Lack of Compliance Equals SEC Sanctions For Deutsche Bank

Well crafted compliance is a significant asset for any enterprise, helping create a positive culture throughout the firm. It is also the first line of defense, safeguarding the firm from liability or at least mitigating it by, for example, identifying red flags that warn of possible issues. In contrast, where the red flags are missed because compliance is not properly constructed or implemented, or worse, ignored, the enterprise and its shareholders pay the price. It was missed red flags that resulted in regulatory issues for a prominent international banking firm. In the Matter of Deutsche Bank Trust Company Americas, Adm. Proc. File No. 3018605 (July 20, 2018).

Deutsche Bank Trust, a subsidiary of Deutsche Bank AG, failed to act on a series of red flags over a five year period beginning in 2011 regarding its handling of pre-release ADRs. ADRs are negotiable instruments that represent an ownership interest in a specific number of foreign securities held in a depositary. The ADR holder has a right to the shares in the Depositary. The instruments may be traded on exchanges or over-the-counter.

Pre-release ADRs represent a newly issued instrument in which the market participant obtaines the ADR in connection with a pre-release agreement. That agreement provides that the acquirer of the instrument beneficially owns the corresponding shares which have not yet been deposited with the depository. Typically the agreements are used where there are timing differences that may stem, for example, from a purchase or sale transaction where delivery will be made within a brief period. In effect, the holder of the shares maintains them for the benefit of the ADR owner until they are deposited. Thus dividends issued during the term of the agreement flow to the ADR owner net of any withholding taxes which must be remitted by the holder of the shares.

Over the five year period here Deutsche Bank Trust failed in a number of instances to take reasonable steps to ensure that “they or their counterparties complied with the pre-release obligations.” The Depositary Receipts Group of Deutsche Bank and Trust was aware or, negligent in not realizing, that many of the pre-release brokers and counterparties with whom they were dealing were not complying with their obligations.

Non-compliance by pre-release brokers and counterparties, or at least the risk thereof, was often apparent from the timing or the economics involved in the transactions. In some transactions, for example, the length of the delay in depositing the shares presented a red flag. That period should have been at most a few days. In fact between June 2011 and September 2016 over 11,300 pre-release transactions were outstanding for 10 days or more while 3,100 were outstanding for 30 days or more.

In other instances the economics of the transaction should have alerted to the firm to the risk that the pre-release agreements were not being implemented. For example, under the terms of the pre-release agreements dividends had to be forwarded to the shareholder net of the applicable tax that was due for the firm and its U.S. shareholder. The pre-release brokers tried to maximize their yield on such transactions as the Depository Receipts personnel knew. They also knew that the fees charged by Deutsche Bank Trust in such instances may have made it uneconomic for the pre-release brokers to remit the foreign tax as required. Likewise, while the pre-release brokers in transactions with Deutsche Bank Trust certified to compliance with the pre-release obligations, in many instances the securities were actually loaned out under arrangements which did not require compliance with the pre-release agreements. Omitting the pre-release obligations permitted the lender to secure a better rate. Collectively the red flags should have alleged the firm to the risk of non-compliance with the pre-release obligations by parties to the transactions. From June 2011 through September 2016 Deutsche Bank and Trust had net revenue from these transactions of $44.5 million.

The firm voluntarily ended these practices after the staff opened its investigation but prior to the receipt of any subpoena. The firm also cooperated with the staff’s investigation by voluntarily highlighting documents of interest, furnishing summaries of materials and expanding the scope of its document collection. In addition, Deutsche Bank and Trust executed tolling agreements. The Order alleges violations of Securities Act section 17(a)(3).

To resolve the proceedings the firm consented to the entry of a cease and desist order based on the section cited in the Order. In addition, the firm agreed to pay disgorgement of $44,458,001.08, prejudgment interest of $6,597,826.59 and a penalty of $22,229,000.54. See also In the Matter of Deutsche Bank Securities, Inc., Adm. Proc. File No. 3-18606 (June 20, 2018)(proceeding against the registered broker dealer based on similar facts and alleging a failure to supervise; settled with the entry of a censure and the payment of disgorgement in the amount of $995,506.60, prejudgment interest of $155,006.02 and a penalty in the amount of $487,753.30).

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