Puerto Rico Loophole Utilized by UBS Targeted by House Lawmaker

Congressman plans to introduced bill to eliminate the island's exemption from the Investment Company Act of 1940

A lawmaker in the U.S. House of Representatives is seeking to close a legal loophole that’s prevented 3.5 million residents of Puerto Rico from enjoying investor safeguards that have been in place in the mainland for 75 years.

Representative Nydia Velazquez, a New York Democrat who sits on the House Financial Services Committee, plans to introduce a bill Friday that would eliminate Puerto Rico’s exemption from the Investment Company Act of 1940, which regulates the conduct of mutual-fund companies, according to a draft copy provided to Bloomberg News.

The limited reach of the law allowed UBS AG to steer Puerto Rico bonds that it underwrote into its mutual funds, which cost investors when the securities tumbled because of the island’s worsening fiscal crisis.

In 2008, when UBS underwrote $2.9 billion of bonds for the cash-strapped Employees Retirement System, funds managed by the bank bought about half the debt. That would have been barred by the Investment Company Act if the funds were sold on the mainland, as reported by Bloomberg on Sept. 22.

“Large investment companies are taking a fee for acting as an advisor to Puerto Rican public entities, then repackaging bonds they issued into mutual funds, which they then in turn sell to unsuspecting Puerto Rican consumers,” Velazquez said in a statement. “This practice constitutes a flagrant conflict of interest and it must stop.”
 

Investors’ Claims

UBS customers in Puerto Rico have filed hundreds of arbitration claims against the Zurich-based bank, seeking damages of more than $1.1 billion. So far this year, UBS has been ordered to pay out more than $7 million, with six out of seven cases decided against the bank.

UBS spokesman Gregg Rosenberg said the bank is pleased with the decision in its favor and that Puerto Rico municipal-bond funds for years delivered returns that frequently exceeded other fixed-income investments. He didn’t respond to questions about the legislation or whether the bank’s acts in Puerto Rico represented a conflict of interest.

The island’s bond prices have dropped because the lackluster economy and loss of residents to the mainland have left it struggling to pay its $72 billion of debt. The government defaulted on some bonds for the first time in August and is seeking to restructure debt that Governor Alejandro Garcia Padilla says it can’t afford to pay, which would leave investors receiving less than they’re owed.
 
Some of the pension-system bonds underwritten by UBS in 2008 tumbled 40 percent this year to 29 cents on the dollar by Sept. 23. They were first sold to investors for 100 cents. By comparison, Puerto Rico’s most frequently traded general-obligation bonds dropped by about 15 percent.

Puerto Rico was exempted by Congress from the 1940 law that regulates mutual funds and hedge funds after David Schenker, then general counsel of the Securities and Exchange Commission, testified that the commonwealth was too distant to regulate.

“It is absurd to suggest we are unable to have a robust financial regulatory presence in Puerto Rico for geographical reasons,” Velazquez said.

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