Broker Pays Over $42 Million Re Pre-release ADRs
Pre-release ADRs have become a focus of SEC Enforcement. To date the agency has filed 10 settled proceedings involving these securities. Typically, the Order in the proceedings asserts that by failing to comply with the pre-release obligation to beneficially own the underlying shares the number of outstanding shares of the issuer is artificially inflated, harming the markets and shareholders. In theory this is true. None of the Orders issued to date, however, details proof to support the theory.
In its most recent case, the Order reiterates the same claimed harm from failing to comply with pre-release obligations without actual supporting factual allegations. This time there is at least a suggestion of actual harm. The Commission’s press release, but not the Order in the proceedings, states that the financial institution resolved criminal antitrust violations with the DOJ, pleading guilty to bid rigging that was conducted by the same securities lending desk at the institution that was responsible for the pre-release ADR lending issues on which the Order is based. In the Matter of Industrial and Commercial Bank of China Financial Services, Adm. Proc. File No. 3-19202 (June 14 2019).
Respondent is a subsidiary of Industrial and Commercial Bank of China Limited. The institution is a Commission registered broker-dealer.
Over a four-year period, beginning in September 2011, the broker operated a matched book or conduit securities lending desk. Its goal was to not hold any position on its books. The desk generated revenue by lending securities, borrower or otherwise obtained, for more than it paid to borrow or obtain the securities.
During the period Respondent had pre-release agreements with four depositaries. Three of those institutions required the broker to execute certifications stating that it was complying with pre-release agreements. Those agreements typically stated that the pre-release broker or its counterparty are collectively maintaining the number of ordinary shares that corresponds to the number of outstanding shares for the benefit of the ADR holder. Compliance with this undertaking ensured that the number of underlying shares is not artificially increased. During the period the broker entered into ten such agreements.
Contrary to its representations, Respondent “was negligent in failing to take reasonable steps to determine whether it complied with the pre-release representations, the Order asserts. This occurred in two situations. First, when the lending desk received requests to borrow “hard-to-borrower” securities, the personnel should have realized that the request “may have arisen from circumstances involving broker-dealers needing to obtain ADRs in order to comply with Regulation SHO’s locate, delivery, and close-out requirements,” the Order states (emphasis added). By not recognizing this possibility, the desk failed to take reasonable steps to comply with its pre-release representations.
Second, Respondent engaged in hundreds of pre-release transactions involving sponsored ADRs of foreign issuers that were scheduled to pay dividends. Respondent forwarded the correct net dividend amount (the dividend less the required holding tax) to the Depositaries as required. Its lending desk “should have understood from the circumstances of many of the transactions that those amounts may not have originated from the ordinary shares held at the time of the pre-release transaction, and that its borrowers may not have been making tax payments that, under the pre-release agreements should have been paid to the foreign jurisdiction,” according to the Order.
Finally, the Broker failed to establish and implement policies and procedures that would have been reasonably expected to determine whether personnel on the securities lending desk complied with the pre-release representations in the transactions. Stated differently, the firm’s compliance procedures should have incorporated due diligence procedures that would have been triggered when either of the possibilities presented above arose. The Order alleges violations of Securities Act Section 17(a)(3).
To resolve the proceedings Respondent consented to the entry of a cease and desist order based on the section cited in the Order and to a censure. In addition, it agreed to pay disgorgement in the amount of $23,983.43, prejudgment interest of $4,458,491 and a penalty of $14,391,262.