Thursday, January 26, 2017

ADRs Find Themselves in an Unwelcome Spotlight

American Depositary Receipts are back in the news.  The Wall Street Journal reported on November 8, 2016 that the Securities and Exchange Commission has issued subpoenas to four large banks with expansive ADR businesses seeking information about trading of ADRs. Citing unnamed sources “close to the investigation,” the Wall Street Journal article said that the focus of the SEC probe seems to be the “pre-release” of ADRs, where a bank may issue depositary receipts without actually having custody of the underlying shares. 
 
Pre-release sounds a lot like naked short selling. But it has a practical business purpose. Banks employ pre-release to bridge settlement times of different countries. When ADR  pre-release techniques are employed, however, regulators expect certain controls be in place. According to the article, the SEC is concerned that "controls designed to prevent market abuse and tax fraud,” particularly with respect to pre-release of ADRs, may not have prevented market manipulation and may have been used illegally to arbitrage between tax systems.
 
The investigation of the four big ADR banks comes on the heels of an earlier investigation of a much smaller player in the market. Just a day following the Wall Street Journal article, independent broker and financial technology provider ITG issued a press release announcing that the company had set aside a $22 million reserve in anticipation of a settlement with the SEC over pre-release of ADRs. They also announced that the company had discontinued transacting in pre-release ADRs in the fourth quarter of 2014. The SEC’s announcement of the settlement said that that "ITG facilitated transactions known as 'pre-releases' of ADRs to its counterparties without owning the foreign shares or taking the necessary steps to ensure they were custodied by the counterparty on whose behalf they were being obtained."
 
ADRs have also become the subject of a sizable class action law suit. In January of 2016, employer-sponsored and labor union pension plans filed suit in New York Southern District Court against one of the banks later targeted by SEC subpoenas in November. The suit alleges that the bank violated its fiduciary duties under ERISA in its handling of ADRs for pension fund and other clients from 1997 until the present. The plaintiffs allege that the bank charged excessive, unauthorized, and undisclosed rates while executing ADR FX Conversions[1] with the plaintiffs' holdings of bank-sponsored ADRs. The complaint accuses the bank of charging excessive rates on ADR FX Conversions by selecting a conversion rate that was less favorable than prevailing market rates. This allegedly increased the bank’s spread on the ADR FX Conversion transactions in excess of the spread for comparably negotiated FX transactions at the time, thus putatively benefiting the bank at the expense of their clients.  
 
With Federal Judge Paul Oetkin’s order on April 12, 2016 consolidating this case with others, the plaintiffs now represent all participants, beneficiaries, and named fiduciaries of ERISA-covered benefit plans that invested directly or indirectly in the defendant’s ADRs from 1997 to 2016. According to a noted ADR expert, “given the that so many public and private pension funds are severely underfunded, and have been suffering greatly in the low-yield environment of the past several years, the other large ADR sponsoring banks may soon be targets of similar litigation. The spotlight focused on ADRs by the SEC investigation may embolden future plaintiffs as well."
 

 

 
[1] i.e., converting into U.S. Dollars dividends or other cash distributions, including net proceeds from the sale of non-US securities, property, or rights (cash distributions), made by foreign companies to the plaintiff class who were invested, directly or indirectly, in ADRs sponsored by the bank.
 
 

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