On December 26, 2018, the Securities and Exchange Commission (“SEC”) announced that a fourth depositary bank (“the Bank”) had agreed to pay a civil monetary penalty and disgorgement totaling $135.1 million to resolve allegations that the Bank violated federal securities laws by issuing American Depositary Receipts (“ADRs”) on “pre-release” without taking reasonable steps to ensure that the broker-dealers to whom it was issuing the ADRs, or their counterparties, beneficially owned the requisite number of foreign securities underlying the ADRs. See In the Matter of JPMorgan Chase Bank, N.A., Admin. Proc. File No. 3-18963 (Dec. 26, 2018). The SEC alleged that the Bank’s conduct violated Section 17(a)(3) of the Securities Act. As with all prior entities charged in the SEC’s investigation, the Bank neither admitted nor denied wrongdoing.
ADRs are negotiable instruments that represent an ownership interest in a specific number of foreign securities that have been deposited with a “Depositary,” or depositary bank. In a typical ADR issuance, a Depositary issues ADRs to a market participant pursuant to a “Deposit Agreement” in exchange for the market participant delivering the corresponding number of foreign securities to the Depositary or its custodian. In a “pre-release” transaction, however, a Depositary provides a market participant (e.g., a broker) with newly issued ADRs before the ordinary shares are delivered to the custodian. “Pre-release” transactions historically have been conducted pursuant to “Pre-Release Agreements,” which require the broker or the broker’s customer to beneficially own the foreign securities underlying the ADRs and to assign the rights to those foreign securities to the Depositary. In other words, in a pre-release transaction, the broker effectively stands in the shoes of the Custodian.
According to the SEC, from at least 2011 to 2015, the Bank’s employees handling pre-release transactions issued ADRs to brokers on pre-release when they had reason to believe that the brokers had not complied with their obligations under the Pre-Release Agreements, including by not ensuring that they or their customers actually beneficially owned foreign securities underlying ADRs. Based on the economics of the transactions, in the eyes of the SEC, the SEC alleged that the Bank’s employees were on notice that the pre-released ADRs were not backed by foreign securities. Although the brokers involved in the pre-release agreements represented to the Bank that they were complying with the ownership requirements, the SEC claimed that the Bank knew or should have known that these representations were false.
The SEC claimed that the Bank’s conduct not only allowed ADRs to be issued in a manner that violated the Pre-Release Agreements and historical purposes for pre-released ADRs, but also led to a distortion of the amount of withholding tax paid to foreign tax authorities in connection with ADR transactions.
The SEC’s settlement marks the eighth enforcement action it has brought related to pre-release ADRs in the last two years. The other enforcement actions have targeted the three other depositary banks, two brokers that frequently obtained ADRs on pre-release under allegedly false pretenses, and two individuals working for those brokers.