The ADR scandal, which the SEC uncovered in late 2014 and began investigating in earnest in 2015 is starting to lead to fines and enforcement action across all of Wall Street.
On January 12, 2017, ITG signed a consent order with the SEC which disgorged all its stock lending profits relating to American Depository Receipts (ADRs) over the past 3 years, plus a 50% fine and accompanying interest.
The SEC press release issued on January 12, 2017, shows that the SEC has a "continuing" five man Enforcement Division team led by Sanjay Wadwa. The 11-page consent order shows that ITG was involved with numerous other counterparties, including banks and other dealers. The WSJ reported on November 8, 2015, that the SEC had subpoenaed four depository banks in relation to ADR handling abuses which appeared to facilitate short selling of naked ADRs.
My investigation and analysis show that other broker dealers may be under investigation for similar issues related to mishandling ADRs. In addition, the major ADR depository banks, JPMorgan Chase, BNY Mellon, Citigroup and Deutsche Bank, are likely being investigated based on the 11 page ITG consent order. For example, on page 5 of the order reference is made to three depositories named Depositories A, B and C which had signed ADR "pre-release" agreements with ITG.
In ITG's Q3 2016 earnings release ITG had reserved $22 million for its "ADR pre-lease" infractions. With this consent order it agreed to pay $24.5 million, an additional $2 million. The consent order stated that ITG's matched book securities lending operations, which it later shut down, had revenues 73% composed of pre-release ADR transactions. Although it represented less than 1% of ITG's broker dealer revenues, it still produced $15.07 million in profits from 2011 to 2014. ITG agreed to disgorge these profits plus 50% more in penalties, plus interest. The SEC order implied that ITG proposed the potential fine to the SEC.
None of the major broker dealers or depository banks seem to have taken any reserves in their earnings for related ADR "pre-release" fines like ITG did in its Q3 2015 earnings. Our investigation suggests that the four major ADR depository banks and major broker dealers who make markets in international equities may be facing very stiff disgorgement, penalties, and back interest from at least one U.S. government agency, the SEC.
Potential Fines are Huge
Most of the SEC consent order relates to naked short selling that ITG facilitated in relation to its securities lending operation. Some broker dealers are deeply involved in securities lending. The Goldman Sachs Group, Inc. (NYSE: GS) held $31.902 billion in securities lending indemnifications from counterparties on December 31, 2015.
Source: GS 10-K p. 82, 2015
This means GS lent out over $32 billion in securities to other firms and had taken in cash collateral from the counterparties. Often the securities are to hedge funds which sell short the ADR they had to borrow from GS prior to giving GS the underlying ordinary shares, i.e. a "pre-release". In ITG's case, according to the consent order, 73% of its matched book securities lending was from pre-lease ADRs. If the same ratio was applied to GS, this could mean GS had lent over $24 billion in ADRs to other broker dealers and hedge funds.
Let's use a more conservative figure, say 33.3%, or $10.632 billion in ADR securities loans in 2015. Assuming GS made a 1% spread on the securities it lent and the collateral, which is probably conservative, it could have profited by $106 million. Let's say only half of those transactions were involved in pre-release infractions. That means GS might be facing fines of $53 million, plus 50% penalties (and interest) for 2015 alone. Over ten years of securities operations, that would be a fine of $797 million before interest. ($53.1 m x 10 x 150%). Add in 3% interest, and the fine could be as high as $820 million. If GS made a 2% spread on these ADR pre-release transactions, the fine would be $1.64 billion. That amount would be equal to 30% of GS earnings attributable to shareholders in 2015 ($5.468 billion).
Are our figures realistic? Yes. Goldman Sachs divides up its Securities Services revenue line into three main categories: providing margin loans, securities lending and prime brokerage services:
Source: Goldman Sachs 10-K report, p. 4, 2015
In 2015 GS reported $1.645 billion in revenue from Securities Services (i.e., not commissions and fees).
Source: Goldman Sachs 10-K report, p. 62, 2015
Most of this is likely from its securities lending operation. Let's say for whatever reason, only half of that is from securities lending. That implies a revenue spread of 2.5% (1/2 x $1.645 billion) or $822.5 million/$32.85 billion from securities lending. Assuming GS's cost of spread is 50%, its net profit would be $421 million from securities lending. If one-third of those profits are related to ADR pre-release infractions, the implied profits which would have to be disgorged are $140 million for 2015 alone. Over 10 years, including a 50% penalty that would be $2.1 billion. This represents 2% of GS's $102 billion market cap and 26.7% of its $7.8 billion estimated net income.
Keep in mind that ITG had 73% of its matched securities lending operations involved in ADR pre-release transactions. We are only assuming that GS had only one-third to one-half of its securities lending involved in pre-release. ITG disgorged 100% of its securities lending profits over 3 years. We are only assuming GS disgorges the exact amount of its ADR infraction profits.
Morgan Stanley (NYSE:MS)
Morgan Stanley does not break out its fees from securities lending as GS does, but it does disclose its margin lending activities assets. In a Note 6 of its 10-K 2015 report, page 184, MS disclosed that it held $398 billion in collateral securities from its securities lending operation which could be resold or repledged to cover short positions of its counterparties. We can assume that as normal course of business a portion of these securities were pre-released ADR positions.
Source: Morgan Stanley 10-K report, p. 184, 2015
If we very conservatively assume (a) that 20% of these were for equities securities, or $80 billion; (b) that 20% of the equities loaned were for ADRs and that the majority of these ADRs, or at least one third were for pre-released ADR transactions, and (c) that MS made at least a 2 or 3% spread on these transactions, MS could have earned as much as $106 million to $160 million in ADR pre-release income ($80,000 million x .20 x .3333 = $5,333 million x 2% = $106 million, and $5,333 million x 3% = $160 million). Let's assume that one half of those ADR pre-release transactions were not properly closed out. That would mean potential disgorgement of $53 million to $83 million for 2015 alone. Over 10 years, that would bring a disgorgement, including a 50% penalty, of $795 million to $1.245 billion before interest. If the penalties cover 20 years of activity the fines could be as much as twice that amount. A 10 year period fine would be as much as 21% of Morgan Stanley's earnings and 1.4% of its market value.
Other Examples: BNY Mellon Corp (NYSE: BK)
The Bank of New York Mellon Corporation is the largest ADR depository bank with 58% market share and over 1,145 sponsored ADR programs, acting in partnership with companies from 64 countries. BNY makes money both from issuing sponsored ADRs to broker dealers which need them on their balance sheets, but also from securities lending. Typically BNY will issue a receipt in return for an ordinary share for a $0.05 per ADR fee. In addition, and more importantly, it takes on cash collateral from the counterparty that receives the ADR. BNY holds the collateral until either the ordinary share which underlie the ADR are delivered to BNY from the counterparty or the ADR is returned to BNY. So BNY receives a free source of depository funding from the cash collateral, a form of free float. It makes a spread on the cash collateral. Often, as pointed out in the SEC consent order with ITG, the ADR is released before the underlying ordinary share was delivered to the bank, due to settlement differences. In many cases at ITG, and we can clearly assume the situation occurred at BNY, the counterparty didn't deliver the ordinary share in a timely fashion. This allows BNY to earn a spread on the cash collateral for a longer than normal period, than would otherwise be the case if the ordinary shares were delivered on a timely basis.
Here is what we can see from BNY's 2015 Annual Report (10-K) filing:
BNY does not break out its securities lending vs. its ADR program fees. It appeared to have $294.1 billion in securities lending indemnifications at the end of 2015. We can assume that a good portion of that amount, if not all, is from ADR issuance.
Source: Bank of NY Mellon 10-K report, p. 57, 2015
BNY made $978 million in Issuer Services fees in 2015, which include both Depository Receipts fees and Corporate Trust fees, and $170 million from securities lending, based on a footnote in its 10-K.
Source: Bank of NY Mellon 10-K report, p. 11, 2015
So some portion of $978 million in issuer services revenue and some portion of $178 million in securities lending revenue are due to Depository Receipts fees and spreads. Assuming 50% in both, BNY had revenue of $578 million from its ADR issuance and lending. Let's also assume half of this if net profit. Over 10 years, it could potentially have made $2.89 billion ($578 million x .5 x 10). But, of course, BNY has been involved in issuing and lending ADRs for much longer than 10 years. Here is a calculation of fines it could face:
So even with some very conservative assumptions, BNY Mellon could get fined from $2.1 to $5.4 billion. Its 2015 net income was $3.05 billion and its market value is a little over $50 billion. Estimated 2016 net income is about $3.7 billion. So up to twice its net income and 10% of its market cap could be levied against BNY Mellon if even conservative estimates are used.
It is not clear where the U.S. government investigation will lead. Here and here are links to articles about an industry whistle-blower who brought this whole issue to the government's attention. He stands to benefit greatly if the civil fines are huge, and he has made some large claims about where the U.S. investigation will lead.
In addition, since most pre-release ADRs that are not settled properly have relate to short-selling or dividend arbitrage transactions, the extra float effectively create phantom shares. These bloat the underlying companies' market shares outstanding and create downward pressure on the stock, thereby harming other shareholders. Once the SEC fines the depository banks, they may face significant derivative lawsuits from pension funds and other class action shareholders who were long term holders of the sponsored ADRs.
JPMorgan Chase, Citigroup and Other Firms
JPMorgan Chase (NYSE: JPM) reported that it did $4.4 billion in securities lending transactions during 2015. It also reported that it earned $2.015 billion in administrative fees, which include securities lending, custody, funds service and securities clearance fees. Assuming at least a quarter of the fees were from securities lending and depository receipt issuance, JPM earned $504 million in fees during 2015. Using the same assumptions we used with BNY, JPM's ADR profits were $126 million, and the portion related to ADR pre-release infractions were $63 million. The bottom line is JPM could be facing $944 million to $2.4 billion.
These potential fines work out to a smaller portion of JPM's net income and market value than BNY and GS. For example, JPM expects to make $24 billion in net income this year and has a market value of $310 billion. So a $2.36 billion fine would only be 10% of its net income and less than 1% of its market value. The same figures, as shown above, is twice net income at BNY and 10% of its market cap, and 2% of Goldman Sach's market cap and 26.7% of its net income.
Citigroup, Inc. (NYSE: C) does not disclose either its securities lending or ADR related fees. However, based on its securities lending indemnification disclosures, we estimate that C produces roughly $38 million in related profits. We could be way off though since this is based on a number of similar assumptions as we made with other depository banks. Nevertheless, based on this estimate, the largest fine C might be facing is $711 million for the past 25 years of pre-release infractions. This represents only 4% or so of Citigroup's $16 billion net income and less than ½% of C's $169 billion market cap. So our estimate is that the potential fines will have a negligible effect.
Other firms. Jefferies Group is a major player in the international equities business, wholly owned by Leucadia National Corp. (NYSE: LUK). LUK does not disclose any public information on Jefferies' securities lending or ADR related transactions or fees, even though it is the major purchased asset of LUK. The same is true for Merrill Lynch, now owned by Bank of America Corporation (NYSE: BAC). UBS Group AG had CHF 13.4 billion (about $13.3 billion) in securities lending indemnifications at the end of 2015. Using the same metrics as above, the effect of any estimated fines would be negligible in relation to its income or market valuation.
The Goldman Sachs & Co, Morgan Stanley and The Bank of New York Mellon Corporation stand to be the biggest losers from any potential ADR fines. This is based on the effect our estimate of potential fines could have on their net income and as a percent of their market value. We recommend, based on the fines that were imposed on ITG on January 12, 2017, investors short these stocks. These companies are likely either close to or in similar negotiations right now with the SEC. The minute they begin to make an offer to the SEC for their potential fines, management must set aside a reserve and announce the amount in their public earnings. This is regardless of whether or not the SEC or any other U.S. government agency accept their proposals. I believe there is a high likelihood that these reserves will either be announced in the 2016 earnings statement or be inserted in the final 10-K earnings documents. In any case, here is what we expect for these companies:
Goldman Sachs : GS could face fines in a range of $800 million to $2 billion, including disgorgement of all or most of ADR securities lending profits before interest, including a 50% penalty payment, for every 10 years of ADR pre-release infractions. This could be as high as 25-26% of GS expected annual earnings and 2% of its market value.
Morgan Stanley : MS could face fines in a range of $800 million to $1.25 billion, including disgorgement of all or most of ADR securities lending profits before interest, including a 50% penalty payment, for every 10 years of ADR pre-release infractions. This could be as high as 21% of Morgan Stanley's expected annual earnings and 1% of its market value.
BNY Mellon : BNY could face fines in a range of $2.1 billion to $5.4 billion, including disgorgement of all or most of ADR securities lending profits before interest, including a 50% penalty payment, for every 10 to 25 years of its ADR pre-release infractions. BNY has a 58% market share of all ADR sponsored ADR programs so it is likely to be a key focus of all SEC enforcement activities in this area. Its fines could be as high as 100-200% of expected annual earnings and up to 10% of its market value.
Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.