By Jonathan Weil
When Congress passed the Investment Company Act of 1940 to prevent abuses of mutual-fund shareholders, it exempted Puerto Rico. The island was "so far away from America that the policing aspects are quite difficult,” testified David Schenker, then the general counsel of the Securities and Exchange Commission.
Since then 72 years have passed. Two faraway states, Hawaii and Alaska, have joined the union. Yet Puerto Rico remains exempt, and that fact is still causing problems.
This week the SEC accused UBS's Puerto Rico subsidiary and two executives of defrauding Puerto Rican mutual-fund customers by concealing a liquidity crisis, artificially propping up market prices, and masking UBS’s control of the secondary market for 23 proprietary closed-end funds that it managed there. Without admitting or denying the claims, UBS agreed to pay $26.6 million to settle the case. (Although the funds are exempt from the Investment Company Act, UBS and the executives are still covered by federal antifraud laws.)
The executives -- former UBS Puerto Rico Chairman and Chief Executive Officer Miguel Ferrer, 73, and Carlos Ortiz, 51, UBS Puerto Rico’s managing director of capital markets -- have denied the allegations. The SEC said the funds' value fell $500 million in 2009 after UBS stopped supporting the market and dumped most of its own shares. Some funds declined 15 percent.
Because the funds were established in Puerto Rico and sold only to island residents, they didn’t have to be registered with the SEC. They also were exempt from the Investment Company Act’s conflict-of-interest bans, which include restrictions on transactions between funds and their managers. Such transactions between UBS and the funds were at the heart of the fraud, the SEC said. Most of the funds’ holdings consisted of Puerto Rico municipal bonds, including pension bonds that UBS had underwritten and then purchased for the funds.
“UBS PR’s conflicts of interest with its customers were exacerbated because the firm controlled the market for the CEFs, and investors could not go to another broker-dealer to sell their CEF shares,” the SEC said. “Many of UBS PR’s customers attempting to sell CEF shares during this time were senior, unsophisticated retail investors who had substantial amounts of their net worth concentrated in the CEFs.”
A February 2009 article by Bloomberg News investigative reporter David Evans cast a spotlight on UBS’s dealings in Puerto Rico.
In 2007, the company became financial adviser to Puerto Rico's woefully underfunded Employees Retirement System, which provides pensions for about 277,000 government workers and retirees. In 2008, UBS was lead underwriter when the system sold $2.9 billion of pension bonds, backed by anticipated future government contributions to the retirement fund.
A UBS mutual-fund manager bought $1.5 billion of the bonds and put them into 20 UBS mutual funds, which the bank sold to investors for a series of upfront and annual fees. Those bonds, which then were rated just one step above junk by the major credit-rating companies, made up about 17 percent of the 20 funds’ $8.9 billion of assets at the time.
The article quoted Ferrer, who also served as chairman of most of the UBS Puerto Rico funds, saying: “We have no conflicts at all. We do each job independent of the others."
The same article also quoted James Cox, a securities law professor at Duke University: “I’ve never seen such a blatant series of conflicts of interest.” Cox said a bank shouldn’t be allowed to provide advice to a bond issuer, underwrite the bonds and buy them for mutual funds it manages. UBS wouldn’t have been allowed to do so in the first place had Congress not exempted Puerto Rico and other U.S. territories from the Investment Company Act. A repeal of the exemption is overdue.
(Jonathan Weil is a Bloomberg View columnist. Follow him on Twitter.)
-0- May/04/2012 20:25 GMT