Special Report: How the U.S. cracked open secret vaults at UBS

Lisa Jucca

ZURICH

Fri Apr 9, 2010 6:12am EDT

ZURICH (Reuters)- After the collapse of Lehman Brothers in September 2008, Switzerland's largest bank was teetering. UBS, which was more than three times bigger than Lehman in terms of assets, had to write down some $50 billion during that tumultuous period.

U.S.

Investors the world over breathed a sigh of relief on October 16 when the Swiss government rescued UBS. But unbeknownst to them at the time, the bank faced a potentially devastating crisis on a very different front.

One day after the bailout, top executives from UBS and Swiss regulators were summoned to a closed-door meeting in New York by U.S. officials who were conducting a wide-ranging tax fraud investigation that centered on the bank.

The UBS delegation, led by newly-appointed Group General Counsel Markus Diethelm, arrived armed with the results of an internal report highlighting instances of tax fraud within the bank, insiders told Reuters. The plan was simple: admit guilt, settle the case quickly and move on.

But Kevin Downing, the U.S. Department of Justice Tax Division Attorney who had been investigating UBS since the middle of 2008, chose that meeting to drop a bombshell: he wanted the bank to disclose names of U.S. tax evaders as a condition for a settlement.

That put UBS in the nightmarish position of either breaching nearly a century of Swiss bank secrecy or risking indictment in the United States.

"UBS was already in a position of weakness from the credit crisis," said one person who attended the meeting and spoke to Reuters on condition of anonymity. "It became crystal clear at that meeting that without addressing the issue of client names, no settlement could be found."

Interviews with insiders and a review of documents reveal previously undisclosed details about how the sprawling tax case was resolved -- at several points in the process, for example, Secretary of State Hillary Clinton was involved.

The confrontation also pushed UBS closer to the brink than is commonly realized. And while the bank ultimately defused the situation by coughing up $780 million and agreeing to hand over some client names, the damage to its huge and increasingly important wealth management operation still weighs heavily on the Swiss banking flagship.

In the months ahead, UBS's new management team will try to stabilize its battered wealth management division, whose advisers have been bolting and taking clients with them.

All of this in turn has forced the bank to confront a broader, more existential question: what exactly is UBS today? An asset-gathering megabank or a leaner player, more attentive to its wealthy clients' needs.

SWISS SECRETS

For UBS and other Swiss banks, the implications of the New York meeting on October 17, 2008 were hardly trivial.

Sharing bank client data would have been against UBS's core principles: confidence, security and discretion, symbolized by the three keys of its 70-year-old logo. Doing so might also shatter wealthy clients' trust in the bank -- and in the whole Swiss financial center.

Under scrutiny by the DOJ was the so-called U.S. cross-border business of UBS. This consisted of wealth management services offered to American residents outside the United States. It operated out of Switzerland and was separate from UBS's New York-based Americas wealth management business.

In documents relating to the UBS case, the DOJ said the bank helped some 52,000 Americans hide billions of dollars of untaxed assets in secret Swiss accounts between 2000 and 2007. According to settlement documents, UBS sometimes used shell financial entities to hide the money, depriving the Internal Revenue Service of hundreds of millions of dollars of tax revenues.

The business was referred to by some UBS executives as "toxic waste" due to the risks it carried under U.S. law. But UBS bankers, seemingly unaware of the legal consequences, made 3,800 trips to the United States to visit these clients in 2004 alone.

The cross-border accounts were hardly a big part of the bank's business. They added up to almost $20 billion, or less than 1 percent of UBS's total invested assets of about $2 trillion (2.174 trillion Swiss francs) at the end of 2008.

The business was so small it was initially below the radar screen of Swiss financial regulator FINMA, at the time known as the Federal Banking Commission. The agency's main concern back then was the systemic risks posed by UBS's increasingly wobbly fixed-income division.

Passing on some UBS client data to the United States was possible under certain strict conditions under an existing U.S.-Swiss tax agreement. U.S. authorities put in a request for the client data to Berne, but the process was cumbersome and slow and the Department of Justice grew increasingly impatient.

The investigation was launched by the U.S. Securities Exchange Commission, which suspected that UBS had breached U.S. securities law. But when the Department of Justice became involved, raising the prospect of criminal prosecutions, Swiss regulators became alarmed.

Their concerns grew in April, 2008, when U.S. authorities briefly detained Martin Liechti, the Zurich-based head of UBS's U.S. cross-border business, while he was visiting Miami. Then in May, Bradley Birkenfeld, a former UBS financial adviser who famously admitted smuggling a diamond in a toothpaste tube on behalf of a client, was arrested. He began a 40-month sentence in January.

Those cases got the Swiss Federal Banking Commission's attention. As the summer wore on, the agency started pressuring UBS to speed things up. But the bank, still in the throes of the financial crisis, was preoccupied with its own survival.

UBS had recently removed its all-powerful chairman, Marcel Ospel, who had blessed UBS's big expansion into the United States a decade earlier and fostered the risky U.S. investments that eventually brought UBS to its knees. Peter Kurer, a well-known Swiss lawyer who had joined the bank in 2001 as its general counsel, replaced Ospel as chairman in April 2008.

Kurer took months to appoint Diethelm as UBS's top lawyer. That lengthy process did not help the bank's dealings with U.S. authorities.

Diethelm, an ambitious former chief legal officer at Swiss Re, had made his name in the legal community by negotiating a multi-billion-dollar settlement between a group of insurers and a developer of the World Trade Center.

But within weeks of taking on the job he found himself working for a nearly crippled lender that was facing indictment in the United States.

Hoping to come to the rescue in what was clearly becoming an untenable situation for UBS, the Swiss Finance Ministry sent a letter to its U.S. counterparts to make clear that Berne was willing to find a solution to the UBS case despite the obvious legal constraints.

That did not sit well with U.S. officials, who saw the letter as political interference, insiders say. The Swiss never got an official response. Instead, the next time U.S. officials contacted the bank, on November 12, it was to inform UBS that Raoul Weil, its global head of wealth management, was being indicted.

"That was a clear message," said a high-level Swiss source. "One can imagine that without the letter they would have at least delayed the indictment of Weil."

Executives inside the bank feared that Chief Executive Marcel Rohner and Chairman Peter Kurer would be next, although neither had been named in court documents, these insiders say.

The indictment of Weil, who immediately stepped down from the executive board and has denied all wrongdoing despite remaining a fugitive in Switzerland, jump-started the negotiations.

In November, the Department of Justice asked UBS to submit a collateral consequences study, normally one of the last steps before an indictment of a company. "They said: we have now the authority from the highest level of government to proceed with an indictment," the UBS source said.

Inside the Federal Reserve Bank of New York, officials were also alarmed. They feared the indictment of UBS could panic already jittery financial markets. But the N.Y. Fed could not interfere in the DOJ's affairs.

"UBS has to find a way to disclose the taxpayer names to DOJ in order to avoid the potentially catastrophic consequences of an indictment," Thomas Baxter, the New York Fed's general counsel, told a Swiss interlocutor, according to another person familiar with the discussions.

In December, UBS held an intense board meeting at which top executives examined alternatives and assessed risks. Kurer, who had recused himself because of pending UBS litigation, could not take part.

At the meeting, directors discussed the possibility of "Notrecht" -- German for emergency law, which the government could use to bypass bank secrecy rules and rescue UBS.

But the board decided that the bank should act within the parameters of existing Swiss law. "UBS had to go back to the drawing board," said one insider.

Was the Department of Justice really going to pull the trigger? Would it risk pushing over the cliff a bank with three times more employees than Lehman Brothers, about 27,000 of whom were based in the United States?

No one knew for sure, but the Swiss decided not to take the risk. On a cold night on February 18, the Swiss government convened an emergency late evening cabinet meeting in Berne and gave its blessing to a hefty $780 million criminal settlement.

More painful than the money, though, was an agreement by UBS to deliver about 280 names of serious U.S. tax avoiders. The government had essentially traded nearly a century of Swiss bank secrecy for UBS's survival.

This was done with the blessing of Swiss regulators, who had to draft an emergency regulation to bypass the court system to save UBS from the risk of failure.

A day after the settlement, the U.S. Internal Revenue Service shocked the Swiss government by demanding that UBS disclose the names of 52,000 possible U.S. tax evaders. The Swiss had clearly failed to take both the criminal and civil investigation into UBS off the table, and pressure on their treasured bank secrecy laws continued.

THE JOHN DOE SUMMONS

Finding someone to take on the job of steadying the UBS ship amid financial turmoil and a U.S. criminal investigation was not easy. "No-one wanted to talk to us because of this thing," said a senior UBS source.

In the weeks running up to the February 18 criminal settlement Kurer interviewed three candidates. One of them was German-born Oswald Gruebel, a former Chief Executive of Credit Suisse credited with turning around the second largest Swiss bank at a difficult time. Gruebel had retired with a bitter taste in this mouth after losing a battle to become chairman of the bank he had spent 22 years with.

On February 26, 2009, barely a week after the settlement of the criminal side of the UBS case, Gruebel agreed to take on the challenge. He immediately signaled a change of tune by announcing sharp cost cuts in an interview with local media. He said it would take him two to three years to rebuild the bank.

Kurer reluctantly left the bank and was replaced by former Swiss finance minister Kaspar Villiger. UBS was counting on Villiger's political ties to help it settle the remaining leg of the U.S. tax case, known as the John Doe summons.

A former trader of humble origins and no formal university education, Gruebel is an outsider in what remains a close-knit hierarchical world of Swiss banking. Born in East Germany in 1943, he fled through the Iron Curtain as a 10-year-old orphan and learned the ropes of the business on Deutsche Bank's bond trading floor in the 1960s.

A straight-talking banker with a dry sense of humor, he is described as "cold" and "tough" by close aides and tends to avoid the limelight. Yet Gruebel is admired by peers as a fighter who possesses deep knowledge of investment banking, wealth management and commercial banking at a time when most banking executives tend to be specialized.

UPHILL STRUGGLE

When Gruebel took the job of chief executive in February, the bank had just been stabilized thanks in part to a loan from the Swiss state. It was also safe from U.S. criminal charges after its February settlement.

But UBS was by no means out of the woods. It still faced a civil tax litigation that threatened the confidentiality of thousands of U.S. clients and led to an exodus of clients and financial advisers. And the bank remained far from profitable, losing over 21 billion Swiss francs in 2008, the biggest annual loss in Swiss corporate history.

The John Doe summons represented a real legal headache for UBS. While it had been possible to stretch Swiss law to settle charges of tax fraud, the summons breached new ground by targeting tax evasion, an area in which the Swiss do not offer international cooperation.

Insiders say that by early March, it was clear that without Swiss government intervention, UBS would face another damaging legal clash that threatened Switzerland's relationship with the United States.

While UBS continued talks with the Internal Revenue Service and the Department of Justice, the Swiss foreign ministry got in on the act, sending officials to visit the U.S. State Department in late March. The following month, Swiss Finance Minister Hans-Rudolf Merz, who at the time also held the rotating post of Swiss President, met with U.S. Treasury Secretary Tim Geithner in Washington.

By their own reckoning, the Swiss were in a weak negotiating position: on April 2, the Group of 20 nations had put them on a list of tax havens and the U.S. administration was pressing ahead with legislation against illicit tax gains in offshore centers.

But they had a few things going for them. The U.S. State Department was grateful for the nation's diplomatic support -- such as representing U.S. interests in places like Cuba and Iran and helping to broker a deal that normalized relations between Turkey and Armenia. The pact was signed in Switzerland last October.

This, insiders said, helped create what they called a "certain atmosphere" that made it possible for Swiss Foreign Minister Micheline Calmy Rey to have numerous phone calls with U.S. Secretary of State Hillary Clinton and to meet her face to face three times in the run-up to the August deal.

In the end, at a crucial July 31, 2009 meeting, Clinton and Calmy Rey were able to agree a deal in principle to avert a damaging court case against UBS.

The Swiss, constrained by their red tape, could not guarantee the timing of the delivery of any client names. But the IRS was satisfied with reassurances that Swiss authorities would eventually do so.

A U.S. State Department official said the United States welcomed the deal "and the continued efforts by the Swiss government to ensure that its obligations under the UBS Agreement are met." The State Department declined further comment for this story.

UBS and the United States settled the civil leg of the case on August 19. There was no fine involved this time around, but a promise to hand over another 4,450 names within a year.

Two months later Gruebel played his ace: after weeks of secret contacts, he hired Robert McCann, a former head of wealth management at archrival Merrill Lynch, to be the new face of UBS's battered American franchise.

Within three months of starting, McCann installed a brand new team of mostly ex-Merrill executives -- known within the bank as the Wealth Management Americas Renewal Team.

STOPPING THE ROT

It has taken Gruebel less than a year to show investors and clients that the bank has regained its financial footing. This involved some tough choices. Gruebel shrunk the bank's workforce by 11,000, to 65,000. He also sold a crown jewel -- Brazil's wealth management unit Pactual -- for $2.5 billion just three years after buying it.

But the Swiss giant is still losing client money and withdrawals at its wealth management franchise accelerated in the fourth quarter of 2009. And investors balked when Gruebel said he saw no immediate recovery in inflows and predicted more withdrawals over the next few quarters.

Since the middle of 2008, a total of 225 billion Swiss francs have left the bank, according to calculations from Keefe, Bruyette and Wood's analyst Matthew Clark. That is more than 11 percent of the bank's combined wealth management assets of 2 trillion Swiss francs at the end of March 2008.

At the current rate, Morgan Stanley analyst Huw van Steenis reckons that rival Credit Suisse will surpass UBS in terms of wealth management assets by next year. "Credit Suisse Private Banking momentum means it could become larger than UBS in Swiss private banking going into 2011," said Steenis, who expects UBS to lose a further 37 billion Swiss francs this year.

Gruebel recognized early on that the loss of credibility among wealth management clients was the single biggest issue he had to deal with. At first, clients were withdrawing their money strictly because of the credit crisis. But the breach of trust that followed the tax fraud scandal in the United States only made the matter worse.

He is expected to face a tough shareholder meeting on April 14. Activist investors like the investment fund Ethos plan to challenge the bank's sizable 2009 bonuses and to vote against the discharge of UBS board members from any responsibility stemming from the credit crisis.

"Having done a fantastic job in building a global brand they were seriously damaged by the fact they went almost bust and did some serious missteps in public relations in the U.S. tax affair," said Michael Malinski, a specialist wealth management consultant who has 22 years of practical experience in the business. "If you are a potential client, unless there was a compelling reason to go with UBS, you would choose someone else."

Even though UBS suffered the bulk of its client outflows outside America, Former Paine Webber President Joseph Grano, who ran the post-merger UBS PaineWebber wealth management business in the United States before leaving in 2004, said he believes the Swiss bank's brand name in the country is beyond repair.

Gruebel's top priority is to stop the exodus of private client money. Some of the outflows are the result of clients choosing to remain with UBS financial advisers who have bolted the bank for greener pastures.

Ultimately, he must figure out what to do with the bank's U.S. wealth management business -- the old Paine Webber franchise that it bought for $12 billion in 2000 and which has been unprofitable ever since.

UBS tried to sell it repeatedly during the crisis, but could only attract low-ball offers.

With McCann on board, UBS believes it has a chance to make the business work. "If he can achieve that, keeping the unit or selling it will be a purely financial choice," said Ray Soudah, founder of Millennium Associates, a Swiss-based M&A consultancy with a focus on wealth management.

More importantly, UBS has another tough decision to make. Given the current political and regulatory pressures in Switzerland, the bank cannot continue playing a big role in both investment banking and wealth management.

Swiss National Bank Chairman Philipp Hildebrand is drafting a proposal that would make it impossible for UBS or Credit Suisse to drag the economy down should another crisis hit the banking sector. And some Swiss political parties, including the radical ultra-nationalist SVP, the country's biggest political force, have called in the past for forcing UBS to sell its investment banking business.

Gruebel, who helped shape the universal banking model in Switzerland, is not expected to give up on investment banking so easily. Nor will Credit Suisse.

But he may be forced to curb investment banking activities, which, unlike the wealth management business, are capital intensive. And in the current financial environment, capital remains an important commodity.

ANGRY GERMANS

Ongoing heavy pressure on Switzerland by cash-strapped Western nations seeking to recoup taxpayers' undeclared cash is also not helping UBS. In the wake of its painful 2009 U.S. tax settlement, all Swiss-based private banks are attempting to kick suspected U.S. tax cheats out. But European governments are not sitting still waiting for this to happen.

Germany, whose citizens own a quarter of an estimated 726 billion Swiss francs of undeclared EU assets stashed in Switzerland according to Helvea analyst Peter Thorne, has been particularly virulent. On March 19, German prosecutors launched an investigation of Credit Suisse for allegedly aiding German clients to dodge taxes.

UBS is also the subject of a German inquiry, launched in February, that focuses on suspected fraud and tax evasion in that nation. None of this is helping the Swiss bank rebuild client trust at a time when Berne is trying to negotiate a sensitive new tax treaty with its German neighbors.

The Swiss giant is reacting to the international attacks on bank secrecy and offshore banking by narrowing its focus to the super-rich and to high-growth markets like Asia, a region where the Swiss wealth manager remains a leader. "In the U.S., UBS is just a shadow of itself. In Asia they are still the strongest. In Europe they are somewhat in between," a former UBS executive said.

Even though the bank still offers private banking services to clients, it has quietly adopted a strategy of making it less attractive for small undeclared European accounts to stick with UBS, insiders say. Banking on a strictly-confidential basis is more costly for clients, who must now travel to Switzerland, at risk of being noticed by custom police, if they want to see how their investments are doing.

The bank has also adopted a new code of business conduct and ethics clearly stating that "UBS does not provide assistance to clients in acts aimed at breaching their fiscal obligations."

And there are indications that unwanted client defections may be slowing. "Outflows persisted in the fourth quarter of 2009 but are well below the peak," said analyst Matthew Clark. "Despite everything that happened to UBS, cumulative outflows only correspond to 16 percent of the wealth management business (ex-U.S.)," he said.

"This is not a lot and this is a very resilient business," he added. "Considering everything that has happened to UBS, its wealth management business has proven remarkably resilient and there is scope to see the glass half full."

All Swiss banks appear to be counting on the government to find a solution to the "Schwarzgeld" or black money, as the untaxed money belonging to Westerners is commonly known in Switzerland.

But the stakes remain exceptionally high. In February, Gruebel said UBS alone holds about 140 billion francs of potentially undeclared assets of Western European origins. Rival Credit Suisse said for it the amount was 100 billion Swiss francs.

Even so, the highest end of the market appears safe for UBS and other Swiss banks. That is because the super wealthy use lawyers to minimize the tax impact through sophisticated watertight tax avoidance structures rather than stashing cash in a secret bank account, or they come from emerging countries that are less sensitive about tax evasion issues.

"Tax evasion is not a problem of the big guys," said one seasoned Swiss banker

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