The (In)famous Article 404 of the Swiss Code of Obligations

1 Oct. 2018

Contracts, whether for providing specific labor-related services or so-called ‘agency’ agreements, form the cornerstone of most industries ranging from hospitality to banking and are especially critical when they involve two or more parties from different countries. But what if there’s a dispute? Switzerland has gained a reputation for being the arbitration center of choice but watch out: article 404 of the Swiss Code of Obligations (CO), and its interpretation by the Swiss Supreme court, are generating a lot of discussion.

Swiss law defines as agency contracts, legal arrangements that imply the provision of services but are not formally labor contracts. Article 404, which applies to agency contracts, states that this type of contract can be terminated immediately.

Principal-Agent Model

The agency contract links principals and agents in a relationship based on trust, whereby the latter (the agent) undertakes to act on behalf of the former (the principal).

Consider for instance, a contract binding a patient and her doctor: unless the patient is a doctor herself, she won’t be able to judge the work of the doctor. The doctor has an obligation to act in the best interests of the patient, but still has some degree of freedom concerning the choice of the treatment. The principal – in this case the patient – can only put her trust in the agent (here, the doctor), because she does not have enough information to judge the behavior of the doctor.

This is a typical case of information asymmetry, whereby the agent has an advantage over the principal in terms of information. The agency contract also differs from service and work contracts because the agent has no obligation to produce a specific outcome, but only to handle the matter in the best interests of the principal.

So to go back to our example, the doctor has no obligation to impose a treatment on the patient, but only to assist her as best he can (and, of course, do no harm). Again, if we do not have the necessary information about the situation and the specific competences, it becomes very difficult to judge the procedure.

It appears clear that, at the heart of the agency contract, there is the matter of trust between the principal and the agent. If that trust is compromised, then, according to Swiss law, the principal can break the contract immediately.

Termination

Under article 404 of the Code, “the agency contract may be revoked or terminated at any time by either party”, the only exception being that of an inopportune time (for example, when the doctor decides to walk away just before an operation).

If it is true that everything is negotiable, another article of the Code – article 19 – states that “a contract may be freely determined within the limits of the law.”

The question is: is this the case with article 404? Again, in 2008, the Swiss Supreme Court said no (see decision: 4A_437/2008). The Supreme Court confirmed that article 404 is an imperative and cannot be negotiated.

What then are the implications of this law? It means that every time an agency contract comes under Swiss law, the principal (or the agent) can break the contract at any time, without prior warning.

This law has been strongly criticized as a potential source of instability between firms. If we cannot guarantee the integrity of a contract, what’s the point of investing in it? What’s the best way to protect yourself from this risk? Is this legislation transforming Switzerland into an unattractive market for international firms to do business?

As economists, we view Switzerland - with its legislation – as the most competitive market we can think of. How can the risk of contracts being cancelled be minimized, especially for the agent? The answer: Quality!

If the agent behaves in the best interests of the principal, why should the principal cancel the contract? Thanks to the credible threat of being able to cancel the contract, the legislation manages to solve the information asymmetry issue efficiently. At the very moment when principal realizes that the agent is misbehaving, she can punish the agent without constraint.

Many industries - including the hospitality sector - are affected by the principal-agent problem. The typical example is that of a manager who has to make decisions on behalf of the owners of the hotel. If the manager takes risks to raise his own profile, perhaps by entering untested markets, rather than maximize profits, he may not be behaving in the best interests of the hotel.

Solutions

The industry has found several solutions to the problem. First, it can align the incentives of managers and firms. If, for example, managers’ salaries are paid on the basis of the profits they make – or if they own stock in the firm – they would clearly be incentivized to maximize profits.

Other interesting solutions have also been found.

A recent trend in the hospitality industry has been to create a clear separation between property ownership, management and the brand.

A typical example is the franchise contract, where an independent hotel operates under the name of a well-known brand. In this case, the principal-agent problem is partially solved, because the brand can increase its presence in the sector, while at the same time the hotel would endeavor to behave optimally and maximize its own profits.

But can we really say that the information asymmetry issue has been completely solved? What if the brand suddenly starts losing its reputation because of the risks taken by its holding group? What if the independent owner does not really respect the brand’s standards and so damages its reputation?

Another solution is the management contract: the hotel owner can delegate the management of the hotel to a specialized firm, which would then act in the best interests of the owners. Once again, how can we be sure the behavior of the delegated firm will be optimal? The hotel owner could pay fees based on performance but is this really the optimal solution?

Article 404 of the Swiss Code of Obligations can reinforce these types of agency contracts, making eventual punishment a credible threat: whenever one party deviates from the right path, it immediately pays the consequences of its behavior.

This legislation has been accused of creating instability. Another way of looking at it is that contracts cannot be taken for granted. The only way you can be sure of not breaking these legally-binding arrangements is to guarantee top quality service. We thus go back to the good, old principles of Adam Smith: in a competitive market, only the best survive. The others should stay out!

Topics: Trends

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Dr. Isabella Blengini
About the author

Dr. Isabella Blengini, is an Assistant Professor in Economics. Her research interests include exchange rate movements, expectations, international capital flows, financial crises optimal monetary policy and portfolio choices.

Isabella teaches in the bachelor program the courses of microeconomics and hospitality economics. After taking her Ph.D. at Boston College, she did a post-doc at the University of Lausanne. She has been visiting fellow in the economics department at MIT and summer intern at the Boston Fed.

Hospitality_Insights_Giuliano Bianchi
About the author

Dr. Giuliano Bianchi is an Assistant Professor of Economics at EHL. He conducts empirical research on forecasting, executive compensation, economics of crime and tourism economics.

Giuliano holds a PhD in Economics from the University of Bologna (Italy), a Master Degree in Economics from the University of Edinburgh (UK), and a Bachelor Degree in Economics from the University of Lugano (Switzerland). Before joining EHL, Giuliano was a Wertheim Fellow at the Labor & Worklife Program, Harvard Law School.

Giuliano’s work has been published in refereed international journals, including Applied Economics and The Quarterly Review of Economics and Finance.

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