The UBS Mess / Opportunity (2/23/09)

After some build up, this week the Government went public with its heavy hammer to UBS -- I resist the temptation to say private parts, but that is an apt metaphor -- for its role in assisting United States taxpayers to underpay their taxes. For years, UBS actively promoted its services to U.S. taxpayers which had the intended bottom-line effect under Switzerland's secrecy laws and various other steps to insure secrecy to hide income that was subject to U.S. The expectation was that U.S. taxpayers participating in this service did not voluntarily report and income from these accounts and pay the resulting tax to the U.S. and equally important to UBS's participation, that UBS would earn lucrative fees for facilitating the U.S. tax evasion. In addition to the U.S. taxpayers not meeting their obligations, UBS failed in its obligations to report to the U.S. As a backstop to the integrity of the U.S. tax system, IRS regulations require foreign banks to withhold and pay to the IRS 30% of income received from U.S. investments maintained in foreign financial accounts. This system, if UBS had complied, would have identified the U.S. taxpayers and resulted in payment of much, if not all, of the resulting taxes. UBS did not comply with this system because it claimed the benefit of being a "Qualified Intermediary" under a U.S. program that requires the foreign bank to identify internally their U.S. and non-U.S. customers and not withhold as to the non-U.S. customers whom they are not required to identify. UBS entered a formal QI agreement with the IRS in 2001 but did not comply with the requirements -- specifically it did not comply with the obligation to identify and to withhold and pay over.

The following are key events this week.

1. On Wednesday, February 18, the Government and UBS announced their a deferred agreement that includes the following: (i) admission of misbehavior; (ii) agreement to cease the misbehavior and impose elevated standards for cross-border U.S. business; (iii) that UBS pay the U.S. $780,000,000 in disgorgement and tax related payments (including the $200,000,000 for the SEC settlement noted in paragraph 2 below), and that UBS turn over certain information regarding a limited set of U.S. taxpayers; (iv) further cooperation and disclosure consistent with an order of the regulating agency in Switzerland; and (v) agreement to the filing of a criminal information charging conspiracy to defraud (Klein conspiracy) with respect to the misbehavior; this information will be dismissed if UBS complies with the DPA and, in the interim, UBS will engage at its expense an external auditor acceptable to the U.S. who will monitor and make reports as to its compliance. The agreement notes that it could have been worse for UBS: "In recognition of the current international financial crisis and after consultation with the Federal Reserve Bank of New York, the Government will forgo additional penalties."

2. On Wednesday, February 18, the SEC and UBS settled a related suit initiated by the SEC's complaint in the DC district court. The key terms of the settlement were (i) an injunction prohibiting further misbehavior of the sort alleged and (ii) disgorgement of $200,000,000. (With this settlement, the total out of pocket to UBS is $680,000,000.)

3. On Thursday, February 19, DOJ announced the filing of a summons enforcement petition to enforce the John Doe summons previously authorized by the district court. The John Doe summons is designed to identify persons unknown to the IRS who likely to have an income tax liability but who are known to the person to whom the summons is issued. In this case, the summons was issued to UBS to identify all of the U.S. taxpayers with whom and for whom UBS had misbehaved. The John Doe summons requires court approval, and the court had so approved in July 2008. The Government, feeling that UBS' response was inadequate even with the commitments in the DPA, filed the petition on February 19 to enforce the summons to get what it alleged were 52,000 names of U.S. taxpayers. It is unclear to me why the Government did not resolve this in the DPA. Perhaps there is some song and dance going on about getting a formal U.S. order that will serve to give the Swiss authorities some cover when they permit UBS to disclose the information. In any event, the summons enforcement complaint is a bit cryptic, but the underlying declarations in support of the complaint assert that (i) UBS did not comply with its QI obligation to identify U.S. taxpayers and withhold and pay over to the IRS, (ii) the key U.S. taxpayer identity information is not available to the IRS from other sources, including the U.S. / Swiss Double Tax treaty, because of the way Switzerland interprets and applies the treaty which will result in at most 300 taxpayers out of a total set of 52,000 being identified; (iii) even for the limited data set of accounts (presently 12) that Switzerland has tentatively determined to disclose, Switzerland will first permit the account holders to contest the disclosure determination under Swiss law, which can be time-consuming.

4. On Thursday, February 19, the Swiss Federal Council issued a press statement stating that the proper functioning of its banking system is critical. The statement asserts cryptically that a key facet of the system is alive (if not healthy): "Banking secrecy remains intact. It serves to protect privacy. However, it does not protect tax fraudsters. The Federal Council expects all financial intermediaries to comply with the law." The statement also acknowledged that there were administrative assistance proceedings, presumably at the request of the United States Government, relating to UBS AG.

5. In the press puffery surrounding all this, the Government asserted that U.S. taxpayers are suffering in these troubled times and that those who cheat the tax system should not be allowed to escape. That message was intended not only for the 52,000 U.S. taxpayers who reputedly misbehaved with UBS, but to all those others who misbehave with respect to the taxes. The message is that you may be able to hide and maybe even escape scrutiny altogether -- maybe. But, the message is, if we get on to you, you are going down.

6. On Friday, February 20, UBS filed an oppostion to the John Doe Summons, asserting that it is prohibited by Swiss law from disclosing its customer information without following the processes under Swiss law which the U.S. feels is inadequate (the whole reason for filing the John Doe Summons after the DPA the day before). Indeed, UBS complained that it was not being given sufficient credit for the DPA, including large cash disgorgement, it had agreed to. The U.S. responded that "UBS has already received credit by not facing immediate criminal prosecution for having committed very serious crimes on U.S. soil."

7. On Friday, February 20, the Swiss Government filed its statement of background information. Needless to say, the Swiss Government opposes the enforcement of the summons. The Swiss Government accuses the U.S. Government of the functional equivalent of war crimes in the context of international comity. Obviously, the Swiss Government is responding to its constituency -- the Swiss banking community -- whose franchise would be destroyed if it is unable to give foreign depositors assurance that they can hide the ball from whomever they wish, including most prominently their local tax administrators. What do Swiss banks really have to offer over their competitors in less secret jurisdictions if it is not the opportunity to hide the ball (really the money).

8. In this regard, if the U.S. Government continues to feel that UBS is not cooperating, it seems that it has the unilateral power to yank the DPA and come against UBS full bore on the criminal information and even expand the charges. The DPA does say that UBS's defense of the John Doe Summons proceeding is not grounds for yanking the DPA, but that noncompliance with any resulting final order could be. Before the U.S. may treat such noncompliance as a default, the Government (here the DOJ) must consult with the IRS and with the Board of Governors of the Federal Reserve. (The latter is where UBS may make its argument that forced compliance would be the equivalent of a death senntence in which the already bad economic system will be rendered a blow beyond the imperatives of tax enforcement.) But, as noted, this proceeding may be just doing the footwork necessary for UBS to finally provide the information with Swiss Government approval with the deniability factor of "the devil made me do it."

8. The bottom line is that, after some further wrangling and posturing both by UBS and the Swiss Government (as it tries to mitigate the damage to its franchise of secrecy), the U.S. Government will likely get this information.

9. Surprisingly, it is reported that the U.S. Government agreed to postpone a hearing date until June (almost 4 months) on what should be a summary proceeding. The Court reportedly encouraged the parties to narrow the issues, which is surprising because the issues are relatively straight-forward. Bottom-line, all UBS has to offer -- argue -- is that the Swiss secrecy law should excempt it from identifying its cohorts in crime.

10. Jack Townsend's Comments: Practitioners know that the Government is unable -- even if it had the will -- to prosecute 52,000 U.S. taxpayers even if Switzerland were to identify them all without further ado. Indeed, the Government will be able to prosecute at most only a minor fraction of that number. Now is the time to take action to insure that your client should not be in the product of that fraction. Specifically, you should consult with your client about the voluntary disclosure policy, That may be costly for your clients in terms of dollars, but may be a much better alternative than either the Sword of Damocles that now must hang over them and, worse, a criminal prosecution.