Pre-Release ADRs: More SEC Fines on the Way?

First ITG. Who is next?

That is the question fund managers and other investors are asking themselves after learning that the US Securities and Exchange Commission fined broker-dealer ITG $24.4 million for violating regulations on how it used the pre-released shares of American Depositary Receipts (ADRs).

The SEC says that ITG violated Section 17(a)3 of the Securities Act of 1933 which prohibits fraud and misrepresentation in the offering and sale of securities. In the case of issued ADRs there must exist a corresponding number of foreign shares in custody. ITG “facilitated” transactions known as “pre-releases” of ADRs to its counterparties without owning the actual underlying shares in the foreign company or taking steps to ensure they were custodied by the respective counterparty on whose behalf they were being obtained.

Whats more,  several of the shares of ADRs obtained by ITG in the pre-release transactions, says the SEC, were used to engage in naked short selling and dividend arbitrage. Of the fine ITG paid, more than US$15 million was from disgorgement — or money earned — and $1.8 million was from interest, More than $7.5 million represented an actual penalty.

ITG’s failure to properly supervise its securities lending desk, says the SEC, caused ADRs to be issued that were not backed by actual common shares leaving them ripe for potential market abuse. What exactly does “caused ADRs to be issued” mean? The SEC’s phrasing implies that ITG is responsible for the depositary bank or banks pre-releasing the ADR shares or printing them on demand for the purpose of being lent. The SEC’s silence on whether the depositary bank or banks ITG worked with knew of their activities is deafening. The SEC declined a request for comment beyond its statement which did not name the banks which lent ITG the shares.

The SEC’s fine follows widespread media reports that the SEC is investigating four depositary banks for illegal pre-release activities involving with ADRs. The four banks are BNY Mellon, JP Morgan, Citi, and Deutsche Bank. In its statement on its settlement with ITG, the SEC mentioned that ITG worked with four depositary banks.

“The ITG fine could either be the tip of the iceberg in a series of fines the SEC will impose on broker-dealers and ultimately the depositary banks themselves,” one operations manager at a US fund management firm which invests in ADRs tells FinOps Report. “Or the SEC could decide that the depositary banks aren’t at fault for the wrongdoing of broker-dealera.” This prediction was seconded by a number of other fund management executives.

Created by JP Morgan in 1927, ADRs help US investors avoid the  hassles of direct ownership of foreign shares, at the same time allowing foreign companies widen their investor base to US investors. Trades in ADRs are made in US dollars, and settled at Depository Trust Company, the US national depository, following the US settlement timeframe of three days after they are executed.

Pre-release isn’t an illegal practice. In fact, its initial purpose was to address the differences in trade settlement times between the US and foreign countries. A broker-dealer can obtain newly issued ADRs from depositary banks before the broker-dealer owns and delivers the corresponding common shares of the foreign company to a custodian bank. But then, the common shares are supposed to be delivered on a timely basis.

However, the practice of pre-releasing ADR shares is now being used for unrelated financially lucrative purposes. Depositary banks can lend broker-dealers the “phantom shares” of depositary receipts in exchange for the broker-dealer providing cash collateral. The depositary bank can make money on the collateral it is holding and sometimes issuance or cancellation fees of the ADRs.

What Went Wrong

So far, so good. Now for the part that isn’t working correctly. The broker must return the shares to the depositary within a reasonable time period. If the shares remain out on loan for too long the depositary must recall the shares from the broker. If it doesn’t get back the shares from the broker, it can use the broker’s cash collateral to buy the shares on the open market and force the “settlement” of the pre-release. The longer the pre-release timetable isn’t settled the higher the interest revenue earned by the depositary bank. Or so claim critics of depositary banks.

If the media reports about the SEC’s investigation of depositary banks are accurate, the SEC is worried that the pre-released shares issued by depositary banks are being used by by broker-dealers for short selling activities prohibited under Regulation SHO. The regulation requires broker-dealers to locate stock or know they can find the stock before executing a short sale. Depositary banks do require that broker-dealers certify that they will not engage in illegal short-selling or other activities and will hold the underlying shares of the foreign issuer.

In its settlement with ITG, the SEC faulted the broker-dealer for poor controls on its securities lending practices with regards to the pre-released ADRs. ITG treated the ADRs as though they were the equivalent of shares used in securities lending agreements. ITG did not take into account its contractual obligations with depositary banks to treat the ADR shares it borrowed from depositary banks as being in the pre-release stage.

ITG made money by lending the pre-released ADRs to other brokers. However, ITG failed to recognize that it lent ADRs that fell under the category of “hard to borrow” or in short supply. The broker-dealers who borrowed the ADRs from ITG either needed them to make a delivery of shares for short-selling activities or comply with the requirements of Regulation SHO.  “ITG facilitated short selling and enabled the settlement of trades with ADRs that were not backed by ordinary shares,” says the SEC.

That’s just for starters. ITG’s securities lending desk also lent the pre-released ADRs to borrowing broker-dealers in complex “dividend related transactions” which did not guarantee that the borrower would pay withholding taxes to foreign governments. The holders of the pre-released ADRs on the relevant record date — namely the broker-dealers who borrowed them from ITG — should have received the dividend payment net of withholding taxes.

Who’s to Blame?

If a broker-dealer takes advantage of the permissible practice of pre-release for nefarious purposes, where does the guilt fall? Is it only the broker-dealer or is it also the depositary bank?. That’s the multi-million dollar question the SEC must eventually answer. Reportedly, it has been receiving warnings from whistleblowers — former depositary bank employees — about misconduct of depositary banks and broker-dealers for over a decade. The lack of oversight of the pre-release of ADRs is just one of the practices where depositary banks are at fault, say the whistleblowers. They are also allegedly engaging in tax evasion and bribery.

The depositary banks will likely argue that they are not at fault if a broker-dealer commits wrongdoing using pre-released ADR shares. “Depositary banks rely entirely on broker-dealers to fulfill their contractual obligations and cannot be held responsible if the broker-dealers do not comply with the representations and warranties they have made regarding their possession of or access to the underlying ordinary shares,” explains Henry Nisser, a partner with the law firm of Sichenzia Ross Ference Kesner in New York. “The depositary banks aren’t able to independently ascertain whether the broker-dealers are holding the ordinary shares of the foreign company in their own accounts. Furthermore, not all depositary banks engage in stock lending.”

Critics of the depositary banks will naturally counter that the banks don’t want to properly monitor the practice of pre-release because of the additional revenues they earn through lending the pre-released ADRs. So the broker-dealers are left to do as they wish. The practice of pre-release was clearly misused by ITG. It is yet to be publicly known whether other broker-dealers are doing the same.

While depositary banks and broker-dealers may benefit from mismanaged activities related to the pre-release of ADRs, investors suffer. Securities analysts say that if misused by a broker-dealer, the pre-release of ADRs can lead to a decline in the share price of the ADR. Institutional investors who are looking to buy ADRs or decide whether to hold or sell them are often unaware that their financial analysis might be distorted by the mishandling of additional shares that the pre-release of the ADRs represent.

At the very least, the SEC’s fine will likely bring about some badly needed reforms. Eliminating or keeping a closer eye on the pre-release practice is a good start. ITG closed its pre-release desk in late 2014, created a new global risk department, reviewed its training curriculum and located its new global chief compliance officer on the trading floor.

Nisser says that eliminating the practice of pre-release altogether isn’t necessary. When implemented correctly, it is a legitimate activity. “Broker-dealers need to set up stricter compliance procedures which include more frequent monitoring of their securities lending desks to prevent the misuse of pre-released ADRs,” he recommends. “An important takeaway from the ITG fine is to never engage in any activity related to pre-released ADRs without owning the foreign company’s underlying shares.”

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