The Commission and SEC Enforcement continue to focus on the question of pre-release ADRs and how those instruments are handled by banks and broker-dealers. To date the agency has brought seven cases involving a broker or a bank based on the handling of pre-release obligations which are ultimately designed to ensure that all the parties are in essentially the same position as with any other ADR transaction while preluding improper practices. Three of the cases brought to date involve depository banks. The latest case in this area centers on BYN Mellon. In the Matter of The Bank of New York Mellon, Adm. Proc. File No. 3-18933 (Dec. 17, 2018).
Respondent is a state-chartered bank based in New York City. Beginning in June 2011, and continuing for the next five years, BNY Mellon served as a Depositary bank that handled pre-released ADRs with pre-release brokers. The bank was involved in thousands of transactions. A number of the pre-release brokers that obtained pre-released ADRs from BNY Mellon over the period failed to properly adhere to the required practices for handling such transactions as detailed in the firm’s compliance manual.
ADRs are negotiable instruments that represent an interest in a specified number of foreign securities that have been deposited with the Depositary or its Custodian. If the ADR is sponsored the agreements run to the issuer as sponsor; if not the agreements run to the Depository. In either event, the Depositary files a Form F-6 registration statement with the Commission. This registers the offer and sale of the ADRs. Since the instruments are tied to the underlying shares they do not increase the number of shares available.
Pre-release agreements traditionally occurred when there may be a timing difference between the issuances of new shares and the ADR. When ADRs are issued under these circumstances the agreements among the pertinent parties essentially maintain the relations among them: The number of shares does not increase; the person holding the ADR is the beneficial owner of the shares. Effectively the pre-release broker or its customer must maintain the ordinary shares for the benefit of the ADR holders – for ordinary shares the Depositary must maintain the shares. Essentially the same arrangements apply when pre-release ADRs are issued over a dividend record date.
Here the Depositary Receipts Division of BNY Mellon did not act reasonably with regard to the pre-release ADRs under the circumstances. Typically, the appropriate agreements were executed to ensure compliance with standard pre-release requires as reflected in the firm’s compliance manual. What might be viewed as essentially red flags, however, suggested that in fact the pre-release brokers were not in compliance with their obligations. For example, certain personnel at the bank knew that pre-release brokers routinely loaned pre-release ADRs they received to counterparties. Those brokers profited from the transactions by charging higher rates than those they had obtained from BNY Mellon. These transactions should have suggested that in fact the pre-release brokers were most likely not beneficial owners of the corresponding shares as required by the executed agreements.
In other instances BNY Mellon engaged in pre-release transactions involving ADRs over a dividend payment date. Here bank personnel should have known that the counterparties were using a strategy to maximize after-tax yielded on the dividends. The transactions suggested that the pre-release brokers were not complying with their obligations. Yet there were hundreds of transactions. Repeated transactions such as these and others should have alerted BYN Mellon to the fact that the pre-release brokers were failing to comply with their obligations. The Order alleges violations of Securities Act section 17(a)(3).
In resolving the proceedings Respondent cooperated with the staff investigation. BYN Mellon consented to the entry of a cease and desist order based on the section cited in the Order. The firm will also pay disgorgement of $29,369,032.43, prejudgment interest of $4,260,199.69 and a penalty equal to the amount of $20,558,322.70.