JPMorgan Chase & Co. building/photo by Shutterstock

Banks handling pre-released American Depositary Receipts, which U.S. residents use to invest in foreign companies, are taking a risk if they rely on agreements, annual certifications or the word of brokers to ensure that they're complying with the law.

Case in point: JPMorgan Chase Bank's more than $135 million settlement reached Dec. 26 with the U.S. Securities and Exchange Commission. The deal resolves charges alleging that the New York-based bank made about $71 million in revenue through abusive ADR practices in thousands of transactions that occurred from November 2011 through early 2015.

JPMorgan, which did not admit any wrongdoing, stopped offering pre-release ADRs in late 2015, according to the SEC. A spokesman for the bank, Brian Marchiony, wrote in an email that JPMorgan was “pleased to have resolved this matter, which is related to an industry practice we voluntarily ended a few years ago.” As part of the settlement, the SEC will not impose a potential civil penalty of nearly $50 million. 

The settlement highlights the pitfalls of weak ADR compliance efforts as the SEC continues to crack down on the improper handling of ADRs and pre-release transactions. The JPMorgan settlement marked the SEC's eighth ADR-related action against a bank or broker and its fourth action against a depositary bank.

Earlier this month, the Bank of New York Mellon agreed to pay more than $54 million to settle an ADR enforcement action with the SEC. Other recent actions cost Citibank more than $38 million and spurred Deutsche Bank to pay a nearly $75 million settlement.

In the JPMorgan case, the SEC alleged that the bank's depositary receipts execution desk employees—they handled the issuance and cancellation of ADRs—essentially turned a blind eye to red flags that were indicative of potential abusive practices. JPMorgan asserted that it had relied on pre-release agreements and annual certifications to ensure that the ADR brokers it dealt with were playing by the rules. The employees also contacted senior staffers at the pre-release broker agencies to determine that they were complying with the law, according to the SEC.

But the SEC found that the bank's actions were “insufficient to address the known risks of pre-released ADRs” and “in light of the information that the [bank employees] had about the practices of the pre-release brokers.” 

In a traditional ADR transaction, a depositary bank, such as JPMorgan, issues ADRs, 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 be used to smooth out inter-jurisdictional settlement timing disparities, the broker can obtain newly issued ADRs from the depositary before delivering ordinary shares to a custodian a short time later.

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

The SEC alleged, in part, that JPMorgan profited by charging brokers fees for the duration of the pre-release transactions, some of which dragged on for months. Meanwhile, the brokers were profiting by lending the ADRs to securities lending desks at other larger broker-dealers at inflated rates.

“That pattern of conduit activity should have alerted [JPMorgan] personnel that the pre-release brokers themselves were most likely not beneficial owners of corresponding ordinary shares,” the SEC stated in a cease-and-desist order.

Sanjay Wadhwa, senior associate director of the SEC's New York regional office and a former associate at the New York law offices of Cahill, Gordon & Reindel and Skadden, Arps, Slate, Meagher & Flom, stated in a news release that the agency has now “held all four depositary banks accountable for fraudulent issuances of ADRs into an unsuspecting market.”

But he added that the SEC continues to investigate “brokerage firms that profited by making use of these improperly issued ADRs.”