Citibank Pays $38.7M SEC Fine For Mishandling ADRs

by Ike Obudulu Posted on November 7th, 2018

Washington D.C., USA : The U.S. Securities and Exchange Commission (SEC) announced today that Citibank N.A. part of Citigroup (NYSE: C) has agreed to pay $38.7 million to settle charges of improper handling of “pre-released” American Depositary Receipts (ADRs).

ADRs – U.S. securities that represent foreign shares of a foreign company – require a corresponding number of foreign shares to be held in custody at a depositary bank. The practice of “pre-release” allows ADRs to be issued without the deposit of foreign shares provided brokers receiving them have an agreement with a depositary bank and the broker or its customer owns the number of foreign shares that corresponds to the number of shares the ADR represents.

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 new ADRs. 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.

This is the second action against a depositary bank and sixth action against a bank or broker resulting from the SEC’s ongoing investigation into abusive ADR pre-release practices. Information about ADRs is available in an SEC Investor Bulletin.

“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.”

Without admitting or denying the SEC’s findings, Citibank agreed to pay more than $20.9 million in disgorgement of ill-gotten gains plus $4.2 million in prejudgment interest and a $13.5 million penalty for a total of more than $38.7 million. The SEC’s order acknowledges Citibank’s remedial acts and cooperation in the investigation.

American Depositary Receipts (ADRs)

The stocks of most foreign companies that trade in the U.S. markets are traded as American Depositary Receipts (ADRs). U.S. depositary banks issue these stocks. Each ADR represents one or more shares of foreign stock or a fraction of a share. If you own an ADR, you have the right to obtain the foreign stock it represents, but U.S. investors usually find it more convenient to own the ADR. The price of an ADR corresponds to the price of the foreign stock in its home market, adjusted to the ratio of the ADRs to foreign company shares.

An ADR is a security that represents shares of non-U.S. companies that are held by a U.S. depositary bank outside the United States (“U.S.”).

What is an ADR?

ADRs allow U.S. investors to invest in non-U.S. companies and give non-U.S. companies easier access to the U.S. capital markets. Many non-U.S. issuers use ADRs as a means of raising capital or establishing a trading presence in the U.S. The non-U.S. company may sometimes be referred to as a “foreign private issuer.” The first ADR was created in 1927 by a U.S. bank to allow U.S. investors to invest in shares of a British department store. Today, there are more than 2,000 ADRs available representing shares of companies located in more than 70 countries.

An ADR is a negotiable certificate that evidences an ownership interest in American Depositary Shares (“ADSs”) which, in turn, represent an interest in the shares of a non-U.S. company that have been deposited with a U.S. bank. It is similar to a stock certificate representing shares of stock. The terms ADR and ADS are often used interchangeably by market participants.

ADRs trade in U.S. dollars  and clear through U.S. settlement systems, allowing ADR holders to avoid having to transact in a foreign currency. An ADR may represent the underlying shares on a one-for-one basis, or may represent a fraction of a share or multiple shares. For example, for one company, an ADR may represent several shares of the underlying security, while for another company, an ADR may represent a fraction of the underlying security. The use of a ratio allows ADRs to be priced at an amount more typical of U.S. market share prices.

ADRs are created by a depositary bank when the non-U.S. company, or an investor who already holds the underlying non-U.S. securities, delivers them to the bank or its custodian in the non-U.S. company’s home country. The bank will issue ADRs to the investor in the U.S. and the investor will be able to re-sell the ADRs on a U.S. exchange or the over-the-counter market. ADR holders may also surrender ADRs in exchange for receiving the shares of the non-U.S. company. These transactions are generally performed by brokers and other types of investors who are active in foreign securities markets.

ADRs may be “sponsored” or “unsponsored.” Sponsored ADRs are those in which the non-U.S. company enters into an agreement directly with the U.S. depositary bank to arrange for recordkeeping, forwarding of shareholder communications, payment of dividends, and other services. An unsponsored ADR is set up without the cooperation of the non-U.S. company and may be initiated by a broker-dealer wishing to establish a U.S. trading market. An ADR, however, may not be established unless the non-U.S. company is either subject to the reporting requirements under the Securities Exchange Act of 1934 or is exempt under the Act.

ADRs are always registered with the SEC on a Form F-6 registration statement. Disclosure under Form F-6 relates only to the contractual terms of deposit under the deposit agreement and includes copies of the agreement, a form of ADR certificate, and legal opinions. A Form F-6 contains no information about the non-U.S. company. If a foreign company with ADRs wishes to raise capital in the United States, it would separately file a registration statement on Form F-1, F-3, or F-4.

If a foreign private issuer seeks to list ADRs on a U.S. stock exchange, it would separately file with the SEC a registration statement on Form 20-F. Registration statements used to raise capital or list ADRs on an exchange are required to contain extensive financial and non-financial information about the issuer.

Market participants have generally categorized ADRs into three “levels,” depending on the extent to which the foreign company has accessed the U.S. markets:

Level 1 ADR programs establish a trading presence but may not be used to raise capital. It is the only type of facility that may be unsponsored and, as a result, may be traded only on the over-the-counter market. Form F-  would be the only form required to be filed. No information about the issuer would be available on the SEC’s EDGAR system; information should be available on the issuer’s website.

Level 2 ADR programs establish a trading presence on a national securities exchange but may not be used to raise capital. Again, Form F-6 would be used to register the ADRs. The non-U.S. company is required to register and file annual reports on Form 20-F with the SEC.

Level 3 ADR programs may be used not only to establish a trading presence, but also to raise capital for the foreign issuer. A registration statement on Form F-1, Form F-3, or Form F-4 would be filed in order to offer the ADRs. The non-U.S. company would be required to also file annual reports on Form 20-F.

What fees are charged to ADR investors?

As a matter of course, an ADR depositary bank may be authorized under the deposit agreement relating to the ADRs to charge a fee, called a custody fee, for the work it performs on the ADR. ADR depositary banks charge holders of ADRs custody fees, sometimes referred to as Depositary Services Fees, to compensate the depositary banks for inventorying the non-U.S. shares and performing registration, compliance, dividend payment, communication, and recordkeeping services.

A common practice for collection of the custody fee is for the ADR depositary bank to subtract the amount of the fee from the gross dividends paid by the bank to ADR holders. Typically, the Depository Trust Company, (DTC) will announce both the gross dividend rate and the net dividend rate after deduction of the ADR custody fee. The ADR depositary banks pay DTC the net dividend, and DTC allocates the net dividend to its users. However, a number of ADR issues do not pay periodic dividends, which prevents the fees from being collected through the above described mechanism. In this case, DTC charges the fee to its users (i.e., banks and broker-dealers) who pass them on to their customers.

Depositary banks may charge other fees, such as relating to the distribution of dividends, foreign currency exchange, voting of shares, and other matters.

What should investors do before investing in ADRs?

Like any other investment, you should learn as much as you can about a company before you invest. Research the political, economic, and social conditions in the company’s home country so you will understand better the factors that affect the company’s financial results and stock price. You should understand that non-U.S. companies are subject to financial and other disclosure requirements that differ from those required of U.S. public companies. Except for the annual report on Form 20-F, non-U.S. companies are generally only required to disclose what is required in their home country. Any disclosure may also not be as extensive or comparable to that of U.S.public companies.

Prior to investing in an ADR, investors should ask their broker-dealer what fees are charged to them as ADR investors. Typically, fees are assessed per ADR. For example, 1000 ADRs could be assessed a fee ranging from $20 to $50. Investors should review the fees reported in the Form F-6 registration statement under the Securities Act of 1933 available through the SEC’s web site at at no charge. Fees can be viewed in the section of the registration statement typically titled, “Description of American Depository Shares” or “Description of American Depository Receipts.” The websites of depositary banks that are active in the U.S. also contain information about investing in ADRs and serve as a source of information for investors.

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