UBS Group CEO on Puerto Rico: 'We could have done things better'

Stefan Wermuth | Bloomberg | Getty Images

Sergio Ermotti, chief executive officer of UBS Group

UBS could have done things differently in Puerto Rico, where thousands of the island's residents blame the Swiss financial services giant for the depletion of their life savings, the bank's CEO said in an interview.

"When you go back and you look at the situation, you could always argue that we could have done things better, or some people could have behaved better," Sergio Ermotti told CNBC's Michelle Caruso-Cabrera in an exclusive interview on Monday.

"When there is scope for admitting something went wrong, we do that," Ermotti said. However, if "we believe that there are situations where people are just trying to take advantage of something, then we will fight and we will just try to present facts."

He was referring to the tsunami of arbitration claims that have been filed against UBS by Puerto Rico-based investors for — among other counts — breach of fiduciary duty, negligence and fraud.

The claims came after 2013, when 23 closed-end bonds funds managed or co-managed by UBS Puerto Rico and sold to island residents lost $3 billion in value, or nearly 70 percent, according to data from Securities Litigation and Consulting Group.

Ermotti said there were not obvious warning signs in the years prior to the UBS Puerto Rico bond funds imploding.

"Until 2013, it was very difficult to predict that things could…evolve in such a way," Ermotti said. No ratings agencies, "nobody was waving their flag about the danger of Puerto Rico."

However, a CNBC investigation in December showed that a mere few months after Ermotti took over as CEO in November 2011, it was clear not only to the ratings agencies, but also to UBS, that Puerto Rico's credit was deteriorating.

In a research report that UBS issued in January 2012, the firm identified major risks for investors holding the Commonwealth's debt, including the "slower than anticipated recovery" and "rising debt burden." The 45-page report recommended: "Conservative investors with concentrated exposure to any single borrower in the municipal market should pursue portfolio diversification.

Ermotti says that despite the extremely tumultuous past few years, the financial firm has stayed on the island and is working together with regulators and through arbitration to try and find the best solutions for their clients.

"We are trying to clearly [and] constructively find resolutions," Ermotti said. "The truth of the matter is we are very committed to Puerto Rico."

UBS Puerto Rico is a subsidiary of UBS Americas Financial Services headquartered in Weehawken, New Jersey. At its peak, UBS had the largest wealth management business in Puerto Rico, representing an estimated 20,000 households. By 2012, UBS investors on the island had about $10 billion invested in the bond funds, or roughly 10 percent of the island's gross domestic product.

UBS Puerto Rico has been the primary underwriter of a series of closed-end funds since the mid-1990s. And it managed or co-managed the 23 proprietary closed-end funds that could only be sold to Puerto Rico residents and corporations whose primary place of business is on the island.

Through the years 2004 to 2008, the direct and indirect revenue generated by the bond funds accounted for 42 percent to 53 percent of UBS Puerto Rico's total revenue. Those profits flowed up the chain to the parent company, UBS AG.

The funds had many unique qualities since they were offered in a U.S. territory, rather than a U.S. state. In particular, the bond funds weren't registered with the Securities and Exchange Commission or listed on a U.S. exchange like a typical mainland closed-end fund.

This was because of a recently closed legal loophole that previously exempted U.S. territories from the Investment Company Act of 1940. That legislation, among other things, limited the use of leverage and barred certain types of transactions.

The exemption allowed the UBS funds in Puerto Rico to be levered in many instances 2 to 1, which was the maximum amount legally allowed by Puerto Rico's securities regulations.

The funds also had an immense overconcentration of Puerto Rico-issued securities. Two particular securities, bonds issued by the island's government development bank and bonds issued by a government-run corporation, accounted for more than 90 percent of the net assets in 10 of the UBS funds by the end of June 2013.

The heavy concentration and high leverage of the funds ultimately led to staggering losses for investors in 2013, after Puerto Rican bonds suffered a massive sell-off.

Ermotti pointed out in Monday's interview that prior to their implosion, the closed-end funds were highly profitable for investors.

"The only thing we know, which is not an excuse but is an explanation, is that in the previous 20 years or so, clients and investors made $3 billion of profits [from the funds]," Ermotti said.

The massive decline in value of the funds "led to multiple regulatory inquiries, as well as customer complaints and arbitrations with aggregate claimed damages of USD 2.5 billion, of which claims with aggregate claimed damages of USD 1.5 billion have been resolved through settlements, arbitration or withdrawal of the claim," according to UBS's first quarter 2018 report.

The firm settled with the SEC in 2012 for $26.6 million and in 2015 for $15 million. Also in 2015, UBS settled with Finra, Wall Street's self-policing regulatory agency, for $18.5 million. A year earlier, in 2014, UBS settled with Puerto Rico's local regulator, the Office of the Commissioner of Financial Institutions, for $5.2 million.

The regulators' charges included that the firm misrepresented and omitted material facts about the closed-end bond funds to investors and failed to monitor the combination of leverage and concentration levels in customer accounts, according to the settlement documents.

UBS Puerto Rico did not admit or deny wrongdoing in any of the settlements.

UBS has disclosed in regulatory filings that the Department of Justice is conducting a criminal inquiry into the impermissible reinvestment of the non-purpose loan proceeds, in regard to the Puerto Rico funds. "We are cooperating with the authorities in this inquiry," the filing states.

Dawn Giel | Leslie Picker | Scott Zamost

• At its peak, UBS had the largest wealth management business in Puerto Rico, representing an estimated 20,000 households. By 2012, island investors had about $10 billion invested in UBS bond funds.
• The bond funds were highly leveraged and concentrated in securities issued by two Puerto Rico government entities.
• In 2013, the funds lost $3 billion in value, or nearly 70 percent. CEO Sergio Ermotti told CNBC there were not obvious warning signs in the years prior to that.

UBS Group CEO on Puerto Rico: 'We could have done things better'