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12 August 2011
The Zurich district court recently issued a decision on the liability of a major Swiss bank in relation to securities sale orders.
The client was a Hong Kong company whose beneficial owner was a US citizen domiciled in the United States. The client had bank account and deposit relationships with a Swiss bank since November 2000. Approximately 75% of the deposited assets were US securities.
On May 27 2008 the client presented the bank with a written sale order with respect to US securities for an amount of US$755,000, but the bank refused to execute the order on the grounds that the client's bank accounts and deposits had been frozen due to an inquiry by the US tax administration. The bank granted the client an interest-free loan in the same amount.
The parties met in July 2008 to discuss the freezing issue. On September 1 2008 the client ordered the bank to sell all of its US securities. The bank informed the client by telephone that this order could not be executed. The client reiterated its sale order on October 7 2008 after being informed by the bank that its assets had been unfrozen.
The US securities were sold on October 7 2008. The client terminated its relationship with the bank on December 23 2008, claiming for damages of over $6.8 million plus interest through a submission of May 22 2009 before the Zurich district court.
The court ordered the bank to pay the client over $6.9 million plus 5% interest as from December 24 2008. It considered that all conditions of civil liability under Swiss law were fulfilled - namely:
The court restated that the rules of the mandate agreement applied to the securities sale order of September 1 2008. A breach of contract occurs where the agent does not execute an order, executes it incorrectly or does not execute it in due course. In the present case the court considered as obvious that the sale order had to be executed immediately and, therefore, that the bank was in breach of its contractual commitments.
None of the bank's arguments were considered valid by the court. The bank insisted on the fact that the client decided to sell its US securities in view of a US tax inquiry directed against it, and not in order to benefit from favourable market conditions. It also argued that the client cancelled its order after being informed of the asset freeze. The bank also claimed that the execution of the contract subsequently became impossible due to the US tax authorities imposing an assets freeze. The court rejected all of these arguments, and in particular considered that the bank did not substantiate its affirmation that the freeze was imposed by the Internal Revenue Service (IRS).
The court calculated the amount of compensation due by comparing the client's assets after the securities sale on October 7 2008 and the hypothetical assets that the client would have had if the sale had been executed on September 2 2008 (September 1 was a public holiday in the United States). It referred for this purpose to the stock exchange rates on each relevant day. It deducted Swiss stamp duty and the brokerage fee from both amounts.
The court contended that if the operation had been executed in September, the bank should have withheld the US back-up withholding tax (a 28% withholding tax on the yields of US securities sales), so this tax should be deducted from the calculation of the hypothetical amount. Since the entry into force of the qualified intermediary system in 2001, non-US banks that claim the status of qualified intermediary must either disclose to the US tax authorities the names of their clients which are US taxpayers and hold US securities or retain the back-up withholding tax (and block any investment in US securities). The bank did not retain the back-up withholding tax in the course of its contractual relationship with the client, including the October 2008 sale. The bank admitted that the client was not correctly treated as a non-US taxpayer. In this regard, the ruling mentioned that the bank signed a deferred prosecution agreement with the US Department of Justice Tax Division and the US Attorney's Office areeing to pay $780 million to settle accusations that it had defrauded the IRS.
The court rejected the bank's argument that the amount of assets must be calculated according to the same parameters, unless the parameters themselves had been modified by the damaging act. However, this was not the case here. Further, the court saw no concrete link between the penalties that the bank had to pay to the US tax authorities within the context of the deferred prosecution agreement and the operation at stake in the present case. Hence, the back-up withholding tax was not taken into account when calculating the hypothetical amount of a sale on September 2 2008.
The causality link and the bank's fault were not in doubt, so the court examined these conditions very briefly.
This ruling was issued by a lower court and the bank has already lodged an appeal before the Zurich Cantonal Court, which may fully review the decision. A further appeal (limited to legal grounds) could be brought before the Federal Supreme Court.
In order to rule out a breach of contract, the bank must demonstrate that the asset freeze was due to the IRS. The bank's lack of cooperation with the court in establishing the facts is surprising, unless evidence in this regard is missing.
The bank considers that the penalties it had to pay in the United States for violation of US tax laws should be borne by the clients which benefited from this practice, and hence it intends to claim these amounts from clients which were in breach of US tax laws. The Zurich district court rejected this claim as falling outside the present case (in particular, because the bank did not present it in the form of a counterclaim or compensation claim), but seems to have left this door open, should this claim be presented in different proceedings. It remains to be seen how the bank will proceed with this matter.
For further information on this topic please contact Christophe Rapin or Christophe Pétermann at Lachenal & Le Fort by telephone (+32 2 646 02 22), fax (+32 2 646 75 34) or email (email@example.com or firstname.lastname@example.org).
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