UBSs Puerto Rico Closed End Funds
Since 1995, UBS has been the underwriter of fourteen Puerto Rico closed-end funds (CEFs) with a total market capitalization of approximately $4 billion. UBS has also been the underwriter and dominant market maker for nine co-managed Puerto Rico closed-end funds with more than $1 billion in total market capitalization.
The UBS CEFs include the following funds:
Puerto Rico Fixed Income Fund I
Puerto Rico Fixed Income Fund II
Puerto Rico Fixed Income Fund III
Puerto Rico Fixed Income Fund IV
Puerto Rico Fixed Income Fund V
Puerto Rico Fixed Income Fund VI
Puerto Rico Mortgage Backed & US Govt. Fund
Tax-Free Puerto Rico Funds I and II
Tax-Free Puerto Rico Target Maturity Fund
Puerto Rico AAA Portfolio Target Maturity Fund
Puerto Rico AAA Portfolio Bond Funds I and II
Puerto Rico GNMA & U.S. Gov. Target Maturity Fund
Puerto Rico Investors Tax-Free Funds I – VI
Puerto Rico Tax-Free Target Maturity Fund I and II
Puerto Rico Investors Bond Fund I
The CEFs represent the single largest source of revenue for UBS PR. UBS PR earns fees from the CEFs through administration fees as well as primary and secondary market sales commissions. Between 2004 and 2008, the CEF business generated half of UBSs total annual revenues and the CEFs also comprised one-third of UBSs Assets Under Management.
During 2008 alone, the CEFs produced $94.5 million in revenue for the firm. The CEFs were intended to exploit regulatory and tax exemptions available only to Puerto Rico based investors. Income earned by any investor in Puerto Rico government bonds is exempt from municipal, state, and federal taxes.
Speculative Leverage in the CEFs.
Most of the UBS Puerto Rico CEFs were leveraged, sometimes over 50%, meaning UBS PR borrowed money to buy securities within the CEFs, thereby increasing the risk of loss in the CEFs. This leverage was described as a speculative investment technique in the Prospectuses for the CEFs. The Prospectuses further state that the use of leverage increases the risk in the CEFs over non-leveraged funds and that the effects of leverage could lead to the loss of some or all of the funds invested. These facts, and the associated risks, should have been disclosed by UBSs representatives in their discussions with customers.
Geographic Concentration Risk in the CEFs.
The Prospectuses for the CEFs further state that the CEFs have a geographic concentration risk as a result of the requirement that at least 67% of the CEFs must be invested in securities from Puerto Rico issuers. The CEFs were therefore more susceptible to economic and political factors adversely affecting Puerto Rico versus a diversified fund.
Issuer Concentration Risk and Non-Diversification Risk in the CEFs.
In addition to the geographic concentration of the CEFs, UBS concentrated the CEFs portfolios in the securities of only a few issuers. For example, at least fifteen of the CEFs had more than 37% of their holdings invested in Bonds issued by the Employee Retirement System (ERS) and the Puerto Rico Sales Tax Financing Corporation (COFINA).
Lack of Suitability and Over-Concentration in the CEFs and Puerto Rico securities.
UBS, UBS PR, and their representatives were required to only recommend securities that were suitable for their customers while taking into account their financial situation. An integral part of this suitability analysis was the need for diversification geographically, amongst asset classes, and within asset classes.
The importance of asset allocation and diversification is also supported by FINRA in its Notices to its members and the investing public. In guidance about building a portfolio on the FINRA website, FINRA states:
Similarly, if you're buying bonds, you might choose bonds from different issuers—the federal government, state and local governments, and corporations—as well as those with different terms and different credit ratings.
Diversification, with its emphasis on variety, allows you to manage nonsystematic risk (company or industry risk) by tapping into the potential strength of different subclasses, which, like the larger asset classes, tend to do better in some periods than in others.
The FINRA publication, Smart Bond Investing (also found on the FINRA website), further describes the importance of diversification in the context of bond investing:
Asset Allocation. Buying bonds can be an important part of an asset-allocation strategy that balances risk and reward. Asset allocation is all about diversification of investments, both within and among different asset classes. In short, it means not putting all of your eggs into one basket.
In putting together a diversified portfolio, you select a mix of stocks, bonds and cash so as to arrive at the risk-reward ratio that stands the best chance of reaching your investment objectives.
Pursuant to FINRA Rules, when recommending CEFs to customers, UBS representatives were required to ensure that the recommendations were suitable and that they did not result in overconcentration.
Liquidity and Pricing Risk.
As shares of the CEFs are traded only in Puerto Rico, they are not registered under the Investment Company Act with the Securities and Exchange Commission (SEC). They have been registered only with the OCFI and they are neither listed, nor traded, nor quoted in any national securities exchange or quotation service.
UBS was the only source for valuation or liquidity of the CEFs. The UBS trading desk set the prices for the CEFs, purportedly based upon the CEFs net asset value, and supply and demand. The CEFs were therefore only traded on the secondary market through UBS, and thus were at risk of becoming illiquid if UBS could not find enough buyers to buy the CEFs from sellers. This risk was exacerbated by the fact that the CEFs could only be sold to a very limited set of buyers - Puerto Rico residents. The CEFs Prospectuses state that no assurance can be given that the CEFs will be liquid or that a trading market will exist.
Statement Regarding the Objective of the CEFs in the Prospectuses.
The Prospectuses for most of the CEFs stated that the fund objective was current income, consistent with the preservation of capital. This objective of preservation of capital is one of the most conservative and low risk investment objectives in the industry. The representation of this conservative objective with regard to CEFs sharply contrasts with their multitude of serious risks and speculative investment techniques referenced by UBS in the Prospectuses.
SEC Order Regarding UBS conduct regarding the CEFs.
In May, 2012, UBS PR consented to the entry of an SEC cease and desist Order related to fraudulent conduct by UBS PR with regard to the CEFs. A copy of this Order can be found here. Examples of facts and wrongful conduct of UBS PR set out in the SEC Order included the following:
Page 2. During 2008 and 2009, UBS PR, its former CEO (CEO) and its Head of Capital Markets (HCM) made misrepresentations and omissions of material facts to numerous retail customers in Puerto Rico regarding the secondary market liquidity and pricing of UBS PR-affiliated, non-exchange-traded closed-end funds (CEFs or Funds). For example, UBS PR claimed CEF prices were based on market forces such as supply and demand. However, UBS PR did not disclose that CEF prices were set solely at the discretion of the trading desk. Moreover, although UBS had certain disclosures about liquidity in prospectuses (not supplied to secondary market customers) and on its website, it did not adequately disclose, among other things, that as the dominant CEF broker-dealer, UBS PR controlled the secondary market. In reality, any secondary market sales investors wanted to make depended largely on UBS PRs ability to solicit additional customers or willingness to purchase shares into its inventory.
As UBS PR, the CEO and the HCM promoted CEF sales throughout 2008, they knew investor demand was significantly declining relative to supply. For much of 2008, UBS PR purchased millions of dollars of CEF shares into its own inventory while promoting the appearance of a liquid market with stable prices, without disclosing UBS PRs actions were propping up prices and liquidity.
But in the spring of 2009, UBS PRs parent firm determined UBS PRs growing CEF inventory represented a financial risk to the firm. The parent company directed UBS PR to substantially reduce its inventory of CEF shares. To accomplish the reduction, UBS PR and the HCM executed a plan, dubbed Objective: Soft Landing in one document, in which UBS PR routinely offered and sold its CEF shares at prices that undercut pending customer sell orders.
During this period, numerous UBS PR customers were also attempting to sell their holdings but UBS PRs actions effectively prevented certain customers from selling their CEF shares. Between March and September 2009, UBS PR sold about $35 million, or 75%, of its inventory to investors. At the same time, UBS PR increased its efforts to solicit sales of CEFs while continuing to misrepresent how it was setting secondary market prices and the liquidity of the market. UBS PR also did not disclose its withdrawal of market support. By September 2009, when UBS PR completed its CEF inventory reduction, the market price of certain funds had declined by 10-15%.
Page 4. The CEF share prices in UBS PR customers monthly account statements were similarly misleading in that they described market values. As with the newspaper prices, these prices were simply what UBS PR thought they should be, not true market prices.
Page 6. Notwithstanding his knowledge of the weak demand for CEF shares in the secondary market, the CEO repeatedly misled UBS PRs financial advisors throughout the fall of 2008 into continuing to promote CEF sales. In numerous e-mails, he repeatedly misstated the strength, stability and liquidity of the CEF market. The CEO did not disclose to the sales force the liquidity issues in the secondary market, or that UBS PR was keeping the CEF prices high by increasing its CEF inventory.
Page 9. UBS PR did not disclose to its customers it was substantially reducing the use of its inventory to support the CEF market. UBS PR also continued to accept customer limit orders without disclosing that it was undercutting those limit orders to sell UBS PRs shares first. UBS PR also failed to disclose the conflict of interest created by recommending CEFs to investors while selling its own shares.
Page 11. UBS PR willfully violated Section 17(a) of the Securities Act, which prohibits fraudulent conduct in the offer and sale of securities, and Sections 10(b) and 15(c) of the Exchange Act and Exchange Act Rule 10b-5, which prohibit fraudulent conduct in connection with the purchase or sale of securities .
Page 12. UBS PR shall, within 14 days of the entry of this Order, pay disgorgement of $11,500,000.00, prejudgment interest of $1,109,739.94, and a civil money penalty of $14,000,000.00 to the Securities and Exchange Commission.
Use of Non-Purpose Loans to Purchase CEFs by UBS.
On October 9th, 2014, OCFI disclosed that it had conducted an examination of the operations of UBS Financial Services Incorporated of Puerto Rico which covered the period between January 1st, 2006 through and including September 30, 2013. The examination related to the offer, sale, and/or purchase of the UBS CEFs. OCFI stated in the Settlement Agreement with UBS that UBS may have recommended and traded potentially unsuitable CEFs in conservative customer accounts of modest means. OCFI also alleged that UBS may have failed to maintain and enforce adequate supervisory procedures in connection with certain client transactions with the use of nonpurpose loans for the purchase of additional CEFs, an ineligible activity for non-purpose loans. Additionally, OCFI observed apparent irregularities in the management of some of these client's accounts and lack of adequate record keeping and diligent supervision by UBS of its agents.
In settlement of the OCFIs findings which can be found here, UBS PR agreed to make restitution to certain low net worth investors and pay a $3,500,000 fine. UBS PR also agreed to review its customer accounts to find additional conservative low net worth investors to determine if additional restitution is required, and to place six brokers on heightened supervision.
UBSs Supervisory Duties with Respect to the CEFs in Puerto Rico.
As a member of FINRA and a highly regulated firm that sells securities, UBS was required to publish and follow compliance procedures designed to ensure compliance with applicable securities laws, regulations, and FINRA Rules. Part of these supervisory duties for all FINRA firms should include the approval and review by supervisors of sales and securities held in customer accounts. Pursuant to FINRA duties, these reviews should have involved reasonable efforts to discover suitability and over-concentration issues in certain securities or geographic areas.
The crash of the CEFs was predictable, and concerns about the CEFs were discussed at a sales meeting in Puerto Rico in 2011 (two years before the crash) with UBS PRs advisors and its Chairman, Miguel Ferrer. This meeting was recorded, and can be found hereon the Reuters site. In the recording, Mr. Ferrer discussed the criticisms of UBS brokers regarding the CEFs, including poor liquidity, excessive leverage, instability, geographic concentration, and others.
In response to the concerns of the brokers regarding the pressure on them to continue to sell the CEFs, Mr. Ferrer responded by telling the brokers to stop whining and to get a new job if there is no product.
Crash of the CEF market.
In 2013, the Puerto Rico municipal bond market crashed which resulted in devastating declines in the reported prices of the UBS closed-end funds as well as a virtual freeze in the market controlled by UBS. These losses in Puerto Rico bonds were exacerbated by the leverage used by UBS in its CEFs. These losses in a multitude of Puerto Rico customer accounts have led to hundreds of FINRA arbitrations being filed against UBS.