In my practice, I repeatedly experience cases in which investors are harmed by the actions of an external asset manager. Frequently, the custodian bank would have been in a position to detect and prevent these unlawful acts. In such cases, the question regularly arises as to whether the custodian bank can be held liable for the investor’s loss. The accusation against the bank is that it could have discovered the unlawful acts and then should have warned its client.

Such cases are, for example

– the asset manager operates an unsuitable investment strategy

– the asset manager engages in “churning”, i.e. he generates income for himself by carrying out too many transactions on the assets. This is especially the case if he receives retrocessions (“kickbacks”) for transactions from the bank or from third parties (e.g. funds, brokers).

– the asset manager makes unauthorised withdrawals from client assets, either to enrich himself or to hide losses on the assets of other clients.

– the asset manager operates a Ponzi scheme.

The banks regularly take the position,

a) that they had no duty to monitor the actions of the external asset manager. They try to protect themselves by providing in their proxy forms that the investors grant comprehensive powers of attorney to the external asset manager and exempt themselves (i.e. the custodian bank) from any responsibility for the asset manager’s actions.

b) that they also had no factual possibility of recognising that the asset manager was not acting in the investor’s interest, e.g. because they could not know what investment strategy the investor was pursuing or what the purpose of the payments drawn from the account by an asset manager was.

c) that the investor himself could have prevented the damage, as he was able to follow the movements in the account and did not intervene with his asset manager (contributory negligence).

The legal situation in Switzerland is as follows:

According to the established case law of the Federal Supreme Court, a custodian bank is in principle not responsible for the misconduct of an external asset manager. It is primarily the client’s responsibility to choose his asset manager carefully, to inform him correctly about the desired investment strategy and also to monitor him. In special situations, however, the custodian bank must inform the investor about recognised damaging actions of the external asset manager, even if this was expressly excluded in the contracts and powers of attorney.

Such a case had to be decided by the Federal Supreme Court on 25 April 2016. Although the case was somewhat special, it shows how important the circumstances of the specific individual case can be for assessing liability.

The Swiss bank was the custodian bank for two funds that had been launched by the external asset manager. However, both funds were failures: The first fund had to be dissolved because of losses, the second because it could not find enough investors. Nevertheless, the same asset manager set up a third fund, but the bank refused to become a custodian. It described the investment strategy of this new fund as incomprehensible and opaque.

When a wealthy entrepreneur from Hungary negotiated with the asset manager to invest in this third fund. Among other things, the asset manager referred to his good business relations with the renowned bank. The investor then asked the bank for a letter of recommendation for the asset manager. The bank issued the requested letter of recommendation for the asset manager. In it, it confirmed its good relations with the asset manager, but did not mention that it had declined to become the custodian for this third fund and that it described the fund’s investment strategy as opaque. An employee of the bank also attended a meeting between the investor and the asset manager. At this meeting, the client wanted to know the bank employee’s opinion about the third fund. In response, the employee only mentioned in general terms the risk of a total loss, but not the doubts the bank had about the fund’s investment strategy.

Subsequently, the investor concluded an asset management contract with the external asset manager, which provided that about 60% of the invested funds would be invested in fund 3. The investor also became a new client of the bank. The bank now maintained an account and a custody account for him and granted him Lombard loans. Subsequently, the asset manager invested substantial amounts in the third fund for the investor, including the money from the bank’s Lombard loan. The fund suffered heavy losses and the shares bought for the investor became worthless. The external asset manager went bankrupt, so that the investor could only look to the bank for compensation.

The Federal Supreme Court first reiterated the well-known case law: if an external asset manager has a comprehensive power of attorney, the bank is not obliged to draw the client’s attention to the risks associated with an investment or to obtain the client’s consent before executing the external asset manager’s orders.

In exceptional cases, however, the bank may have such a duty. This is the case if the bank would recognise, if it had paid due attention, that the client did not recognise the specific risks associated with an investment he intends to make, or if a special relationship of trust has developed between the bank and the client over the years, so that the client was entitled in good faith to expect advice and a warning from the bank even without a corresponding request.

In this case, the Federal Supreme Court did not directly decide whether the bank was liable, as it referred the case back to the lower court, the cantonal court, for a new assessment. It ordered the lower court to reassess the case and in particular to examine

a) whether the bank had information that should have led it to warn its client of the risks associated with the system;

b) whether the bank should also have drawn the client’s attention to the lack of diversification of the external asset manager’s investments.

In doing so, the Federal Supreme Court made it clear that mere general warnings to the client were not sufficient to fulfil these particular obligations. In other words, even though the Federal Supreme Court did not directly affirm the bank’s liability, but left this to the lower court, it made it abundantly clear that it considered liability to be justified on the basis of the information withheld from the investor.