On February 2, 2012, the U.S. Department of Justice (DOJ) indicted Swiss bank Wegelin & Co. for tax fraud.  A U.S. court also froze Wegelin’s correspondent account in the US, seizing $16 million, an unprecedented move.  In non-legalese, this is a bombshell.  It will cause ripple effects in the global banking world.  It also shows that the U.S. has the upper hand in the four year old battle with the Swiss over “secret” bank accounts.

As we wrote, six days ago, Wegelin & Co. split itself up.  Wegelin’s U.S.-client accounts, under IRS and DOJ scrutiny, were kept intact, while the non-U.S. accounts were sold off to another Swiss bank.  This was an attempt to separate and contain the liability for the U.S.-client accounts, similar to the way other “toxic” assets like subprime mortgage and failed derivatives are packaged, contained and sold off at a discount.  The rationale for the Wegelin split was that legal action by the U.S. would be focused on the U.S.-client accounts, while the other accounts would now be owned by a new entity, immune from U.S. legal challenge.

The Wegelin split followed the indictments of three Wegelin bankers in early January, 2012.  DOJ has been prosecuting individual foreign bankers, lawyers and trustees, as well as the banks themselves, along with U.S. clients who had the Swiss accounts.   Following UBS’s 2009 admission of assisting U.S. tax fraud, some fifty separate prosecutions have ensued.  DOJ is specifically alleging that after UBS came under IRS and DOJ scrutiny, Wegelin bankers deliberately courted UBS clients, and their non-compliant funds, offering a safe harbor from the IRS.  Wegelin bankers assured former UBS clients that because Wegelin has no U.S. branches, it was immune from prosecution.

DOJ’s indictment of Wegelin and seizure of its U.S. correspondent account, and Wegelin’s self-engineered break up, clearly demonstrate that Wegelin bankers were wrong.

Thus, the first conclusion:  Even if a foreign bank lacks a U.S. presence, it is still vulnerable to U.S. prosecution and seizure of assets.  UBS settled with the U.S. (and Credit Suisse appears to be poised to settle) because of its substantial U.S. assets subject to U.S. jurisdiction: branches in the U.S., assets in the U.S., employees in the U.S. and a lucrative U.S. banking license, any of which could be seized by a U.S. court.  Wegelin’s perception of non-vulnerability because of no U.S. assets failed to take into consideration two things:  (1) it was offering the very same tax fraud services as UBS, fully aware that UBS was under criminal  investigation for those very services, and (2) it had a correspondent account at a bank in the US, in fact, at a UBS (coincidence?) branch in Connecticut.

The seizure of $16 million is a small sum by international banking standards, but this will have far-reaching effects.  Many foreign banks do not have branches in the U.S. but must have access to the U.S. banking system via correspondent accounts in order to transact.  The Wegelin events may cause foreign banks to pull their correspondent accounts out of U.S. banks.  The seizure of Wegelin’s correspondent accounts, in combination with the new requirements applicable to foreign banks under the Foreign Account Tax Compliance Act (FATCA), including 30% withholding on U.S. investment income for non-compliant banks, may cause foreign banks to consider whether they should leave the U.S. market entirely.  The U.S. has now demonstrated that it has tremendous leverage over the entire world banking system: virtually every bank invests its reserves in U.S. treasuries and other safe U.S. bonds, thereby earning U.S. investment income, and virtually every foreign bank has a correspondent account with one or more US banks.

Lately, the IRS and DOJ offensive against the Swiss has been somewhat of a chess match.  Following UBS’ settlement with the U.S. in 2009, the US indicted Credit Suisse bankers last July, indicted Julius Baer bankers last October, and Wegelin bankers last month, in addition to investigating other Swiss banks like the Kantonal banks.  The Swiss would rather have a global settlement rather than defending bank by bank.  Last week, the Swiss responded to a DOJ ultimatum for banking information by surrendering millions of e-mails between bankers and U.S. clients; however, the information was provided in encrypted form, to be un-encrypted when the U.S. side delivered something in return, such as a global settlement.

It’s possible that the Wegelin indictment and asset seizure was a direct response to the cheeky Swiss move of disclosing, but not fully disclosing.  However, the indictment required significant time to investigate and prepare.  DOJ likely had the Wegelin indictment ready for a while (along with, probably, indictments against Credit Suisse, Julius Baer, the Kontanal banks, etc.) and was waiting for the opportune time to serve it.

The Wegelin indictment and asset seizure can also be viewed as a statement that the U.S. has more leverage in the four year old offensive against banking secrecy, that unless the Swiss deliver what DOJ wants, the U.S. can cripple the Swiss banking system and severely affect the Swiss economy.  This is exactly why UBS caved to the US in 2009.  For UBS to not have revealed the secret UBS accounts would have resulted in extreme U.S. action, with significant negative consequences to not only UBS, but to Switzerland in its entirety.  Thus, large banks like UBS and Credit Suisse, with assets in the U.S., had a clear vulnerability to U.S. legal action.  Now, it is clear that small banks, even those without a U.S. presence, are also vulnerable.  And U.S. clients with non-compliant accounts at any foreign bank continue to be exposed to discovery and prosecution.

As we wrote last month, the re-opening of the IRS Offshore Voluntary Disclosure Initiative (OVDI) was timed to precede another U.S. step in the offensive against Swiss banking secrecy, so as to incentivize U.S. taxpayers to come forward and make their Swiss accounts compliant.  The Wegelin indictment and asset seizure demonstrate that the U.S. is getting closer to checkmate.

1.  In response to a deadline imposed by the United States Department of Justice (DOJ), the Swiss gave to the U.S. a cache of e-mails between Swiss bankers and their U.S. clients.  The number of e-mails is in the millions.  However, in a surprising move in this continuing chess game between DOJ and the Swiss, the information was provided to the DOJ in encrypted form.  The Swiss state that they will de-crypt the information when the U.S. responds favorably, such as by agreeing to a global Swiss banking settlement covering all Swiss banks.

I am not a computer nor encryption expert, but I find it odd that the Swiss would think that the resources of the American government would not be used to crack the encryption. It’s almost a belief that Swiss encryption is better than American counter-encryption.  But then again, the Swiss once believed that their banking secrecy was invincible also.

At some point, the Swiss bank account data, currently encrypted but in U.S. hands, will be revealed.  This can happen by way of a global settlement with the Swiss (as the Swiss hope), going after individual banks one at a time (first UBS, then Credit Suisse, now Baer, Wegelin, the Kantonals, etc. . . ), or the US cracking the encryption.  Once that happens, depending on the number of U.S. taxpayer account holders revealed, this could be the biggest breach of Swiss banking secrecy since UBS revealed close to 5,000 names of U.S. account holders.   Good thing the IRS re-opened the OVDI a few weeks ago.

Query whether other countries, such as Britain and Germany, which reached agreements with Switzerland on non-compliant accounts, will now attempt to get more out of the Swiss.

In addition, one must ask whether the Swiss would try such a tactic – – revealing, but not actually revealing – – within the context of an actual lawsuit.  The provision of the encrypted data was within the context of a DOJ investigation and settlement negotiations, not within the context of an actual lawsuit like United States v. UBS AG.  An actual lawsuit would be held before an actual judge.  A judge would probably not think very highly of purported compliance but not actual compliance.  The U.S. assets of the Swiss banks (branch offices, assets on deposit, banking licenses) would be vulnerable to an adverse judgment or finding of contempt by a U.S. judge.

This is the latest example of not only the deterioration of Swiss banking secrecy, but also of how the Swiss, who previously promised their clients the world’s most secretive banking, will shed those promises and give up their clients in the face of foreign pressure.

We repeat: Good thing the IRS re-opened the OVDI a few weeks ago.

2.  Last Week, Wegelin & Co., Switzerland’s oldest private bank, essentially split apart.  One part, the part that used to service American account holders, remained Wegelin.  The other, larger part containing Swiss and other European business, was spun off and sold.  The reason for the break up was to contain the liabilities associated with the non-compliant bank accounts of U.S. taxpayers.  We know that Wegelin has been under investigation by the IRS and DOJ for providing non-compliant banking services.  In January 2012, three Wegelin bankers were indicted by DOJ for facilitating tax fraud via “secret” accounts.  The indictments include allegations that Wegelin took over such accounts after the account holders left UBS in favor of other banks, supposedly “under the radar”.  DOJ is also prosecuting Americans who had such accounts at Wegelin.

What is interesting is that to the Swiss, the U.S. accounts need to be isolated and separately contained, as a means of damage control.  We are reminded of assets considered to be “high risk”, such as collateralized debt instruments and subprime mortgages, and left out of sales of banks and bank assets, sold on their own at a sharp discount because of their toxicity.

Will Wegelin’s acquirer (Notenstein Privatbank, an entity set up specifically for this acquisition, which in turn was bought by Swiss bank Raiffeisen) now be insulated from liabilities arising from the non-compliant accounts of U.S. taxpayers?

Our answer is, probably.  For one thing, if Raiffeisen is now the target of a DOJ subpoena or “John Doe” summons, it will now probably be able to legitimately say that it lacks the account data responsive to the DOJ request, since that information will likely have remained with Wegelin.  In fact, assuming that Raiffeisen was not offering similar non-compliant banking services as UBS, Credit Suisse, Wegelin, etc., and further assuming that Raiffeisen only bought “clean” European accounts rather than non-compliant American accounts, it is likely that Raiffeisen may be insulated from future DOJ attacks.  However, to the extent that former Wegelin bankers merely changed employers, these individuals may still face accountability for assisting tax fraud at their former employer.  As we have seen, DOJ charges both banks and individual “facilitators” including foreign bankers, attorneys and trustees (along with, of course, American owners of such accounts).

3.  As we have written, Switzerland still offers banking advantages: a safe and stable political, economic and social structure; experienced banking infrastructure and regulation; an educated, savvy banking workforce; good investment opportunities; privacy and confidentiality vis-a-vis private, civil creditors, and asset protection.   What Switzerland no longer offers is tax secrecy.  Thus, assuming a Swiss account is tax-compliant, it offers many benefits.  Assuming a Swiss account, or any foreign account, is not tax-compliant, the beneficial owner of the account must take heed of the eradication of offshore banking secrecy, and make the account compliant.