Legislation to Lift the Investment Company Act Exemption for Funds Based in U.S. Territories
May 16, 2018
Legislation to Lift the Investment Company Act Exemption for
Funds Based in U.S. Territories
Introduction
In addition, an oft-cited illustration of the harmful potential
Overseen by the Securities and Exchange Commission
of territorial mutual funds being outside of the ICA’s
(SEC), the Investment Company Act (ICA; P.L. 76-768) is
purview involved a Puerto Rican unit of the Switzerland-
the principal body of federal securities law regulating
based global financial group, UBS Group AG and one of its
pooled investment entities that offer securities to the public
Puerto Rican units, UBS PR. In the early part of the current
known as investment companies (most commonly in the
century, UBS PR became an adviser to the Puerto Rican
form of mutual funds). The ICA requires mutual funds to
pension agency, the Employee Retirement System (ERS).
register with the SEC and subjects them to SEC
Later, in 2008, it served as the principal underwriter (an
enforcement and regulatory oversight. It also delineates the
entity that assumes the risk of acquiring newly issued
responsibilities and sets parameters for investment
securities, hoping to later resell them to the public) of ERS
companies in areas such as required disclosure, investor
bond offerings, reportedly acquiring $3 billion in ERS
fees, investment limitations, use of leverage, fiduciary
bonds. The unit reportedly then faced challenges selling the
duties, and prohibitions on self-dealing by fund managers.
bonds in the difficult market environment of 2008. As a
consequence, it resorted to selling nearly $1.7 billion of the
According to H.Rept. 115-103 (which accompanied H.R.
bonds to about two dozen mutual bond funds that it either
1366, U.S. Territories Investor Protection Act of 2017),
managed or co-managed. In turn, shares in the funds, which
when the ICA was enacted in 1940, Congress determined
held significant amounts of ERS bonds, were sold to Puerto
that it would be problematically costly for the SEC to travel
Rican residents. Subsequently, according to reports, the
to and inspect investment companies located beyond the
value of the bonds markedly declined, resulting in the funds
continental United States in U.S. territories, such as Alaska,
with the ERS bonds losing about 70% in value by 2013. As
Hawaii, the Philippines, the Panama Canal Zone, Puerto
a consequence, fund shareholders reportedly suffered
Rico, Guam, and the U.S. Virgin Islands. As a result,
millions of dollars in losses.
mutual funds organized in those locales were exempted
from the ICA and were not required to register with the
H.R. 1366’s sponsor, Representative Nydia Velazquez, has
SEC. In various instances, those jurisdictions later enacted
characterized the developments surrounding the UBS funds
their own individual mutual fund regulations. However,
as a kind of cautionary tale. Correspondingly, she has
those regulatory schemes reportedly have generally lacked
argued that had the Puerto Rican funds been under the
the ICA’s comprehensiveness and rigor. Subsequently,
ICA’s regulatory regime, a considerable amount of the
while some territories such as Alaska and Hawaii lost their
island’s citizens’ losses from the UBS managed funds may
territorial status when they became states, remaining
have been prevented.
territories such as Puerto Rico, the United States Virgin
Islands, and Guam, still retain the ICA exemption.
Other observers have identified two potentially problematic
aspects of the UBS Puerto Rican operations that they say
Legislation
directly resulted from the absence of the ICA regulatory
Several legislative proposals would change this territorial
regime:
exemption from the ICA. Section 506 of S. 2155, which
passed the Senate; S. 484; H.R. 1366, which passed the
The UBS managed funds were said to be excessively
House; and Section 1161 of H.R. 2429, three years after
leveraged to the greatest extent allowable under Puerto
enactment, would repeal the historical exemption from ICA
Rican securities law, levels that increased their riskiness.
compliance enjoyed by mutual funds organized in U.S.
According to Craig McCann, a former SEC official, and
territories, such as Puerto Rico and the Virgin Islands. The
now the principal of Securities Litigation and
legislation would also give the SEC the option to extend the
Consulting Group, a securities litigation consultant,
three years before the ICA exemption is lifted by another
those leverage levels would not have been allowed
three years.
under the ICA.
The Potential Impact of the Current Legislation
The Puerto Rican-based UBS operations underwrote a
The most common argument for repealing the ICA’s
municipal bond offering (ERS). It then packaged them
territorial exemption is that the historical logistical
into mutual funds whose shares were sold to the public.
challenges of getting to the non-continental U.S. territories,
Some observers, including Craig McCann, have said
a central rationale for the exemption, clearly no longer
that such “affiliated party transactions” involving UBS
applies.
underwriting bond offerings that it then packaged into
funds that it also managed would not have been allowed
under the ICA.
https://crsreports.congress.gov
Legislation to Lift the Investment Company Act Exemption for Funds Based in U.S. Territories
The current legislation has garnered little criticism. In all
the Virgin Islands, and other U.S. possessions will face
likelihood, it would result in territorial-based investment
significant new legal and regulatory challenges.”
companies incurring additional costs to comply with the
new investment company regulatory protocol. This point
was echoed in comments made by a corporate law firm,
Sullivan & Worcester. In 2016, referencing similar
Gary Shorter, Specialist in Financial Economics
legislation in the 114th Congress, the firm wrote that if it
became law, “investment companies located in Puerto Rico,
IF10888
https://crsreports.congress.gov
Legislation to Lift the Investment Company Act Exemption for Funds Based in U.S. Territories
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https://crsreports.congress.gov | IF10888 · VERSION 2 · NEW