The Securities and Exchange Commission has settled charges that it was threatening to impose on Merrill Lynch regarding the improper handling of 'pre-released' American Depositary Receipts. The banking giant will pay more than $8 million.

ADRs – US 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, as long as the brokers who receive 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 that the ADR represents.

The SEC’s order found that Merrill Lynch improperly borrowed pre-released ADRs from other brokers when it should have known that those brokers – middlemen who obtained pre-released ADRs from depositaries – did not own the foreign shares needed to support those ADRs. Such practices served to inflate the total number of foreign issuers' tradeable securities, which resulted in practices such as dividend arbitrage and short-selling of a kind that the SEC does not like. The order against Merrill Lynch found that its policies, procedures and supervision failed to prevent and detect violations of securities laws concerning the borrowing of pre-released ADRs from these middlemen.

When Merrill Lynch made its offer of settlement it did not admit or deny the SEC's findings. It did, however, "admit the subject matter of the proceedings" and pay 'disgorgement' of $4,448,291.52 in ill-gotten gains. This sum represents its net revenues from the securities lending transactions that it concluded with the pre-release brokers.

This particular case was settled in an administrative proceeding, a quasi-judicial determination of fault. There are no jury trials in SEC administrative proceedings. All cases are run by a single SEC administrative law judge who handles nothing but SEC-related matters.

This is the SEC’s ninth formal proceeding against a financial institution to result from its current investigation of abusive ADR pre-release practices, which has thus far resulted in monetary settlements exceeding $370 million.