Banks Using Employee Contracts to Protect Trade Secrets

A rash of departures by high-profile executives, along with a spike in merger activity, has bankers doubling down on ways to retain their most-valuable employees.

A big issue involves intellectual property, or IP, bankers, lawyers and consultants say. Banks don't want their trade secrets walking out the front door without getting something in return.

"When most people hear IP, they think of an invention or the ingredients of a secret sauce," says Tricia Legittino, a lawyer at Frandzel Robins Bloom & Csato in Los Angeles who represents banks. "It's your customer list [and] it's also knowledge of a specific bank's risk tolerance and risk management."

High-ranking employees might possess knowledge, for instance, of when a bank might go after borrowers who default on a loan, and in which situations they might be less aggressive, Legittino says. That's an extraordinarily valuable piece of knowledge for competitors.

Recent situations involving PNC Financial (PNC), JPMorgan Chase (JPM) and Capital One Financial (COF) show the extremely high level of importance banks place on executives who possess critical information.

PNC last week filed a lawsuit in Illinois federal court against three former employees for trade secrets theft. The Pittsburgh company claims that the workers breached their employment contracts when they bolted for Fifth Third Bancorp (FITB) and began courting their former clients.

When Mike Cavanagh, former co-head of Chase's investment bank, left in March for private equity fund Carlyle Group, Chief Executive Jamie Dimon practically begged him to stay, according to media reports. Earlier, Chase was involved in a legal dispute with First Data, when the payments company hired Chase's co-chief operating officer, Frank Bisignano. First Data later agreed to pay millions to Chase to settle the dispute.

Capital One filed a lawsuit against two former executives — John Kanas and John Bohlsen — when their new company, BankUnited (BKU), agreed to buy Herald National Bank in New York. Capital One claimed the executives, who joined the company after it bought North Fork Bancorp, had violated a noncompete clause. Kanas and Bohlsen agreed, in June 2012, to pay $20 million to settle the matter.

Banks like Chase and Capital One can pursue expensive litigation to recover some financial losses when senior executives leave. But there is little they can do to prevent the loss of the institutional knowledge and trade secrets those executives possess, says Charles Elson, a finance professor at the University of Delaware who specializes in corporate governance.

"It's pretty hard to prevent stuff from leaving," Elson says.

For smaller banks, an emerging wave of consolidation is causing management teams to lock down valued talent. In many mergers, a common mistake is to overlook locking down executives at the target institution with compensation incentives, says Richard Herrington, president and chief executive of Franklin Financial Network in Tennessee.

To that end, Herrington has offered retention agreements to about 20 employees of MidSouth Bank in Murfreesboro, Tenn., which Franklin is acquiring. Those employees have special knowledge of their market that Franklin can't replicate, but he desperately wants to keep.

The agreements — which all the targeted MidSouth employees have accepted — are intended to soothe their concerns while the merger remains pending, which Herrington calls a "period of purgatory." The deal is expected to close this quarter.

"Mergers are all about change and some people don't like change," Herrington says, adding that there is a threat of employees leaving ahead of the deal's completion. "The important thing we're working on is to remind the people how they are crucial to success of new bank."

The issue could become widespread among community banks, says Mark Miller, a lawyer at Baker Donelson in Nashville. As a rising number of community banks have regulatory actions lifted, it frees them to explore strategic options, including a possible sale. That makes employees antsy, he says.

Banks want to get their key people protected so they don't look to leave "when they see strangers come in and have meetings behind closed doors," says Miller, who is advising Franklin on its MidSouth purchase.

Some banks are working out incentives with top employees in advance of merger talks, Miller says. Those can include clauses in contracts that protect an employee from losing his or her job; accelerated vesting periods, "stay" bonuses and standard noncompete clauses.

"They're trying to get it worked out on the front end, [promising] payments over time to incentivize those employees to stick around post-merger," Miller says.

Some banks have started including clauses requiring the nonsolication of customers as part of annual equity awards, says Stephen Brown, a partner at Mercer who works in financial services and executive compensation.

Banks can also make legal claims that a competitor engaged in tortious interference if an employment contract is breached, Miller says.

Another potential danger for banks is the difficulty the industry has with its image, says Vicki Elliott, who leads Mercer's financial services talent consulting network. The black eye that banks suffered following the financial crisis has made it more difficult for banks to compete with the "shadow banking industry" for talent, she says.

"Much of the talent departure has been going completely outside the normal universe of commercial banking — asset managers, hedge funds, private equity," Elliott says.

Banks have also started to upgrade in-house technology to keep a closer watch on employees, Legittino says. Steps include requiring employees to enter special log-on information on their work computers each morning.

The steps let human-resources managers and other supervisors monitor communications that employees sending from their work computers. If an employee is believed to be sending resumes out to potential new employers, management can act.

"You need to monitor what's going on on your system," Legittino says.

Employees should also be restricted to accessing only the parts of a bank's computer network that are directly related to their jobs, Legittino says. That can help limit an employee gain knowledge of the bank's entire customer list. "Some employees don't need to look at certain lists," she says.

Ultimately, there is little a bank can do to stop an employee from simply remembering something from his time on the job and relating it to a rival during a chance meeting in the community, Legittino says.

"There is a very fine line between what's a trade secret or a customer list, and if the employee has that in their head, how do they wipe that slate clean when they leave?" she says. "You can't restrain trade like that if they run into someone at the store. The best thing a bank can do is be vigilant."