1. The current events and related issues

The Securities and Exchange Commission made press release on Dec 26, 2018, the press release announced a more than $135 million fine would be paid by JPMorgan Chase Bank N.A. in settlement of the charge against the company on improper handling of “pre-released” American Depositary Receipts (ADRs) (SEC, 2018). According to the US Securities and Exchange Commission, the charge posed towards JPMorgan Chase Bank N.A. was the eighth action against a bank or broker, and fourth action against a depositary bank (SEC, 2018). Aside from JPMorgan Chase, SEC also posed charges on ITG, Citi Bank, BNY Mellon and Merrill Lynch, Pierce, Fenner & Smith Incorporated, which were the results from the ongoing investigation into abusive ADR pre-release practices. U.S. Securities and Exchange Commission has held all four depositary banks accountable for the fraudulent issuances and improper handling of ADRs. The investigation on American Depositary Receipts (ADRs) was initiated after the discovery of fraudulent transaction of American Depositary Receipts (ADRs) at ITG in 2017 (SEC, 2017).

Sanjay Wadhwa, the Senior Associate Director at the SEC’s New York Regional Office, stated that “the SEC investigation would continue into the those brokerage firms who made profit through improperly issued ADRs”, as the Senior Associate Director at the SEC’s New York Regional Office had previously claimed that “Wall Street institutions were participated in an industry wide fraud” when posing charges to the Citi Bank (SEC, 2018).

Information on American Depositary Receipts (ADRs)

American Depositary Receipts (ADRs) were U.S. securities but represented foreign shares of a foreign company aboard. The American Depositary Receipts (ADRs) were initially created in 1927 U.S. investors can transfer the ownership of foreign securities in the United Sates with the development of ADRs. Foreign companies were able to increase its investor base in US with the introduction of ADRs (SEC, 2003).  American Depositary Receipts (ADRs) required foreign shares holding at a depositary bank at the corresponding number, while the trading of ADRs were made in U.S. dollars and settled at Depositary banks.

The initial practice of pre-release of ADRs was to complement the trading settlement time frame differences between the U.S. and foreign countries.  The usual settlement time of securities in U.S. would be three days, the broker dealer could obtain the newly issued ADRs before the shares of the foreign company has been delivered to a depositary banks. The depositary banks could withstand the pre release practice as long as the shares has to be delivered within the settlement frame. The current practices among Wall Street Institutions today were solely for the purposes to make lucrative profits. The American Depositary Receipts (ADRs) should be backed with corresponding numbers of foreign shares at the depositary banks, SEC found institutions like JP Morgan has been make over thousands of transactions without any foreign shares to support the new ADRs they have created. Those transactions were categorized at “pre released” transactions, and resulted in a sudden inflation on the total number of the foreign issued traceable securities in the U.S. financial market. Aside from market distortion, the Wall Street Institutions have taken abusive practices including short selling and dividend arbitrage at zero costs, and those abusive practice should never been occurred with appropriate investment procedures. SEC has concluded the behavior of Wall Street Institutions issue American Depositary Receipts (ADRs) with no corresponding foreign security as fraud.

The “pre-release” practice of the American Depositary Receipts (ADRs) allowed brokers issue new ADRs without actual foreign shares deposited at depositary bank, in this case, the depositary bank were lending “phantom shares” of depositary receipts to the brokers in exchanges for cash collaterals and made money on the collaterals it is holding.

  1. The relevant law and discussion

In the cases of JP Morgan, the company agreed to pay a total monetary relief of more than $135 million, the charges contained more than $71 million of gains made by fraudulent practices of the ADRs at JP Morgan and $14.4 million in prejudgment interest, and a fine of $49.7 million for the inappropriate practices.

JP Morgan and other Wall Street Institutions has been violating the Securities Act of 1933 and the legal structures on the ADRs, the Section 17(a) 3 of the Securities Act of 1933 prohibited fraud and misrepresentation when consider the offering and sales of securities (SEC, 2017).

As discussed above, the issuance of American Depositary Receipts (ADRs) required corresponding number of foreign shares in depositary bank, the “pre releases” of ADRs violated the underlying assumption and procedures for the brokers to making sure if there were foreign shares existed and by knowingly participating in the fraudulent practices, the Wall Street Institutions have distorted the financial markets of ADRs.

The U.S. Securities and Exchange Commission investigated the ITG group and announced penalties at the end of 2017, SEC investigation found ITG has made more than $15 million from the disgorgement and $1.8 million interest in relation with the practice, SEC issued $7.5 million monetary penalty on ITG for the pre-release transactions of ADRs (SEC, 2017). The four depositary banks for ADRs were the BNY Mellon, JP Morgan, Citi, and Deutsche Bank, U.S. SEC found ITG has previously worked with all four depositary banks with the American Depositary Receipts (ADRs) transaction, the findings lead to another round of investigation. SEC has conducted a series of investigation on the brokers and depositary banks, it was found that all of the depositary banks were participating in the illegal pre-release activities involving with ADRs.

The ADRs should properly registered follow the Securities Act registration, where the ADRs and the deposited underlying foreign securities require separate registrations and exemption from Securities Act registration (SEC, 2003). The legal structures for ADRs were developed in 1955, there registrations of ADRs were adopted by the SEC and brokers would use Form S-12 for ADRs registration, in 1983 the Form F-6 replaced Form S-12 but the initial structure remained in place till today (SEC, 2003). The Form F-6 only concerned the contractual terms of the deposit, but not the disclosure on the foreign company that the ADRs represent and the place securities were traded, the Form F-6 must be complete before the issuances of new ADRs and the depositary begins to accept deposits of securities (SEC, 2003).

  1. Analysis on the current events

Starting from the Securities and Exchange Commission conducted on ITG, series of charges were posed against Wall Street institution in relation with the “pre-release of ADRs”, and those charges were posed with violation of the Section 17(a) 3 of the Securities Act of 1933 and failure to supervise the securities trading. The lack of internal control and proper supervision leaved probability of market abuse, short selling and arbitrage. In one of the comment offered by JP Morgan to proposing ADR rules, the company stated “The ADR Group at JPMorgan Chase Bank served as depositary bank for 231 issuers of American Depositary Receipts in 38 countries” (JP Morgan, 2003), the influences of depositary bank like JP Morgan were significant. One of the concerns in relation with large investment banks like JP Morgan is the continuous violation of legal regulations and the damage those institution could cause to the general public and the financial markets.

In the case of inappropriate handling of American Depositary Receipts (ADRs), JP Morgan made more profit than all other institutions and depositary banks, the ability of large investment institutions to short selling and arbitrage with dividends also motivated the investment institutions to take fraudulent actions. However, did those Wall Street Institution went too far for unethical and illegal conducts? Taking JP Morgan Chase Bank for example, there were multiple charges and litigations posed on the institution by SEC, including misleading information in RMBS offering with Credit Suisse; the London Whale Trading scandal; violation of consumer protection rules; misleading on the algorithmic trading abilities and etc.

The deregulation on U.S. financial institutions were considered as one of the main reasons for the financial crisis in 2008, with deregulation large institutions in US were making speculative investments with consumer deposits. After the 2008 financial crisis, many attentions have been paid on U.S. financial institutions, the Dodd–Frank Wall Street Reform and Consumer Protection Act (12 U.S.C. § 1851) was one of the major legal action took to restrict the Wall Street institutions to continuing participating in abusive finical investments, which only profit the institution itself and protected consumer rights against illegal and unethical conducts among financial institutions. Aside from the Dodd-Frank Act, Volker rule further tightened the investment banks regarding to the ability to hedge and benefit from trading on consumer deposits. The Volcker Rule refers to § 61 of the Dodd–Frank Wall Street Reform and Consumer Protection Act (12 U.S.C. § 1851), which intended to restrict banks or institutions to engage in proprietary trading, the proposed rules were in ongoing debate from 2010 till 2014 (Federal Reserve, n.d.) and many institutions were still applying for extensions for liquidating the illiquid assets hold in investment portfolio.

Stricter rules, guidance and regulations were given to financial institutions regarding to the ethical or illegal conducts existed within those businesses, indeed those business were extremely profitable, JP Morgan was able to absorb the $6 billion trading losses from London Whale scandal with their annual profits, however, the sources of their profits were doubtful.

SEC found JP Morgan fraudulently issuance ADRs to unsuspecting market, while the company itself was profiting through the improperly issued ADRs, at the times of ITG investigation, the SEC posed charges on the supervisor of ITG’s securities lending desk under Section 15(b)(6) of the Securities Exchange Act of 1934 and preventing violation of Section 17(a)(3) of the Securities Act of 1933 (SEC, 2017). According to the charges laid by SEC on ITG, the supervisors at the investment institution has the obligation to identify and prevent illegal actions happened at the institution under their supervision. Therefore, aside from the issuance of ADRs without actual underlying foreign shares, the lack of internal control and supervision were seriously impacted the operation of financial institution in U.S. From the SEC investigation, it was found that depositary banks were lending shares to the brokers, it is at the broker’s obligation to return the shares or the depositary banks should call for return of the shares.

The depositary banks would charge for interests on the shares lending out, however, the broker-dealers could use borrowed shares for short selling activities, which is strictly prohibited under the Regulation SHO. The regulation required the broker to locate the stocks or know where is the stock before short sale, and stated “a broker-dealer to have reasonable grounds to believe that the security can be borrowed so that it can be delivered on the date delivery is due before effecting a short sale order in any equity security” (SEC, 2015). While the depositary banks would require broker-dealers certify that they will not engage in illegal short-selling or other related activities with the underlying shares of the foreign securities. Therefore, the improper handling of the ADRs were not from the broker or the depositary banks alone, but could considered as an organized crime with both parties involved and benefited with the pre-released ADRs.

The SEC investigation focused on the transaction of “pre-released” American Depositary Receipts (ADR) between 2011 and 2015 (Henry, 2018). While the SEC investigation has made a series of charges and findings some reforms and regulations might be necessary on the American Depositary Receipts (ADR) and the practices adopted by large financial institutions like JP Morgan or Citibank. The inappropriate handling and fraudulent activities used by depositary banks and broker-dealers were benefiting themselves through the pre-release of ADRs, at the same time the foreign issuance company and investors could suffer loses because of short selling activities and inflated share numbers. The pre-release of ADRs could result in share price declining on the ADRs, investors might stay unaware of the practices of the pre-release of the ADRs, at the same time, the market was distorted with the mishandling of the ADRs and foreign shares, it would be more difficult for investors to make the buy, hold or sell decision on ADRs.

All four of depositary banks were charged with fraudulent issuance ADRs, inappropriate handling and abusive practices of ADRs solely for institutional profit making and dividend arbitrage in the financial market. From the press release made by The Securities and Exchange Commission, the investigation will continue with focus on the brokerage firms that profited by making use of these improperly issued ADRs.