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UBS Under Attack
Thursday, 26 March 2009 15:22

Letter from America
A massive legal row is brewing between the US authorities and the Swiss bank


Last month, in writing about the proposed “Stop Tax Havens Abuse Act,” we expressed cautious optimism that the bill would be off the legislative agenda for at least the next year, reasoning that the Obama Administration simply had too many other priorities that demanded immediate attention.

We also—admittedly naively—took the President at his word when he talked of repairing the United States’ image in the world, believing that the Administration would not assume the aggressive posture that the bill demanded. And, perhaps most ridiculously of all, we even suggested that the Administration would, in spite of all campaign rhetoric, initially pursue a “Reaganesque” tax policy of maintaining the currently low tax rates on upper-income Americans in the belief that the economy was currently too weak to support tax increases.  

Alas, this is the problem with print media. The lead time between article submission and printing can be as short as a few days, but at the pace at which things are changing, a few days can be an eternity. Just days after we submitted last month’s article, the Obama Administration proposed the biggest expansion of the Federal Government since Franklin Delano Roosevelt’s New Deal and proposed paying for this almost entirely with tax increases on high-income earners. It also launched what could only be described as a full frontal assault on Swiss banking giant UBS, demanding that the bank—in direct violation of Swiss law—hand over the names of 52,000 American account holders.

In light of recent developments, including the prospect of a hostile G20 meeting in April, it is now obvious that we were far too optimistic. The Stop Tax Havens Abuse Act may or may not come up for congressional deliberation, but the Administration has made it very clear that it intends to forcefully attack offshore financial jurisdictions even without the new Act. This will potentially affect hedge funds, insurance companies, and other financial intermediaries in addition to “onshore” companies with various offshore or outsourced operations, and wealthy individuals seeking privacy and legitimate tax-minimization and lawsuit-protection strategies.

The Obama Administration’s prosecution of UBS may yet surpass that of the Bush Administration against the offshore internet gambling industry, and the results of this prosecution will almost certainly be further reaching. At the root of the issue is a question of banking privacy and to a large extent a question of national sovereignty and of jurisdiction in a globalised world in which capital is mobile.

With its well-deserved reputation for stability, neutrality, first-class service and honest administration, Switzerland is home to approximately one third of the world’s $7 trillion in offshore assets.  It is this all-important reputation that has allowed Switzerland to differentiate itself from other jurisdictions. Should Switzerland’s reputation for discretion and privacy be materially damaged, it is nearly certain that a not insignificant amount of those deposits would find a home elsewhere. This has already been proven true in the case of UBS. Citing bad publicity from investments gone wrong and the deepening tax evasion scandal as major contributing factors, The New York Times reports that clients withdrew 123 billion Swiss francs ($105 billion) in 2008—nearly 8% of assets under management. New figures have not been released, but it is safe to assume that the bank has lost additional assets during the first three months of 2009, and we will never be able to calculate the potential assets lost to bad publicity, as would-be investors decided to choose the next bank down the street.   
The bank’s reputation within Switzerland—and among its foreign account holders—was perhaps irreparably damaged by its settlement with the US Justice Department in which the bank gave up the names of 250-300 US account holders (and paid $780 million in fines) to avoid criminal prosecution.

Reputations, once damaged, are hard to rebuild. UBS realises this, and it has acted aggressively to restore confidence by replacing its chief executive and chairman respectively with a former Credit Suisse CEO and a former Swiss finance minister. Banks have certainly survived bigger setbacks in the past and managed to survive, and we believe that UBS, though wounded, will retain its place among the world’s elite financial institutions. That said, its scale and scope will almost certainly be reduced, both on the asset side—possibly involving greater regulation of the credit risks being taken and the amount of leverage used—and the deposit side—almost certainly involving additional curtailment of offshore financial services to Americans and citizens of various other countries.

Is Switzerland’s Financial Stability at Risk?

The problems facing UBS have essentially created two distinct risks to Switzerland. The first is the potential loss of banking privacy due to the bank’s confrontation with the U.S. Justice Department. Ivan Pictet, president of the Geneva Financial Centre, estimated in an interview with a local Swiss paper that the loss of banking privacy could reduce assets managed by up to one half. Even if Mr. Pictet is overestimating the potential damage, the fact remains that, in this new world of mobile capital, offshore investors can easily find a new destination for their money. We consider this the primary risk facing the country and the focus of this article.  

The second issue is the threat to Switzerland’s currency and financial stability due to aggressive lending and investing done by the country’s two global banks—UBS and Credit Suisse. In a widely circulated article in the Swiss newspaper Tagesanzeiger, economist Arthur Schmidt argues that Switzerland faced the prospect of national bankruptcy due to the exposure of its banks to bad loans in Eastern Europe. Schmidt argued that a large-scale bailout of the two banks by the Swiss National Bank would cause a collapse in the value of the Swiss franc, reducing it to the status of a weak currency.  

Thus far, Mr. Schmidt’s fears appear to be wildly overblown. Forbes reports that Swiss bank loans to Eastern Europe were only $75 billion and, according to the Swiss National Bank, posed no risk to the currency. The Swiss franc managed to survive the write-down by UBS of (thus far) $53 billion in US mortgage-related securities, keeping its status as a hard currency intact. It would seem that this aspect of the crisis is containable.  

Still, there appears to be a growing consensus in Switzerland that UBS and Credit Suisse have become simply too large and that their size must be reduced in order to avoid being a risk for Switzerland in the future. At approximately $2 trillion, UBS’s balance sheet is roughly four times the size of Switzerland’s GDP. Were UBS an American bank, its balance sheet would be less than 15% of GDP.  Needless to say, a UBS “blow up” would be catastrophic to Switzerland’s financial stability.  

Banking Privacy Under Siege

Let us now return to the focus of this article, the US Justice Department suit against the bank. By UBS’s own admission, the bank overstepped the bounds of typical Swiss discretion in becoming a little too brazen in helping American account holders hide assets.  

Swiss law makes a clear distinction between tax evasion and tax fraud, the former being merely a civil offense while the latter an actual crime. Failing to report offshore income would be considered tax evasion to the Swiss, whereas actual tax fraud generally involves more aggressive tactics, like the falsification of documents. There is clearly a difference between discreetly failing to ask questions and actually offering assistance in breaking the law.  In the criminal case that was settled by UBS surrendering the account information of 250-300 Americans, both Swiss and American authorities agreed that UBS crossed that line.  

The civil case is another story altogether. The very next day after the high-profile criminal settlement, the US Justice Department filed a civil suit against the bank demanding the identities and records of 52,000 American account holders—nearly triple the 19,000 under investigation in the original criminal complaint. UBS has until April 30 to prepare its defence for the civil trial that would take place on July 13.

Many Swiss are justifiably outraged by the US Administration’s actions, accusing the Americans of negotiating in bad faith. They accuse the Americans of demanding an end to Swiss banking privacy while the US itself—particularly in the case of Delaware corporations and LLCs—continues to offer privacy havens of its own. To many Swiss, compromising banking secrecy is tantamount to compromising Swiss national sovereignty, and the UBS civil suit is nothing short of a hostile act of aggression. UBS could potentially lose its ability to conduct business in the United States, and it could also be held in contempt of court, resulting in new fines and possibly a reopening of the criminal case. It is unclear how Switzerland would respond to such a development.  Cooler heads may yet prevail, and the US Justice Department may yet scale back its demands. But for now, we appear to be heading for confrontation.

On March 8, the Swiss justice minister said in no uncertain terms that UBS would not be allowed by the Swiss government to release the 52,000 names. With the April 30 deadline—and the G20 meeting—approaching, the pressure is certainly building.

If Swiss banking privacy could survive pressure from Nazi Germany, one would think it would survive the US Justice Department. This is by no means certain at this point. The next few months will be telling.

 

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