Can a Financial Services Firm Require an Employee to Cover Mistaken Trades?

April 30, 2015

An employee of a financial services firm, whose compensation consists of fees and commissions, asks whether it is legal for his employer to require him to reimburse a client directly for any losses the client suffers because of a trading error.

Turning the question around, would the employee have a right to recover from the employer if the client suffers losses because of a security breach or cyberattack?  What if the employee’s relationship with the client or the employee’s professional reputation is damaged because of the security breach?

Teased into pieces, this is what the question looks like:

  • When may an employer require an employee to pay for mistakes?
  • When may an employer require an employee to reimburse a client directly for mistakes?
  • May an employee require an employer to reimburse the employee for harm to the employee/client relationship or future earnings?
  • Does the law apply differently to the financial services industry?

This is an interesting collection of problems because beyond a financial services firm’s obligation to make the customer whole, it is about the employer/employee relationship that exists between the firm and the employee. That relationship is governed by federal law, state law and contract, and any or all of these might be implicated in this scenario.

The financial advisor’s duty to the client

The term “financial advisor,” can cover a lot of ground. It can mean a registered investment advisor or a financial planner who is not a registered investment advisor but has a Series 65 license, which qualifies the investment professional to function as an investment adviser representative in certain states.

A financial advisor can provide a wide range of services other than advice about trades, including investment management, income tax preparation and estate planning. Some are compensated on a fee basis; others, who effectively function as salespersons, earn commissions. Most earn a combination of both.

An investment advisor who is registered under the Investment Advisors Act of 1940 has a fiduciary duty to act in the client’s best interest. Broker-dealers, who are regulated by the Financial Industry Regulatory Authority (FINRA), have only a “suitability” obligation, to make recommendations that are consistent with the best interests of the underlying customer.

If an investment advisor mishandles a trading error, it can lead to a violation of the Investment Advisors Act. In any event, all financial advisors, whether or not RIAs, have a very strong business incentive to make the client whole for any loss caused by a trading error, even if the firm takes a loss. That is why many carry Errors & Omissions insurance.

But it is worth keeping in mind that the overall purpose of financial regulation is to protect customers from the misdeeds of financial professionals, not financial professionals from the misdeeds of each other.

Most also have policies and procedures in place about how to handle trading mistakes, and that is likely the source of the practice described of having the employee reimburse the client directly.

Can an employer require an employee to cover mistakes?

The most familiar analogy may the cashier whose till comes up short. Is it any different for the financial advisor who makes a trading error– not just an unwise trade that might or might not violate either the fiduciary or suitability standard, but a genuine fumble, such as trading the wrong security or buying rather than selling?

In 2006, the Wage and Hour Division of the Department of Labor considered a situation in which an employer wanted to fine exempt employees for damage to company equipment, including cel phones and laptops.

The WHD took the position that

deductions from the salaries of otherwise exempt employees for the loss, damage, or destruction of the employer’s funds or property due to the employees’ failure to properly carry out their managerial duties (including where signed “agreements” were used) would defeat the exemption because the salaries would not be “guaranteed” or paid “free and clear” as required by the regulations.

Some deductions are allowed, but largely for absences and violations of safety rules.

Losses and damage are not among the exceptions, even when the damage to the employer may come in the form of loss of a client or harm to reputation. The underlying rationale may be that the employer already has a remedy, which is to terminate the employee. Even contract employees would likely not be protected in the event of substantial harm to the employer.

This is one of the differences between the protections for exempt and non-exempt employees, like the cashier in the familiar example. Even a non-exempt employee may be required to pay for damage only if:

  • The employee signed a written agreement prior to the shortage (at the start of employment or when the policy related to deductions is adopted) by which he or she agrees to such a deduction; and
  • The deduction does not bring the employee’s hourly rate below the minimum wage.

Under California law, for example, an employer may not deduct for cash shortage, breakage, or equipment loss unless caused by the employee’s gross negligence, or dishonest or willful act, but because of the protections of federal law, this would also apply only to non-exempt employees.

If the injured client is a client of the employer, not the employee, then whatever legal duty is owed to the client is owed by the employer. That issue is covered by financial law and regulations.

The employee of the financial services business who makes a trading mistake is just like the exempt employee who damages company equipment.  Whatever duty is owed by the employee to the employer is covered by employment law. And a requirement that the employee reimburse the employer for mistaken trades does not appear to be in compliance with WHD guidance.

What about paying the client directly?

As a general principle of contract law, two parties who make an agreement with one another (even if that agreement takes the form company policies and procedures with which the employee agrees to comply), can create an obligation to a third party under only very limited circumstances.

Practically speaking, this more like an indemnity agreement, where the employee agrees to indemnify the employer for financial losses that are the result of the employee’s mistake. Either way, there is a strong argument that this is just another form of prohibited wage deduction.

The employer might have a better chance with a tort argument. Under general principles of tort law, there are situations, including those involving negligent hiring or supervision where an employer can be liable for the misconduct of an employee. The employer can then try to recover damages from the employee, but this may be a fruitless endeavor, depending on the employee’s resources.

What if the employer’s negligence damages the value of the employee’s “book of business”?

What if, instead of an employee’s trading mistake, the employer negligently fails to prevent a security breach and customers are harmed? The employee would probably not be able to take the position that he was an intended beneficiary of the relationship between the employer and the customer and so, had an independent right to recover.

However, what if the employer’s failure caused angry clients leave in droves, thus making it difficult for the employee to earn a living and possibly damaging his professional reputation for the future?

In theory, the employee has the same three avenues of recovery that the employer does: litigation, insurance and contract provisions. In practice, this argument may push employment law beyond where it is today.

The statutory protections for employees under state and federal law are generally limited areas such as wages, safe working conditions and non-discrimination. And insurers have yet to write policies that cover employees from employers’ professional misdeeds.

However, employees do sometimes seek indemnity from employers for expenditures or losses incurred in the course of employment. If, for example, a customer sues and recovers from a worker for some action the worker did in the normal course of employment and under the direction of the employer, the worker may be entitled to reimbursement from the employer.

If the employee of a financial services firm provided services to a client as required by the employer, but the client was injured because of the firm’s failure to protect sensitive information from cyberattack and if the client (somewhat  surprisingly) sued the employee, then the employee might have a claim against the employer.

It would be harder to make the argument that the employee should recover from the employer for loss of future earnings because the customer moves onto a different financial advisory firm and the employee, with tarnished reputation, has difficulty finding another job. Employees, like those who worked for Enron at the turn of the 21st century, appear to be genuinely vulnerable to the consequences of employer mismanagement.

The very valuable employee might, in theory, be able to negotiate an indemnity clause to cover such a situation as part of an employment contract. At this point that would probably be an employee’s only recourse.

The financial services industry is heavily regulated for the protection of consumers. The employer/employee relationship is much less regulated except with regard to wages, safety and illegal discrimination. The employee’s best protection beyond these areas may be through careful negotiation of an employment agreement, where the employee is in a bargaining position to do so.

Anne Wallace, Esq.

By

Anne Wallace is a New York lawyer who writes extensively on legal and business issues. She also teaches law and business writing at the college and professional level. Anne graduated from Fordham Law School and Wellesley College.

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