What role should the client’s risk profile play when drawing up a wealth management mandate? We are going to attempt to answer this question, with reference in particular to the recent Federal Supreme Court decision handed down on 23 October 2020 (4A_72/2020).
This case involved a client who, in 2006, entrusted the management of her assets to an external wealth manager similar to Onyx & Cie SA. According to the agreement signed by the parties, the investment strategy aimed to provide an “absolute return” using direct investments, investment funds and/or alternative investments, including hedge funds. The agreement stated that the manager could invest between 0% and 100% of the assets in each of the different classes indicated: cash, fixed income, equity and alternatives. However, in principle the manager was not authorised to invest directly in derivatives.
A few years later, the customer complained about two investments in funds, worth a total of €3m, saying that the manager should have opted for a conservative management strategy in line with her risk profile, whereas the manager maintained that they had agreed on an aggressive strategy.
The client took the case to the Geneva Court of First Instance and won. The court held that the manager had violated the agreed strategy. It considered that the risk profile should have enabled the client to maintain her capital, while taking a limited degree of risk, and that the manager could not rely solely on the percentages (0% to 100%) given in the agreement and was unreasonable in taking maximum risk.
The judge held that one of the investments was made in violation of the agreed strategy and the principle of diversification. The other investment was not compatible with the client’s risk profile, nor with the principle of spreading risk.
At appeal, the Court of Justice dismissed the client’s case. Having established the real, common intent of the parties, the judges stressed that the objective of the investment was high profits and that the client had to accept the corresponding level of risk. The parties had therefore opted for an aggressive management strategy.
The client appealed to the Federal Supreme Court but the appeal was rejected. The court held that once a client and their wealth manager have agreed on an investment strategy, the client cannot then go back and complain that their risk profile has been incorrectly assessed.
Based on this principle, is our Supreme Court’s reasoning tenable?
1. Case law principles regarding risk profiling
Background: under a wealth management agreement, a client retains an investment manager, such as our family office Onyx & Cie SA for example, to manage all or part of their assets by determining the stock market operations to be carried out, within limits set by the contract. We call this service discretionary management. It is different to an advisory service, where the client makes their own investment decisions based on analyses, market estimates and the manager’s recommendations.
From a legal angle, a wealth management agreement is governed by articles 394 and following of the Swiss Code of Obligations, in particular as regards the manager’s responsibility.
Of course, even if a manager has been engaged under a discretionary mandate the client can still, on an occasional basis, instruct them to buy or sell a specific investment. In this situation, the policy at our family office is to create a written record of the investments made under the client’s direct instructions, and which are therefore not the manager’s responsibility.
The Federal Supreme Court’s judgement begins by explaining that before entering into a wealth management agreement, the manager must start by establishing the client’s risk profile. This will define the degree of risk that the client is prepared to take (subjective tolerance for risk) and the degree of risk they can afford to take, given their lifestyle (objective capacity for risk).
Together with due diligence, the risk profile is the cornerstone of the wealth management mandate. At our family office, Onyx & Cie SA, it is about ten pages long. It contains all the relevant information about the client’s financial situation, their investment objectives, their propensity for risk and their investment knowledge and experience.
The client must also be given information about the risk-reward concept as applied to investments. Of course, the higher the return targeted, the higher the risks involved in the investment. We call this the “no risk, no gain” principle and risks are generally categorised on a scale ranging from “very low” to “high”.
Lastly, at Onyx & Cie SA, we have recently added a further questionnaire to explore our clients’ positions on “Environmental, Social and Governance (ESG)” factors, as these are increasingly important.
However it is approached, the requirement to assess the client’s risk profile is part of the manager’s due diligence (under article 398 paragraph 2 of the Swiss CO) and also forms part of the prudential regulations (see article 12 of the Swiss Financial Services Act (FinSA) passed on 15 June 2018 and margin numbers 7.1 and 7.2 of the FINMA guidelines on asset management (Circular 2009/1), article 1 of the SBA’s Portfolio Management Guidelines issued in November 2020, and article 7 of SAAM’s Swiss Code of Conduct for Independent Asset Managers issued on 1 August 2017).
The wealth manager uses the client’s risk profile to establish an investment strategy in line with their investment objectives and their investment constraints.
Of course, the wealth manager must explain the risks of the investment strategy that they propose, so that the client has all the relevant information with which to make their decision. The wealth manager’s duty to inform is heightened if they are proposing risky speculative investments, or if the client has little knowledge of financial markets. In general however, wealth managers can assume that clients understand the standard risks of buying, selling and holding equity, bonds and shares in investment funds, and that they only need to provide information on risk factors beyond the standard risks, such as those linked to derivatives and structured products.
Lastly, as the Federal Supreme Court mentions, the manager’s duty to inform, advise and warn their client is more extensive in the context of a discretionary management agreement than it would be if they were providing investment advice only or simply administering a bank account.
The duty to inform exists initially at the pre-contract stage. If an agreement is signed, the violation of this duty can give rise to claims based on contractual liability.
However, and this is the central factor in this case, the Federal Supreme Court considers that, even if a risk profile has not been drawn up, once the client has signed an agreement they cannot protest about losses suffered on the grounds that a more conservative investment strategy would have been more appropriate to their personal situation if the agreement demonstrates that they had agreed to use a risky, speculative investment strategy. Such contradictory behaviour does not deserve any protection, as laid down in article 2 paragraph 2 of the Swiss Civil Code (CC) (4A_140/2011).
2. The grounds for the Federal Supreme Court judgement
In the case presented to it, the Federal Supreme Court began by noting that as for all contracts, for a wealth management agreement to be signed there must be a mutual expression of intent by the parties (article 1 paragraph 1 of the Swiss Code of Obligations [CO]). For a contract to exist, there must be an exchange of expressions of intent, which are normally offer and acceptance. The contract is formed if the offer and the acceptance correspond. Unless it is declared null and void due to a defect of consent, a contract is formed even if the manager has failed to fulfil their pre-contractual duties.
In order both to determine whether a contract has been formed and to interpret it, the judge must ascertain the real mutual intent of the parties, discounting any inaccurate expressions and names they may have used, either in error or to disguise the true nature of the agreement.
To ascertain the content of a contract, the judge must look, firstly, for the real mutual intent of the parties (subjective interpretation), if necessary empirically based on evidence. Evidence here includes not only the contents of the parties’ written or verbal declarations of intent, but also the general context including all the circumstances that reveal the intent of the parties, which can be statements before the contract was formed or events afterwards, and in particular subsequent behaviour that shows how they viewed the agreement at the time.
The judge may be unable to ascertain the parties’ real mutual intent – due to a lack of evidence or because the evidence is inconclusive – or may observe that one party did not understand the intent expressed by the other when the contract was formed. For a party to say during the court case that they did not understand is not enough, there must be evidence for this. In such a situation, the judge must resort to a normative (or objective) interpretation, established by looking at the parties’ objective intents and establishing what each of them could and reasonably should, in good faith, have understood by the other party’s declarations of intent (principle of trust).
Based on the principles set out above, the Federal Supreme Court observed that the Court of Justice had succeeded in establishing that the parties’ real mutual intent was to manage the portfolio in an aggressive way, with the objective of generating significant profits and including a corresponding degree of risk. The client, who had for example authorised the manager to invest in hedge funds as they saw fit, had opted for an aggressive investment strategy by not setting a maximum percentage for variable-income investments (in equity or alternative products) or by authorised asset class.
As the lower court’s assessment was based on facts, the Federal Supreme Court could only review it if it was considered to be arbitrary. However, the client was unable to demonstrate that the lower court’s interpretation of the contract had been arbitrary. This complaint was therefore judged to be inadmissible.
Based on the case law outlined above (4A_140/2011), the Federal Supreme Court felt that the client also had no grounds to maintain, when she suffered losses, that a more conservative investment strategy would have been more appropriate to her personal situation. The fact that the manager had not assessed her risk profile, which potentially could have shown that a more conservative strategy would have been appropriate, is irrelevant.
In particular, the judges upheld the lower court’s assessment that: “the manager’s evaluation of the client’s level of knowledge and their risk tolerance (‘customer profile’) serve to ensure that an appropriate contract is formed. However, this evaluation has no actual consequence as regards risk, because risk is defined solely by the clauses of the contract. So, when a client accepts a wealth management contract outlining a risky, speculative investment strategy, they cannot then make claims based on a lack of evaluation, the results of which should have led to a more conservative investment strategy”.
3. Critical appraisal of the decision: due diligence and risk profile
Although the Federal Supreme Court’s reasoning is favourable to Switzerland’s wealth managers, we are not really convinced by it. It reduces to the very minimum the wealth manager’s duty to inform their client and assess their risk profile.
Indeed, although agents do not provide any guarantees to their clients, they do owe them due diligence. This due diligence can be assessed objectively by determining how a conscientious agent in the same situation would have managed the case. A wealth manager acting in a professional capacity and charging a fee for their services is of course held to a higher standard. So, when the manager is given wide scope to make decisions, they are only responsible for losses resulting from transactions that are considered unreasonable, in the sense that a professional would not have reasonably and objectively entered into them. Lastly, an agent can under certain circumstances be held liable for a transaction that falls within the bounds of the contract.
The manager’s obligation to assess the client’s risk profile means that they have to recommend to each client the most appropriate investment strategy for them. They must then present the strategy to the client, and explain all the details of it.
Of course, the client is free to opt for a more aggressive or more conservative strategy than that indicated by their risk profile. However, they can only do this once the manager has explained to them in full the consequences of their choice, and this can only be done on the basis of their risk profile. In other words, the client must be in possession of all the facts in order to make their decision, and the manager needs to assess their risk profile to provide these facts to them.
So, contrary to the conclusion reached by the Federal Supreme Court in its judgement of 23 October 2020, we believe that a wealth manager who has failed to demonstrate due diligence should be answerable for the losses suffered by the client. Not to hold them liable flies in the face of the rules used by lawmakers in the FinSA and by professional bodies such as the SBA and the SAAM.
In addition, it is a far less clear position than that adopted by the Federal Supreme Court in 2014 (4A_364/2013 of 5 March 2014), when it upheld the compliant of a nurse with no financial markets experience that the strategy used to manage her assets was too risky. In this case, the manager had not assessed her risk profile and the court held that, given her lack of experience, the client was not in a position to understand the consequences of the investment strategy.
Given the fluctuations in case law in this field, we recommend that managers always keep accurate records of their clients’ choices. If the client wishes to use a management strategy that does not fit with the risk profile established by the manager, they should be asked to sign a “disclaimer” to say that the manager has explained all the risks of the investment strategy that they have chosen and that it does not fit their risk profile, and that they understand the consequences. In any case, it is clear that a wealth manager should draw up a risk profile for each and every client. It is the very basis of the wealth management relationship, and now forms an integral part of all prudential regulations.