The U.S. broker-dealer subsidiary of Italy’s Intesa Sanpaolo will pay more than $35 million to settle charges that it violated federal securities laws by issuing and receiving ADRs without possessing the underlying foreign shares.
The SEC reports that broker-dealer Banca IMI Securities Corp. (BISC), a wholly owned subsidiary of IMI Capital Markets USA Corp., which in turn is a wholly owned subsidiary of Intesa Sanpaol, an Italian banking group, has agreed to pay more than $35 million to settle charges that it violated federal securities laws when it received American depositary receipts (ADRs) without possessing the underlying foreign shares.
In all, BISC will pay more than $18 million in disgorgement plus more than $2.3 million in interest and a $15 million penalty, according to the SEC. BISC, which also has agreed to be censured, nonetheless neither admits nor denies guilt.
The SEC’s order finds that BISC violated Section 17(a)(3) of the Securities Act of 1933 and failed reasonably to supervise its securities lending desk personnel.
ADRs are U.S. securities that “represent shares of a foreign company, and for all issued ADRs there must be a corresponding number of foreign shares held in custody at a depositary bank,” the commission reminds us, adding that “under ‘pre-release agreements,’ brokers such as BISC may obtain ADRs without depositing corresponding foreign shares provided the broker owns or takes reasonable steps to determine that the customer owns the number of foreign shares that corresponds to the number of shares the ADR represents.”
However, the SEC finds that BISC “obtained pre-released ADRs and lent them to counterparties without satisfying the proper requirements.”
According to the commission, “BISC’s improper handling of ADRs, which lasted from at least January 2011 to August 2015, made it possible for such ADRs to be used for inappropriate short selling or inappropriate profiting around dividend record dates.”
More specifically, the SEC contends that, since at least January 2011, “BISC had Pre-Release Agreements with four Depositaries. Contrary to certain provisions in these agreements and how pre-release transactions were supposed to work under the Depositary Agreements, associated persons on BISC’s securities lending desk had an ongoing practice of obtaining, and then lending, pre-released ADRs from Depositaries without taking reasonable steps to determine whether the requisite number of ordinary shares was owned and custodied by the person on whose behalf the pre-released ADRs were being obtained. The result of this conduct was the issuance of ADRs that in many instances were not backed by ordinary shares as required by the Depositary Agreements.”
The SEC further specifies that, from at least January 2011 until August 2015, BISC “developed a matched book securities lending operation, whereby BISC obtained securities from a bank or broker-dealer and in turn lent them to another broker-dealer.… Pursuant to those agreements [with the four depositories], BISC had a practice of obtaining ADRs through pre-release transactions with Depositaries and lending those ADRs to broker-dealer counterparties. BISC profited from these transactions by obtaining the pre- released ADRs from Depositaries at lower rates than the rates at which they lent them to other brokers.”
In fact, according to the commission, approximately “63% of BISC’s securities lending profits during this period were generated from pre-release transactions.”
The SEC notes also that, in “certain countries, demand for ADR borrowing increased around dividend record dates so that certain tax-advantaged borrowers could, through a series of transactions, collect dividends without any tax withholding. Pre-released ADRs that were improperly issued were used to satisfy that demand.”
The SEC also points to “one specific example, in October 2011, [when] Depositary A issued the ADRs of a foreign issuer (‘Issuer A’) through pre-release transactions with BISC. At this time, the tax treaties with the foreign tax authority provided for a statutory withholding rate of 15% for ADR holders who were U.S. residents. Depositary A and BISC entered into pre-release transactions through which BISC obtained 2,300,000 ADRs from Depositary A; BISC then loaned those ADRs to a counterparty (‘Counterparty A’).
“As reflected on spreadsheets tracking these transactions, Counterparty A agreed to an ‘all in’ rate of approximately 94.42% over the periods in which the transactions were to remain open, and BISC and Depositary A agreed to an ‘all in’ rate of 90.48% over the same periods,” the SEC continues.
“In this example, Counterparty A would retain approximately 5.58% of the dividend (or 100% less 94.42%) and pay BISC a rebate rate that approximated 9.42% of the dividend, and BISC would pay Depositary A a rebate rate that approximated 5.48% of the dividend (or 90.48% less 85%), such that BISC made a spread that approximated 3.94% of the dividend (or 94.42% less 90.48%). Post-dividend, as was often the case, Counterparty A delivered ADRs to BISC to close out its loan and BISC then delivered the ADRs to Depositary A to close out the pre-release transactions,” according to the SEC.
“This one set of transactions resulted in $76,288.80 in revenue for BISC,” according to the SEC. “BISC’s securities lending desk personnel should have known that BISC’s borrowers may not have been paying withholding taxes that may have been owed to the foreign jurisdiction on dividends received on ordinary shares, and that ordinary shares were not properly custodied for the benefit of ADR holders,” SEC officials add.
“U.S. investors who invest in foreign companies through ADRs have a right to expect market professionals to create new ADRs only when they are backed by foreign shares so that the new ADRs are not used to game the system,” Sanjay Wadhwa, senior associate director of the SEC’s New York regional office, says in a prepared statement. “As our order finds, BISC’s actions left the ADR markets ripe for potential abuse.”
The SEC also acknowledges BISC’s cooperation in the investigation, specifying “BISC voluntarily highlighted documents likely to be of interest to the staff.”
Intesa Sanpaolo, the Italian banking group that is BISC’s corporate parent, describes itself as having a “selected retail banking presence in Central and Eastern Europe, the Middle East and North Africa, with approximately 1,200 branches and 7.8 million customers in 12 countries. Intesa Sanpaolo is also present in 29 countries in support of its corporate customers’ cross-border business.”
FTF News reached out to Intesa Sanpaolo, asking specifically if oversight procedures had been changed since the SEC penalty. An Intesa Sanpaolo spokesman declined to comment.
To view the SEC’s entire order about this matter, click here.
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