The value of proprietary closed-end bond funds heavily invested in Puerto Rican municipal debt and created by a unit of UBS AG is plummeting, leaving the Puerto Rican arm of the firm and its 132 financial advisers there embroiled in a potentially lengthy and drawn-out legal fight with local investors who purchased the highly leveraged funds and now want their money back.
The UBS Puerto Rico family of funds consists of 14 such closed-end funds, sold exclusively through registered representatives and brokers with UBS Financial Services Inc. of Puerto Rico. Anxiety in the broader municipal bond market has reached Puerto Rico and eroded the net asset value of the funds because of their heavy allocation to local securities.
According to marketing materials, UBS had sold more than $10 billion of the funds through the end of 2012.
One plaintiff's attorney, Lars Soreide, said he filed a Financial Industry Regulatory Authority Inc. complaint against UBS Financial Services of Puerto Rico last week on behalf of a 70-year-old retiree whose portfolio of $500,000 was invested entirely in proprietary closed-end funds, along with individual municipal securities contained inside the funds she already owned.
She opened a line of credit with UBS that “she used to buy her home, and is now selling the portfolio to cover the equity line she took out,” said Mr. Soreide. “She relied on the income [from the municipal holdings] to pay for retirement, and UBS has been liquidating the holdings to pay interest on margin loans.”
Making matters worse for UBS, which has a recent history of costly embarrassments, the firm has put one broker on administrative leave after claims emerged that the adviser encouraged clients to buy securities on a line of credit, according to a report Wednesday by The New York Times.
Robert Mulholland, the head of advisers in the Americas for UBS, and other brokerage executives met last month with the firm's local sales force in San Juan. Mr. Mulholland reportedly told the brokers: “I would characterize this as the perfect storm,” according to the Times report. UBS spokesman Gregg Rosenberg confirmed the Times report, adding that the firm had policies and procedures governing the Puerto Rico funds, including ones regulating sales practices and suitability.
“UBS provides training to financial advisors to ensure proper disclosures regarding risk such as concentration and liquidity,” he said.
The eroding municipal bond market has taken a toll on UBS' proprietary closed-end funds. For example, at the end of August, the Puerto Rico Fixed Income Fund Inc. reported a net asset value, or NAV, of $5.46 per share. Less than a month later, on Sept. 25, the fund reported a NAV of $3.74 per share, a decline of 31%.
The fund had an initial public offering price of $10 per share in 2003. Through August, it had a five-year annual total return of close to 5%, compared with a market return of almost 8%, according to the UBS marketing documents.
Like the other series of UBS Puerto Rico funds, the Puerto Rico Fixed Income Fund had a mandate to allocate at least 67% of its assets to local securities, which exist in a thinly traded market.
Closed-end municipal bond funds domiciled in the United States can only have leverage of up to 30% of the fund's assets, municipal bond managers said. The UBS Puerto Rico municipal closed-end funds are not domiciled in the United States and have different rules regarding debt; the funds can have leverage of up to 50% of total assets, and an extra 5% in special circumstances. Leverage on such investments can magnify losses.
Plaintiff's attorneys who have spoken with UBS clients invested in the closed-end municipal bond funds tell strikingly similar tales about how their assets were allocated and exposed to the funds. Clients were heavily invested in the funds, with retirees or near retirees investing as much as 100% of their portfolios in them, along with individual Puerto Rican municipal securities. The firm's pitch relied heavily on both the federal and local tax benefits gained by investors in Puerto Rico, a commonwealth, according to attorneys.
Some UBS clients reportedly borrowed on margin or used a credit line to buy individual Puerto Rico bonds and the UBS closed-end funds, attorneys said, adding that this practice raised the question of whether the product was suitable for the investors or whether there was proper supervision of the brokers.
UBS was not the only seller of the municipal bonds, attorneys noted. Other banks with broker-dealer operations in Puerto Rico include Banco Popular and Banco Santander.
“We think this is really on the doorstep of the firms themselves and many of the advisers may be victims because they may not have received full disclosure of the supply/demand imbalance,” said Jeffrey Sonn, a partner with Sonn & Erez PLC.
“We're seeing very concentrated portfolios. There was a lot of pressure on brokers to sell these products,” said Scott Silver, a plaintiff's attorney. “UBS probably does 80% of its business down there in bond products for retail clients. It's been a dominant player on the island for a long time.”
“General weakness in municipal markets across the U.S. and Puerto Rico and apprehension about the direction of interest rates have led to steep declines in Puerto Rico municipal bond and closed-end fund prices and a lack of liquidity for these securities,” UBS Americas spokeswoman Karina Byrne said. “UBS has been monitoring this situation and continuously provided our clients with research and insights on interest rates risks and municipal bond price fluctuations."
The impending scrutiny by plaintiff's attorneys comes more than a year after the Securities and Exchange Commission flagged UBS Financial Services Inc. of Puerto Rico for sale practices surrounding the municipal securities. In 2008 and 2009, the firm's “former CEO and its head of capital markets made misrepresentations and omissions of material facts to numerous retail customers in Puerto Rico regarding the secondary market liquidity and pricing of UBS Puerto Rico non-exchange traded closed-end funds,” according to the firm's profile on the BrokerCheck data base maintained by the Financial Industry Regulatory Authority Inc. It paid $26.6 million in fines and restitution to settle the SEC action.
In addition, UBS has suffered a series of costly missteps recently. In August, UBS AG, the Swiss parent, agreed to pay $120 million to settle a lawsuit by investors who accused the bank of misleading them about the financial condition of Lehman Brothers Holdings Inc. in connection with the sale of structured notes.