05 JanTrailer Fees & Retrocessions; Kickbacks by any other name

Two news items from opposite sides of the Atlantic have inspired this first post of 2016. The kickback is nothing new, nor is it something confined to banks. The latest cases show just how banks try to gain the upper hand in the game of cat & mouse both with regulations and clients.

The dictionary definition of kickback highlights how such payments are often secretive and mostly improper. The banks’s special variation on the kickback is something known as the trailer fee, the retrocession or the rebate. Largely, these are associated with mutual funds and hedge funds, and sometimes with structured products; the funds charge a periodic management fee to the fund holders and then share some part of that fee with the banks acting as custodians for the clients.

Exactly what the bank’s share is varies. As ever, size matters; the bigger the bank, the larger potential there is to negotiate a larger trailer. Now comes the $64’000 question; who does this rebate belong to?

Switzerland, as the home of private banking and wealth management, is a country where the banks have already had their name in the headlines and their day in court. Historically, the banks ploughed the obvious course; they used their size to negotiate high “retros”, excluded funds that did not pay retros or not enough and directed funds to the selected funds.  In my years at both Goldman Sachs and Credit Suisse, I saw first hand the operational effort that went into negotiating, tracking and claiming these fees.

Eventually, this topic ended up on the table of the Swiss Supreme Court, which in 2012 sent down a decision that where the banks were operating discretionary accounts for clients, all retros had to go to the clients. Rightly a distinction here was being made based on who made the investment decision: the bank or the client. Messy legal cases followed with claims for fees from prior years: see NZZ 24.10.2013, “Banken spielen bei Retrozessionen auf Zeit”.

Just in time for the new year and the usual practice of charging annual fees at the start of the year, one of the big Swiss banks, Credit Suisse (CS) , has apparently decided to use a change in its General Terms & Conditions (GTC’s) to slip in some language that allows it to pocket any and all retros. Perfectly legal, but offering nothing by way of transparency.

In the US, banking giant JP Morgan has recently settled with the SEC in a similar case. The SEC charged that from 2008 to 2015 JPM failed to disclose its preference for investing in funds from which it received substantial retros.  JPM was find just over $300 million and ordered to make full disclosures.

Lessons Learned: Banks are universally devious, cunning and underhand; American ones clearly no better behaved than their Swiss cousins. Using the  GTC’s to regulate something that affects performance and returns is a very poor and non-transparent approach. CS has clearly not learned a thing from past episodes; in the noughties, it ran into huge problems when trying to use the GTB’s to mandate that clients a priori approve the lending of securities to the bank.

Retrocessions need to be banned. I have to agree with the NY Times journalist who wrote the article cited above. As funds and other banking products may be issued in many jurisdictions, each with a varying quality of regulation, I think a three pronged attack is needed here:

  1. Ban the payment of retrocessions where securities are issued
  2. Ban the acceptance of any form of payment or incentive; this in case rule one does not work
  3. Add a disclosure requirement under the rules laid out by the GIPS rules. GIPS is the Global Investment Performance Standards. This should require banks to report to all clients, discretionary or not, if any retrocessions were relieved and what they were at a instrument level.

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