When it comes to their handling of American Depositary Receipts, depositary banks have more than just an investigation by the US Securities and Exchange Commission to worry about.
BNY Mellon, Citi and JP Morgan are being targeted with class action lawsuits filed in a New York court by disgruntled investors, alleging overcharges in foreign exchange fees related to dividends and other cash distributions on ADRs. BNY Mellon is being sued by a group of investors led by Anne Normand, Don Farofano and David Feige while Citi and JP Morgan are both being sued by Benjamin Michael Merryman and two trusts. The suits involving Merryman were refiled in New York after an Arkansas judge dismissed them on jurisdictional grounds. All of the plaintiffs are being represented by the law firm of Kessler, Topaz Meltzer & Check. Lief Cabrasar Heimann & Bernstein also represent the plaintiffs in the case against BNY Mellon.
The class action suits are now in the discovery phase in the US District Court for the Southern District of New York. A jury trial or summary judgement is months away but for now the judges presiding over the class actions are allowing the cases to proceed only on the grounds of breach of contract.
At the crux of the three lawsuits is the allegation that the depositary banks improperly deducted a spread on foreign cash conversions of dividends and other cash distributions. That spread was in addition to any fees or expenses the banks were permitted to charge for foreign exchange transactions under the depositary contracts. The litigants claim that too often investors received unfavorable, or below average rates, compared to the range of rates used in the interbank market — the foreign exchange market for large global banks. The banks’ extra earnings, claimed investors, breached the terms of the depositary contracts and showed bad faith.
While agreeing that the claim of breach of contract may have merit, the New York judges vetoed claims for breach of the implied covenant of good faith and fair dealing. Those claims, they ruled, could not exist concurrently with the breach of contract claim. The judges also refused to allow the investors to seek additional money for punitive damages because their cases only involved a breach of contract.
None of the investors indicated the amount of money they are allegedly owed. Those figures will likely be debated over the next few months between competing experts taking into account the number of investors affected, when they purchased the shares of ADRs, what forex rates the banks charged, when the currency conversions were executed, and what investors should have charged. Critical to either side winning the case is just how much data can be produced and verified. Poor recordkeeping on the part of the banks’ could tip the scale in favor of investors.
The investors’ attorneys did offer some analysis to back their claim that investors paid “poor rates” for foreign exchange transactions, but the banks will likely dispute the validity of the data and methodology used. Did the banks intend to defraud investors to earn extra revenues, were they simply lax in controlling their conversion rates, and how often did investors pay inflated foreign exchange rates? These are the important questions at the center of the case. An even more worrisome question that banks could be forced to answer is why some foreign issuers, whose sponsored ADRs are not the target of the lawsuits, chose to conduct forex conversions themselves rather than allow the depositary banks to do so.
Bank Rationale
What do the banks now have to say for themselves? Citi and JP Morgan won’t comment while BNY Mellon says it will continue to defend itself vigorously. Of course, each of the banks had plenty to say when it came to trying to persuade a New York judge that the case against it without merit. The banks argued that the spreads they made on the foreign exchange trades should not be considered fees or even expenses because they are simply part of the foreign exchange rate. The banks also tried to have the cases thrown out on the grounds that beneficial investors had no legal standing to sue them. The investors did not hold ADR shares in their own name, but in the name of their financial intermediaries. The judges didn’t buy either rationale.
It is unclear whether the legal rulings in New York against the retail investors will affect the SEC’s reported investigation into the activities of depositary banks. However, at the very least depositary banks must be feeling the heat. The SEC’s investigation led to brokerage ITG being fined over US$24 million for the misuse of pre-release ADRs.
US dollars purchase ADRs as a means of investing in foreign shares with the benefit of trading and settling transactions in US dollars under a three-day timetable. Each ADR represents one or more shares of a foreign company. Depositary banks are responsible for converting foreign-currency dividends and other income payments into US dollars. They also issue shares of ADRs in pre-release form for broker-dealers to borrow on the condition that they return the shares quickly and own the underlying equity of the foreign companies.
In its enforcement action against ITG, the SEC said the brokerage borrowed the “phantom” shares and lent them to other brokerages. On the surface there is nothing illegal about that practice except that ITG never owned the foreign shares backing the ADRs as is required under SEC rules. The brokerages, which borrowed the shares from ITG, engaged in illegal short selling activities. It remains to be seen whether the SEC will call other brokerages to the carpet for similar misdeeds.
Depositary banks do require broker-dealers to sign contracts promising no wrongdoing when it comes to pre-release shares of ADRs. However, it is uncertain just how rigorously those depositary banks actually enforced those contracts. According to whistleblowers who have lobbied the SEC to investigate the depositaries for a multitude of wrongdoings, the depositaries profited from lending out the pre-release shares and not recalling them. They earned revenues from the cash collateral posted by the broker-dealers who borrowed the shares.
In anticipating what will happen in the SEC’s enforcement drama, the whistleblowers speculate that the brokerages which borrowed the pre-release shares directly from the depositaries will argue that the banks encouraged them to do so and never asked any questions about their practices. Brokerages, which in turn, borrowed those pre-release shares from other brokers will say they didn’t know they were pre-release shares. Meanwhile depositary banks will counter that there was no way they could enforce the terms of their contracts because they had no knowledge of what occurred after the pre-release shares left their shop.
Industry sources with knowledge of the ADR business say that the spectre of SEC fines has prompted some brokerages to shut down their pre-release desks. While that may cut the revenue stream that depositaries enjoys from brokerages for that activity, they are still earning money from the foreign exchange conversions on ADR income payments, say the plaintiffs in the class action lawsuits against the banks.
Interpretative Distinctions
Among the judge’s rulings in the three class action lawsuits against the depositary banks, the one involving JP Morgan appears to be the most restrictive. Judge Valerie Caproni ruled in favor of JP Morgan when it came to imposing a statute of limitations, limiting the number of ADRs affected and requiring arbitration in the case of one ADR. She rejected the investors’ request that claims going as far back as January 2002 be considered, instead applying a starting date of November 2010.
Caproni’s rationale: the investors’ argument that the statute of limitations should be extended because JP Morgan fraudulently concealed its practice of earning spreads on forex conversions until 2012 didn’t carry weight. “The court agrees with JP Morgan that the plaintiffs could have done the analysis on which their complaint is based at any time. The information needed to reveal JPM’s alleged breach of contract was always available to plaintiffs,” she wrote in her ruling. “The data they would have relied upon simply would have covered an earlier period of time such as from 1997 to 2002, 2002 to 2007 or 2007 to 2012, instead of 2002 to 2014.”
Caproni also rejected the investors’ request that they be allowed to sue on behalf of holders of 107 ADRs sponsored by JP Morgan in which they never invested. Instead, they can only sue JP Morgan for breach of contract involving the 12 ADRs in which he invested. In addition, the contractual obligations of one of those ADRs — that of China’s Chinghuwa Telecom — requires them to resolve any disputes through arbitration. Caproni’s decision could spell the end of any class action suit when it comes to that particular ADR.
By contrast, the judges in the lawsuits involving BNY Mellon and Citi agreed that the investors could sue on the basis of all ADRs handled by the banks, not just the ones they invested in. The judges also extended the statute of limitations so that in the case of BNY Mellon, the suit can include all investors who purchased any ADRs sponsored by BNY Mellon as far back as 1997. “These statute of limitations do not apply if BNYM’s alleged active fraudulent concealment of its breaches of the deposit agreement tolls them, ” wrote Judge J Paul Oetken. In the case of Citi, the suit could include all investors who bought any ADRs sponsored by the bank as far back as 2000.
The recent class action lawsuits aren’t the first time banks have found themselves in the hot seat for their foreign exchange practices. In their role as custodians for large buy-side firms some, including BNY Mellon, have been forced to pay megafines to settle allegations they executed forex trades for those institutional investors at bad exchange rates. Whether that precedent has any bearing on the cases involving ADRs remains to be seen but for now, former ADR executives tell FinOps Report there is plenty of reason to believe that the banks will settle up.
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