Securities Regulation Daily SEC continues crackdown on ADR mishandling with $38.7M in penalties for Citibank
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Wednesday, November 7, 2018

SEC continues crackdown on ADR mishandling with $38.7M in penalties for Citibank

By Lene Powell, J.D.

In the latest in an industry-wide crackdown, the SEC required Citibank, N.A. to pay a total of $38.7 million for improperly handling "pre-released" American Depositary Receipts (ADRs). Similarly to previous enforcement actions including Deutsche Bank, the SEC found that Citibank improperly provided ADRs to brokers in thousands of pre-release transactions when neither the broker nor its customers had the foreign shares needed to support those ADRs. This improperly inflated the total number of a foreign issuer’s tradeable securities, facilitating abusive practices like inappropriate short selling and dividend arbitrage (In the Matter of Citibank, N.A.Release No. 33-10571, November 7, 2018).

"Our charges against Citibank are the latest in our ongoing investigative effort to hold accountable Wall Street institutions that participated in an industry-wide fraud," said Sanjay Wadhwa, senior associate director of the SEC’s New York Regional Office. "Our investigation into these practices has revealed that banks and brokerage firms profited while ADR holders were unaware of how the market was being abused."

"Pre-released" ADRs. In its role as a depositary, Citibank typically issues ADRs to a market participant that contemporaneously delivers the corresponding number of foreign ordinary shares to Citibank’s foreign custodian. However, deposit agreements may provide for "pre-release" of ADRs. In these transactions, brokers or other market participants that have entered into pre-release agreements with a depositary can obtain newly issued ADRs from the depositary bank before they deliver the corresponding ordinary shares to the custodian.

The pre-release agreements provide that the broker, or customer on whose behalf the broker is acting, beneficially own the ordinary shares represented by the ADRs, and assign all beneficial right, title, and interest in those ordinary shares to the depositary while the pre-release transaction is outstanding. The depositary must take reasonable steps to ensure that these pre-release obligations are met.

Negligent handling by Citibank. According to the SEC, Citibank failed to act reasonably in many pre-release transactions between 2011 and 2016, given that Citibank personnel knew or should have known that pre-release brokers and their counterparties may have been falsely certifying compliance with the pre-release obligations. As a result, many of the ADRs that Citibank provided to the pre-release brokers were not actually backed by ordinary shares.

For example, Citibank knew that pre-release brokers routinely onward delivered pre-released ADRs they received to counterparties, including securities lending desks at other larger broker-dealers. This pattern should have alerted Citibank that the pre-release brokers themselves were most likely not beneficial owners of the corresponding ordinary shares.

Another fact that should have raised questions was that although the traditional reason for a pre-release transaction was to manage settlement timing issues, in practice, Citibank had thousands of pre-release transactions outstanding for durations that could not be caused by settlement timing issues. The SEC said that Citibank should have recognized that these transactions were being used for trading strategies that had nothing to do with settlement timing, such as maximizing after-tax dividends or short-selling without ownership of shares.

According to the SEC, Citibank profited $20.9 million from the negligently conducted pre-release transactions, which violated Section 17(a)(3) of the Securities Act. The penalties included $20.9 million in disgorgement, $4.2 million in prejudgment interest, and a $13.5 million penalty, for a total of more than $38.7 million.

Continuing crackdown. This is the second action against a depository for mishandling of ADRs, as Deutsche Bank was ordered to pay nearly $75 million in July for similar lapses. It is also the sixth action involving pre-released ADRs, including actions against SG AmericasITG, and Banca IMI Securities.

The Release is No. 33-10571.

MainStory: TopStory Enforcement FinancialIntermediaries FraudManipulation

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