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Caught in the Middle

Chuck Volz is the owner of Finnegan's Wake, a Philadelphia pub. That's how he got to know a young Temple University professor named Todd Napolitano who lived down the block.In 1997, Napolitano asked Volz for help in starting a new career as a broker at Merrill Lynch. Volz became Napolitano's first sizable account. Volz says Napolitano "reached out and worked" for him--with success. His retirement

Chuck Volz is the owner of Finnegan's Wake, a Philadelphia pub. That's how he got to know a young Temple University professor named Todd Napolitano who lived down the block.

In 1997, Napolitano asked Volz for help in starting a new career as a broker at Merrill Lynch. Volz became Napolitano's first sizable account. Volz says Napolitano "reached out and worked" for him--with success. His retirement account grew from 250,000 dollars to 650,000 dollars in one year.

Napolitano also did well for himself, grossing 425,000 dollars in his first full year of production. He credits two people: his father, a 35-year veteran at TV network ABC who sent referrals; and a mentor in his branch, who taught him a growth-stock strategy that was "incredibly successful--up some 200 percent last year," Napolitano says.

That strategy used to be available on the Merrill Lynch computer system. But it was removed about a year-and-a-half ago as the firm shifted its focus. "It was not the sort of business that financial planners ought to be doing," Napolitano says. "It was not involved with mortgages or mutual funds." So he decided a change was in order. On Jan. 7, 2000, he joined Morgan Stanley Dean Witter.

Merrill sued. On Jan. 11, it got a temporary restraining order (TRO) against Napolitano in the U.S. District Court for the Eastern District of Pennsylvania. It was a fairly standard order upholding Merrill's noncompete language. It forbid direct or indirect solicitation of Merrill customers, and prohibited the rep and MSDW from accepting account transfers from Merrill clients. Other firms get similar TROs.

That's when Volz discovered that training contracts with restrictive covenants are routine in brokerage--and that he could be enjoined along with his broker.

After evidence discovery and oral arguments, the TRO was extended on Feb. 2 by Judge Bruce Kauffman, who issued a 19-page ruling.

In that ruling, the judge ordered MSDW to send a form letter to all clients who had filed account transfer forms, telling the customers that the court enjoined MSDW "from conducting business with you. As a result, we are unable to process an account transfer at this time."

That pretty much nixed Napolitano's efforts to take his book. He says 95 percent of his clients submitted transfer forms within a few days of his departure.

By industry practice, Napolitano did nothing unusual. He resigned after the close on a Friday. Using phone numbers stored in an electronic organizer and a cell phone, he called about 100 clients over the weekend informing them that he was changing firms. He was even careful not to make an outright solicitation.

But the judge saw red. The broker's actions were part of a "brazen effort" to prevent Merrill from getting a TRO until the following Monday, Kauffman wrote.

Kauffman also ordered MSDW to include his 19-page ruling in the client mailing. MSDW tried to argue that it wasn't a party to the action. But Napolitano says Kauffman threatened to throw him in jail if the mailing didn't go out immediately.

"We sent it FedEx that day," Napolitano says.

His clients were then able to read for themselves why the judge felt their right to choose a financial adviser was considered secondary to Merrill's contractual rights.

As Kauffman put it: "Napolitano self-servingly argues that a denial of an injunction would serve the public interest by preserving 'the unqualified right of the investing public to make decisions in their choice of investment advisors.' ... The Court must also consider the even more compelling public interest in the enforcement of contracts."

Volz was surprised. "Frankly, they should be telling clients when they sign up, 'You might like Joe Smith, but if he leaves, you have to stay with us,'" Volz says.

In the five weeks Volz waited for the case to play out, he says Merrill called him four times. When he said he intended to transfer to Napolitano, he got "put on the back burner." No one was assigned to his account until he insisted on it, he says.

"I had everything I own [at Merrill], and my whole life savings got put into limbo." His children's accounts were also frozen.

Like all TRO cases, Napolitano's was sent to arbitration. Several days before the first hearing on Feb. 16, the case settled for an undisclosed amount. Napolitano and his clients were once again free to do business with each other.

Why the speedy resolution? Napolitano figures it may have had something to do with the fact that he had about 100 clients willing to testify at his arbitration.

Mary and Steve Israel are also former Merrill Lynch clients whose accounts were frozen.

An aircraft financing specialist with Bell Helicopters in Fort Worth, Texas, Steve Israel had worked with broker Ashley Hodge at Merrill for three years. "He became my broker when I got married," Steve says. His wife, Mary, has a hair styling salon, and Hodge and his wife are patrons of her business.

"We wanted to do business with people who do business with us," Steve says. Plus, Hodge worked in the same building as he did and attended the same church.

But things got sticky when Hodge and his partner Bob Straight left their Merrill branch in Fort Worth a year ago and went to J.C. Bradford. Merrill sued the brokers, freezing the Israels' accounts in the process.

Federal Judge Terry Means enjoined J.C. Bradford "from accepting any business or account transfers from any [Merrill clients]."

The Israels, of course, wanted to move their accounts. "I traded phone calls and argued with Merrill for about a week," Steve says. He sent several faxes and talked to someone in operations three times in an attempt to transfer their accounts. Calls to the Merrill branch manager went unreturned. Their accounts were transferred only "after I threatened to get an attorney on them," Steve says.

Jim Ramsey, Bradford's associate general counsel in Nashville, Tenn., told RR last year during the fight that "unless Merrill allows it to occur, we can't process ACATS requests without the potential of a contempt proceeding being brought against us."

Says Steve, "Bottom line, Merrill got in a pissing match with Ashley Hodge and Bob Straight, and I got caught in the middle."

Hodge and Straight were on ice for six months. Their court-ordered injunction on July 6, 1999, was upheld by an NASDR arbitration panel and extended through Jan. 6, 2000.

Merrill accomplished its purpose. Hodge and Straight say they know several other Merrill brokers who were thinking about joining Bradford but got scared off.

Despite the delays, the core of the team's business came over, Hodge says. About 25 percent of their former Merrill clients representing about 50 percent of their prior asset base have transferred.

Kicking Customers Courts around the country have enjoined customers, right along with their brokers. To be sure, judges have ruled against firms and denied TROs. And judges almost always restrict TROs to a few weeks, or until the first arbitration hearing.

But few of these cases ever go to arbitration. Instead, the firm that recruits a broker pays off the plaintiff firm and everyone goes back to work. That's why it is puzzling that judges buy the "irreparable harm" argument firms make in asking for injunctions against individual brokers and their customers.

* Nevertheless, it happened to customers in Michigan when a four-person team from Merrill went to PaineWebber. In September 1999, a federal judge ordered PaineWebber not to process transfer requests from 500 customers. The judge ordered that a "dear customer" letter be sent saying: "PaineWebber acknowledges receipt of your account transfer form [but the injunction] 'prohibits [the four brokers and PaineWebber] from processing your account transfer request or doing any business with you at this time.'"

However, Merrill was ordered to provide the phone number and location of the four brokers to clients who called.

Five of the clients filed an emergency motion to kill the transfer restriction. They cited NASD and NYSE rules requiring timely account transfers (see "Ignoring the Rules," Page 58), and told the court they "do not regard Merrill Lynch as their broker and are anxious that Merrill Lynch not interfere with their right to choose their own broker."

Their motion was granted and the case settled shortly afterward. The clients' attorney declined an interview on behalf of his clients. PaineWebber also declined an interview on behalf of the brokers.

* In November 1999, two judges in the U.S. District Court for the Southern District of New York also froze customer accounts. They ordered that the same form letter Napolitano and MSDW had to use be sent to clients. One of these cases involved a two-person team that had moved from Merrill to MSDW. The other was a lone Merrill broker who had gone to Salomon Smith Barney.

* In another case this past November, a federal court in Pennsylvania prohibited a three-person team that left Merrill from "accepting any business or account transfers from" any of the clients who had been solicited "at any time in the past for the purpose of doing business with the defendants' new employer, Prudential Securities."

The court helpfully noted that customers' accounts were not really frozen. "They can still consult with Merrill Lynch or another brokerage besides Prudential," it said.

* When a four-person team left Merrill's Las Colinas, Texas, office for J.C. Bradford in late March, the U.S. District Court for the Northern District of Texas ordered Bradford not to accept transfers from Merrill customers. Judge Sam Lindsay did allow clients who got assets transferred under the wire of the TRO to stay at Bradford. Judge Lindsay felt his decision not to reverse the completed transfers was "extremely fair [since the brokers were] asking the court for relief from a problem that they may well have precipitated."

* In Hawaii this past February, a three-person team that left Merrill for MSDW also had their customers' accounts frozen. Judge Helen Gillmor ordered, "If any customer of Merrill Lynch attempts to contact any of the Defendants, they shall be advised that the Defendants (and those acting in concert with them, including other Dean Witter representatives) are unable to communicate with them."

* This past January, SSB was the plaintiff seeking and getting a TRO against a broker in the U.S. District Court for the Middle District of Pennsylvania. And in a twist, it also got itself enjoined from processing ACATS requests received from the former broker's clients.

A Contract Is a Contract Why the tough stance by judges? The tendency of courts is to enforce contracts, says an executive at a Merrill competitor who asks not to be identified by firm or function, but who is involved in TRO cases. Once a court has found that the clients were improperly solicited, then the accounts become "the fruit from the poison tree," the exec says.

Merrill's view is that any problems are the fault of defecting brokers. And courts buy that argument.

Bill Halldin, a spokesperson for Merrill, maintains that "the judicial system decides whether accounts can transfer, not us. Unfortunately, clients are sometimes inconvenienced as a result of broker misconduct.

"I think it's important to remember that the courts are first and foremost concerned with the theft of confidential client information and violations of trade secret laws," Halldin continues. "Both are violations of law--violations that are independent of any employment agreement."

(Merrill has always maintained that it has grounds for taking legal action against departing brokers even when they do not have signed contracts.)

And, when the broker does have a contract, "the employment agreements are clear," Halldin says. "Employees acknowledge that the firm has a right to seek a restraining order if illegal or improper acts occur."

Finally, Halldin says, "Our judicial system doesn't allow people to break laws and be exempt from the penalty simply because that penalty might inconvenience someone else."

Brokers and clients enjoined from working together see it differently.

"My clients didn't care what a federal judge said," says Michael Vallee, one of the four Texas brokers on the Merrill team that went to Bradford. "All they cared about was that they had lost control of their financial affairs. The only reason Merrill wanted a TRO was to receive afinancial reward for the loss of my production, and for that benefit, they held my clients hostage."

Under NASD Rule 11870 and NYSE Rule 412, firms must cooperate in transferring accounts "expeditiously." So when courts enjoin a receiving firm from accepting accounts, they effectively order the violation of industry rules.

"[Rule] 11870 is argued in every single case" by the broker's attorney, says an executive at a Merrill Lynch competitor. "As far as I know, the NASDR has never issued any ruling [against blocking account transfers] because Merrill lobbies the hell out of them."

An NASDR spokesperson would say only that "while NASDR can't comment on [specific TRO cases], we are taking a close look at the issues" of account transfers being blocked.

Merrill, the competing exec notes, will process the ACATS so it's in compliance. But it will also get the other firm enjoined in court so that the receiving firm can't accept accounts. If it does, it's in contempt of court.

An SEC spokesperson also declines comment on specific TRO cases, but says agency staff "affirms the importance of investors' choice of who is their broker and the ability to move their accounts in a timely manner."

Investors caught up in TRO cases "from time to time" make complaints to the SEC, says another spokesperson in the SEC's Office of Investor Education and Assistance. Those complaints are part of a much larger number who complain about transfer glitches in general. Account transfer problems are the second-largest complaint category at the SEC.

The industry executive says if regulators outlawed firms from restricting accounts in TRO cases, it "would eliminate this nonsense in a heartbeat." If the firms couldn't stop account transfers, then it would no longer make economic sense to pursue TRO cases, he says.

Since TRO cases are filed in a number of courts before a variety of judges, there can be huge differences in the rulings that are issued. If you are ever TRO'ed, you might get lucky and get a judge who believes that the clients' interests should come first.

The bible, so to speak, of pro-broker and pro-client rulings are the exhibits that Tom Campbell of the New York law firm of Smith Campbell & Paduano uses in arguing against TROs. Taken together, the two books of exhibits--one demonstrating instances of courts denying TROs and the other of arbitrators refusing requests for injunctive relief--measure five inches thick.

Here are some of Campbell's favorite pro-broker and pro-client rulings from the books.

* "There is a grave concern about allowing a large institution to essentially try to supplant the relationship that clients have with their brokers. When you are looking at irreparable harm and public interest, certainly clients have as much an interest in this dispute that is going here as the parties."--Merrill Lynch, Pierce, Fenner & Smith v. Bramer, 1993

* "Each member of the affected public has a right to know that the broker with whom he has entrusted his accounts is no longer servicing his accounts because she has gone to another brokerage firm. It is in the best interest of the public, therefore, that these affected clients be informed of [their broker's] move so that they might decide on their own whether to follow her to Prudential or to stay with Merrill Lynch to be serviced by another broker there ..."--Merrill Lynch, Pierce, Fenner & Smith v. Casellas, 1996

* "Rule 412 of the New York Stock Exchange provides that customers' accounts should be handled in such a way that the coordination of activities between brokerage firms on a single account should not cause customers to endure losses as a result of firm competition."--Prudential Securities Inc. v. Plunkett, 1998

* "It would be contrary to public policy to prohibit the defendants from servicing clients that may consist of family and friends and/or customers solicited from cold calls."--American Express Financial Advisors v. Hugo, 1999

Since Merrill Lynch also recruits, it's sometimes the defendant in a TRO case. In January, B.C. Ziegler & Co. of West Bend, Wis., won a 1.7 million dollar award from Merrill in a case involving four brokers who left Ziegler for Merrill. An NASDR panel gave Ziegler 700,000 dollars in compensatory damages and 1 million dollars in punitives.

Ziegler took a page from Merrill's own book by arguing that its client information was a trade secret, and that Merrill's recruiting activity violated Ziegler's noncompete, nondisclosure and nonsolicitation clauses.

Merrill argued that firms don't own the customers and defended its recruiting practices. Arbitrators summarized its argument: "[Merrill argued that] a customer's account is not the property of [a firm], and other brokers and brokerage firms are always privileged to solicit customers ... and encourage those customers to transfer their accounts to the soliciting broker or firm."

The panel agreed, dissolved a court-ordered TRO and set the brokers and clients free.

Merrill also made use of a Wisconsin law requiring firms to produce customer information to the brokers upon their resignations. That 1978 law, designed to protect customers, says that when a broker leaves a firm, he or she has 30 days to request copies of customer holding pages. The firm must honor the request within 15 days.

Panelists do occasionally restrain account transfers, but often with interesting exceptions.

In the rare instance when a TRO case goes to a full arbitration hearing, panelists sometimes uphold injunctions and freeze customers. But they may also make exceptions.

* In an arbitration case decided this past October, a Merrill Lynch rep who went to First Union Securities was allowed to accept transfers, but was ordered to remit 60 percent of gross commissions for one year to Merrill, with the exception of money earned serving four relatives.

* Arbitrators this past September ordered a rep and PaineWebber to pay Merrill more than 500,000 dollars, and submit to a six-month injunction, with a carve-out for the broker's family members and any clients he had prior to joining Merrill.

* In a case decided this past August, a panel extended for a year an injunction against a former Merrill rep. The broker was allowed to keep accounts that had already transferred, and to accept transfers of accounts he did not solicit to move.

* In February 1999, an arbitration panel extended for one year an injunction against a former Merrill rep in Pennsylvania. The broker was prohibited from contacting Merrill clients who did not respond to the rep's solicitation to move to Salomon Smith Barney. SSB was allowed to process the transfer requests of five customers who did respond.

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