include, for example, checks and promissory notes. A negotiable instrument is a signed, transferrable document promising payment to a named payee at a specified time or upon demand. For example, your mortgage document is likely a negotiable instrument transferrable between banks, which explains how your bank can sell your mortgage to another financial institution, and then you get a notice to send your payments elsewhere.
The promissory notes that brokers sign with respect to EFLs are typically form documents prepared by the brokerage firms, and they contain a lot of form language. It is common, for instance, for these notes to specify that the broker will repay “Brokerage Firm, its affiliates, successors, and assigns,” regardless of the existence or status of any such “affiliates, successors, and assigns.” Under the UCC, this language arguably means that the brokerage firm and these other entities are joint payees, which in turn means that the note can only be enforced by all the payees together. Otherwise, even if the broker paid off the brokerage firm, any of the other payees would still be able to enforce the note, requiring the broker to pay multiple times on one obligation. Consequently, all named payees must be joined in any enforcement action. But here’s the catch – these other entities are probably not parties to the arbitration agreement between the broker and the brokerage firm, nor are they subject to FINRA’s jurisdiction. Which means they can’t be joined in a FINRA arbitration, which should mean that the arbitration should be dismissed.
It’s unclear whether this defense has been tried yet at FINRA, because arbitration awards often don’t specify the reasoning for the arbitrators’ decision. It would be interesting to see how it would be received.
The Texas Free Enterprise and Antitrust Act
Another new theory suggests that the structure of an EFL, which requires a broker to remain with a brokerage firm for a number of years or face immediate acceleration of the repayment obligation, violates the Texas Free Enterprise and Antitrust Act. A recent case from the Houston Court of Appeals in an analogous situation suggests how this argument would go.
In that case, the court held that “provisions in an employment agreement that require an employee to repay substantial parts of her compensation upon termination” are unenforceable as unlawful restraints on trade when they lack reasonable limits and “impose a substantial penalty on the exercise of an at-will employee’s right to quit her job.” Sounds familiar, doesn’t it?
Kelley Rieves worked as an assistant manager for the Buc-ee’s chain of convenience stores in Texas. Her compensation was split between an hourly pay rate and a flat monthly bonus amount. Although Rieves could choose the percentage split between these amounts, within limits (she chose 70-30), the requirement that her salary be split in this way was non-negotiable, meaning she couldn’t just ask to have it all paid to her as a higher hourly wage. The flat monthly amount was called “Additional Compensation.” Although Rieves remained an at-will employee (i.e., she could be fired at any time, for any reason or even no reason), she signed an employment agreement with Buc-ee’s that specified that she had to work for the company for 60 months and, thereafter, provide 6 months’ notice if she decided to leave in order to be entitled to the Additional Compensation. If Rieves left for any reason (or was fired) without meeting these requirements, she would be liable to repay all the Additional Compensation she had received to Buc-ee’s. The next year, she signed a new agreement with similar provisions, but the time period she had to stay was 48 months and the monthly payout changed to a percentage of the net profit for the store where she worked and was called “Retention Pay.” Ultimately, Rieves resigned to take a job for a non-competing business around 3 years after she joined Buc-ee’s. The company then demanded repayment of both the Additional Compensation and Retention Pay, plus interest and attorneys fees.
As the court explained, the Texas Free Enterprise and Antitrust Act declares contracts in restraint of trade to be unlawful. Therefore, agreements restricting an employee’s professional mobility are illegal unless they are protected by the Texas Covenants Not to Compete Act. That law says that an enforceable covenant not to compete (which is a contract preventing a departing employee from competing with a previous employer) must have reasonable limitations as to time, scope, and geographic area, and must be of no greater restraint than necessary to protect the employer’s competitive interest. Under Texas Supreme Court precedent, these standards also apply to provisions that impose a severe economic penalty on a departing employee. The court concluded that the repayment obligation imposed a severe economic penalty on Rieves without any limitation based on whether she intended to undertake any competitive activity or within certain geographic areas. In fact, her obligation would be the same even if she were fired without cause or left to take a non-competing job or no job at all. Thus, the repayment provisions were unreasonable and therefore unenforceable.
The repayment provisions facing Rieves mirror those a broker is faced with in an EFL promissory note. The broker is required to repay the entire bonus amount, plus interest, upon departure – no matter why he or she leaves, and no matter who he or she goes to work for. A brokerage firm can even fire a broker without cause and still recover the bonus amounts. Because the amounts are so large, brokers typically don’t have the cash to pay off this obligation, which imposes a severe economic penalty on any broker who tries to change jobs. This is on top of any direct anti-competitive provisions in a broker’s employment agreement – for instance, a prohibition on contacting any clients until the repayment obligation is satisfied. Again, it’s not clear whether this argument has been made at FINRA, or how it may have been received, but it appears to offer another avenue for a broker to escape the crushing repayment burdens of EFLs.