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$8M Merrill Lynch Settlement Over American Depositary Receipts Puts Focus on Foreign Investment Compliance

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Merrill Lynch has reached a more than $8 million settlement with the U.S. Securities and Exchange Commission, adding to a growing list of recent enforcement actions over alleged improper American Depositary Receipts trades and underscoring the importance of having robust compliance programs.

The SEC alleged Merrill’s securities lending desk mishandled more than 40,000 pre-released American Depositary Receipts in trades that occurred between June 2012 and November 2014. The New York-based bank generated about $4.4 million in net revenues through the improper transactions, according to the SEC.

The Merrill case marks the ninth SEC enforcement action against a bank or broker related to the trade practices in question. So far, the SEC’s ongoing efforts have spurred more than $370 million in settlements.

“Our action conveys the message that an entity like Merrill may not avoid liability by using another broker to obtain fraudulently issued ADRs on its behalf,” Sanjay Wadhwa, senior associate director of the SEC’s New York Regional Office, said in a prepared statement

Merrill, which did not admit or deny the SEC’s findings, agreed to pay more than $4.4 million in disgorgement of “ill-gotten gains” along with about $724,000 in prejudgment interest and a $2.89 million penalty.

A spokesman for Bank of America, which acquired Merrill in 2008, noted in an email that the bank voluntarily stopped trading pre-release American Depositary Receipts more than four years ago. He declined to comment further.

U.S. residents can use American Depositary Receipts to invest in foreign companies. In a traditional transaction, a depositary bank issues the receipts, which represent a portion of an ordinary share of a foreign company and can be traded on U.S. stock exchanges or over the counter, to brokers who contemporaneously deliver the corresponding number of foreign securities to the depositary’s foreign custodian.

But in a pre-release transaction, which is supposed to smooth out inter-jurisdictional settlement timing disparities, the broker can obtain newly issued receipts from the depositary before delivering ordinary shares to a custodian a short time later.

The broker must “beneficially own” the ordinary shares that the receipts represent and assign all beneficial rights, title and interest in those shares to the depositary while the pre-release transaction is underway.

But the brokers that Merrill worked with were acting as middlemen who obtained pre-released receipts from depositaries without owning the shares required to support those receipts, according to the SEC.

“Such practices resulted in inflating the total number of a foreign issuer’s tradeable securities, which resulted in abusive practices like inappropriate short selling and dividend arbitrage that should not have been occurring,” the SEC alleged.

The agency found that “Merrill did not have any supervisory policies and procedures in place governing the firm's potential indirect borrowing of pre-released ADRs from pre-release brokers."

The SEC also concluded that the bank had "failed to establish and implement policies and procedures that would be reasonably expected to detect” the inappropriate handling of pre-release American Depositary Receipts.

The SEC reached similar conclusions in December, when it accepted a $135 million settlement offer from JPMorgan Chase Bank, which also stopped offering pre-release receipts several years ago.

Other recent related actions have cost Bank of New York Mellon more than $54 million, Deutsche Bank nearly $75 million settlement and Citibank more than $38 million.