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UBS May Be Sued by SEC Over Puerto Rico Closed-End Bond Funds

UBS Might be Sued by SEC
UBS AG signage stands outside the Swiss banking firm's offices in Stamford, Connecticut. Photographer: Chris Ware/Bloomberg

UBS AG may be sued by the U.S. Securities and Exchange Commission over the sale of mutual funds that bought $1.5 billion in bonds Switzerland’s largest bank had underwritten in Puerto Rico.

The SEC’s Miami office issued a Wells notice to UBS Financial Services Inc. of Puerto Rico and UBS Financial Services Inc. regarding “secondary market trading and associated disclosures” of closed-end funds sold in the Caribbean island in 2008 and 2009, the Zurich-based firm said in a report to investors. The notification typically lets recipients respond to investigators’ claims before the agency approves legal action. The SEC may decide to not pursue a case.

UBS, a former financial adviser to the island’s Employees Retirement System that provides pensions for government workers, led the 2008 sale of $2.9 billion in bonds by the pension fund. The sale produced $27 million in fees for the Swiss bank and its co-underwriters. A UBS manager bought $1.5 billion of the securities and put them into 20 mutual funds, also sold by the bank. The bonds represented about 17 percent of the funds’ $8.9 billion in assets at the time.

“The whole thing from the ground up was riddled with conflicts of interest that could only work to the advantage of UBS and not in the interest of investors,” James Cox, professor of law at Duke University School of Law in Durham, North Carolina, said in an interview. “These Wells notices tend to not go away easily, and there is a lot of pressure on the enforcement side to turn these cases around quickly.”

Hector Mayol, the administrator of the Puerto Rico pension fund, said in an interview that the SEC last year requested documents concerning UBS’s underwriting of the bonds, which he has provided.

UBS Responds

The SEC has issued similar Wells notices to some current and prior employees of UBS that the firm didn’t identify, according to fund reports posted on the bank’s website.

“UBS believes the funds have been excellent long-term investments for investors and has submitted a formal response outlining the reasons why it believes no enforcement action is warranted,” Karina Byrne, a spokeswoman for UBS, said in an e-mailed statement. “The firm also maintains that the negative financial results, if any, to shareholders of the funds who traded their shares through UBS during the relevant periods were less than $5 million in the aggregate.”

That amount is less than 1 percent of the value of the funds purchased in the secondary market, according to Byrne. UBS said in its report to investors that the Wells Notice “does not relate to the management of the funds themselves.”

John Nester, a spokesman for the SEC in Washington, declined to comment.

Bond Ratings

The bonds, backed by anticipated future government contributions to the pension fund, were rated one step above junk by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings. The funds, which include the Puerto Rico Fixed Income Fund Inc., are closed-end, meaning UBS doesn’t agree to buy back the shares for customers who want to cash out. UBS publishes prices for the shares, which aren’t traded on an exchange like most closed-end funds, in investor reports, and there are no public records of trading volumes or prices.

The Puerto Rican Employees fund had assets of $1.9 billion and liabilities of $18.9 billion as of June 2009, leaving it 90 percent underfunded.

Bloomberg Markets magazine, in its April 2009 issue, reported on the multiple roles played by UBS in Puerto Rico as adviser to the pension fund, underwriter of its bonds and manager of the mutual fund portfolios that purchased the bonds.

Conway MacKenzie Inc., a Birmingham, Michigan-based consulting firm hired by the pension to investigate why it’s running out of money, wrote in an October report that the transaction ended up hurting the fund.

‘Inherently Flawed’

“The $3 billion pension obligation bond transaction was inherently flawed, misconceived and speculative as a mechanism to improve the system’s funding ratio,” the firm said. “It merely provided a short-term temporary cash measure which blindly guided decision makers despite many warning signs. The negative arbitrage and fees paid actually worsened the funding position.”

The Conway Mackenzie report was commissioned last June by Mayol, who became the administrator of the pension fund in 2009, after the pension bonds were issued.

Mutual fund shareholders, including the retirement fund Union de Empleados de Muelles de Puerto Rico PRSSA Welfare Plan, sued UBS in February 2010, saying the firm breached its fiduciary duty to investors by reaping fees on the bond offering while charging fund fees including a 4.75 percent upfront commission. They claim damages worth “tens of millions of dollars, and likely substantially higher.”

Byrne said UBS has filed a motion to dismiss the case and said the allegations are “without merit.”

“Mutual funds managed by UBS operate in accordance with all applicable laws and disclosure requirements, including with respect to the oversight and management of any potential conflicts of interest,” she said.

Fund Returns

The $368 million Puerto Rico Fixed Income Fund produced an annual return of 5.4 percent to investors in the five years ended Sept. 30, according to the investor report posted on UBS’s website. The $411 million Puerto Rico Fixed Income Fund II averaged 5.6 percent returns in the same period.

Funds established in Puerto Rico and sold only to residents of the island aren’t required to register with the SEC. They’re also exempt from the Investment Company Act of 1940, so they avoid that law’s restrictions on transactions between funds and their managers.

UBS, now led by Chief Executive Officer Oswald Gruebel, suffered the largest loss in Swiss corporate history in 2008 after bets on U.S. mortgage-backed securities backfired. In 2009, UBS avoided prosecution in the U.S. by paying $780 million and admitting it helped thousands of Americans evade taxes.

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