Criteria for an Advance Waiver in Execution-Only Mandates

Criteria for an Advance Waiver in Execution-Only Mandates

In its ruling of May 24, 2024, the Swiss Federal Court addressed, albeit only marginally, the topic of execution-only transactions for the first time. It stated that the principles applicable to asset management regarding advance waivers cannot be directly applied to execution-only transactions without scrutiny. In light of recent scholarship, which affirms the obligation to disclose retrocession fees even in pure account/deposit relationships, we consider it necessary to examine the prerequisites for waivers in execution-only business relationships.

Following the consistent reasoning of the Federal Court, the agent (i.e., the bank) should neither gain nor lose from the contract. In other words, the bank should not unjustly enrich itself but should be properly compensated for its services. Regarding retrocession fees, it must be noted that the payment of such compensation by the sponsors of collective investment schemes (e.g., funds, structured products, etc.) to the distributor (i.e., the bank) appointed by the client effectively increases the fee agreed upon between the distributor and the client, albeit indirectly.

Retrocession payments to the bank occur solely thanks to the client's investments or the actions of the financial service provider. If the client had not given the mandate and the assets had not been in the client's account, the bank would not have received any retrocession fees. Since compensation is a key contractual element, we believe that there is an obligation to disclose and return retrocession fees, regardless of the contractual relationship (whether it be an asset management mandate, advisory mandate, or execution-only mandate).

In execution-only transactions, the purpose of the duty to account and return funds is not solely to avoid conflicts of interest but rather to ensure a proper allocation of assets between the principal and the agent. The primary objective of Article 400, Paragraph 1 of the Swiss Code of Obligations is to secure the fiduciary nature of the contract.

From a logical perspective, in pure account/deposit relationships, where the agent merely executes the principal's instructions, it is not possible to predict in advance when and to what extent the principal (i.e., the client) will conduct or commission transactions. The mere fact that, in execution-only relationships, the client decides all transaction parameters does not mean that an advance waiver is no longer possible. Ultimately, the decisive factor is whether the client can estimate how much the agent earns or how much the client's services cost. In its ruling of May 24, 2024, the Federal Court merely reiterated that the principles for advance waivers in asset management cannot be directly applied to execution-only relationships. Execution-only clients must also be able to estimate the amount of retrocession fees, and the allocation of assets between the principal and the agent must be clear, as described above.

Furthermore, not only does the Federal Court's case law demand this, but regulatory requirements (see Art. 26 of the Financial Services Act, FIDLEG) also require that clients must be expressly informed about compensations prior to the provision of the financial service or before concluding the contract. It should also be noted that FIDLEG does not differentiate between different types of contractual relationships (see Art. 3, Letter C of FIDLEG) and applies the duty to account and return to all financial services.

In asset management contracts, the exact amount of compensation cannot be determined in advance because the total amount of managed assets is continuously changing, and the exact number or scope of the transactions to be carried out is unknown at the time of the waiver. For this reason, the Federal Court introduced a range of managed assets so that the client can relate the size of the retrocession fees to the agreed compensation. However, the situation is different in investment advisory and execution-only relationships. The agent (i.e., the bank) is aware of the key terms of existing retrocession agreements with third parties. Thus, at least upfront fees and linearly structured retrocessions can be determined once the client gives the mandate and therefore must be disclosed to the client as an exact amount before the financial service is provided. Given that specific key term agreements exist for each financial instrument, this should be easily achievable, for instance, by incorporating this information into the respective e-trading systems. In this regard, consideration should be given to creating an online-accessible database where these key terms are stored.

Therefore, when the Zurich Commercial Court (see HG190234-O) posits that less stringent requirements for waivers in execution-only mandates may suffice, Liti-Link can understand this reasoning. As the Federal Court ruled on May 24, 2024, the range of managed assets is not applicable in such cases. Nevertheless, it remains crucial that, similar to the waiver requirements for asset management mandates, the key terms of existing retrocession agreements with third parties must be disclosed. However, our experience shows that banks and asset managers withhold these key terms even in asset management mandates. Execution-only clients, however, cannot make informed investment decisions without knowledge of these key terms (a percentage value expressed for various products), and the allocation of assets between the principal and agent is thus not clearly regulated.

Whether a similar reference point (i.e., managed assets) needs to be specified for execution-only mandates can remain open for now. The decisive factor is that the investor must be able to estimate how much the agent earns, which is why the key terms of existing retrocession agreements with third parties must be disclosed.

In summary, we believe that the following criteria must be cumulatively met for an advance waiver in execution-only mandates:

1. The principal's intent to waive must be clearly stated in the agreement.
2. The key terms of existing retrocession agreements with third parties must be known to the principal.

In this context, one should bear in mind in whose interest retrocession agreements are made, as financial service providers enter into retrocession agreements for their own benefit. Bank clients themselves do not derive any apparent advantages from retrocessions. On the contrary, retrocessions obscure the actual price of individual services, making comparisons more difficult and ultimately driving prices higher.

The key difference between execution-only clients and asset management clients lies in their respective perspectives. While in asset management mandates, the bank, being aware of the key terms of existing retrocession agreements with third parties, makes the investment decisions, it is the bank itself that negotiates these specific terms with third parties. In contrast, execution-only clients, as experience shows, are left in the dark. The concrete values or amounts for various products are withheld from them, even though retrocessions have a significant impact on profitability. Transparency looks different!

In conclusion, if financial service providers build an opaque compensation system for their own benefit, they can surely be expected to properly and transparently inform their clients. What matters is not the bank's perspective, but rather the client's perspective and their right to information!