What are American Depositary Receipts (ADR)?
The term American depositary receipt (ADR) refers to a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares—usually one share—of a foreign company’s stock. The ADR trades on U.S. stock markets as any domestic shares would.
ADRs offer U.S. investors a way to purchase stock in overseas companies that would not otherwise be available. Foreign firms also benefit, as ADRs enable them to attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges.
How American Depositary Receipts Work
Investors willing to invest in American Depositary Receipts can purchase them from brokers or dealers. The brokers and dealers obtain ADRs by buying already-issued ADRs in the US financial markets or by creating a new ADR. Already-issued ADR can be obtained from the NASDAQ or NYSE.
Creating a new ADR involves buying the stocks of the foreign company in the issuer’s home market and depositing the acquired shares in a depository bank in the overseas market. The bank then issues ADRs that are equal to the value of the shares deposited with the bank, and the dealer/broker takes the ADR to US financial markets to sell them. The decision to create an ADR depends on the pricing, availability, and demand.
Investors who purchase the ADRs are paid dividends in US dollars. The foreign bank pays dividends in the native currency, and the dealer/broker distributes the dividends in US dollars after factoring in currency conversion costs and foreign taxes.
Such a practice makes it easy for US investors to invest in a foreign company without worrying about currency exchange rates. The US banks that deal with ADRs require the foreign companies to furnish them with their financial information, which investors use to determine the company’s financial health.
Types of American Depositary Receipts
ADRs that are sold in the US market are categorized into two types, which are:
- Sponsored ADR
- Non-sponsored ADR
- Sponsored ADR: In sponsored ADR, the foreign company that is looking to issue shares to the public gets into an agreement with a US Depository bank for the purpose of selling shares in the US capital market.
The US depository bank carries the responsibility of sale, distribution of shares to the public and also maintains record-keeping, dividend distribution. ADRs that are sponsored are listed in US stock exchanges.
US stock exchanges are regulated by the SEC (Securities and Exchange Commission) which acts as a watchdog for all the necessary compliances that should be maintained while trading in US stock exchanges and instruments.
- Non-sponsored ADR: Non-sponsored ADR is created by brokers and dealers without the involvement of the foreign company. These types of ADRs are sold over the counter and do not require any registration with the SEC (Securities and Exchange Commission).
Levels of American Depositary Receipts
ADRs are grouped into three levels depending on the extent of the foreign company’s access to the US trading market.
1. Sponsored Level I
Level I is the lowest level at which sponsored ADRs can be issued. It is the most common level for foreign companies that do not qualify for other levels or that do not want their securities listed on US exchanges. Level I ADRs are subject to the least reporting requirements with the Securities and Exchange Commission, and they are only traded over the counter.
The companies are not required to issue quarterly or annual reports like other publicly traded companies. However, Level I issuers must have their stock listed on one or more exchanges in the country of origin. Level I can be upgraded to Level II when the company is ready to sell through US exchanges.
2. Sponsored Level II ADRs
Level II ADRs have more requirements from the SEC than Level I, and the company gets an opportunity to establish a higher trading presence on the US stock markets. The company must file a registration statement with the SEC.
Also, the company must file Form-20-F in accordance with the GAAP or IFRS standards. Form 20-F is the equivalent of Form-10-K, which is submitted by US publicly traded companies. If the issuer fails to comply with these requirements, it may be delisted or downgraded to Level I.
3. Sponsored Level III ADRs
Level III is the highest and most prestigious level that a foreign company can sponsor. A foreign company at this level can float a public offering of ADRs to raise capital from American investors through US exchanges. Level III ADRs also attract stricter regulations from the SEC.
The company must file Form F-1 (prospectus) and Form 20-F (annual reports) in accordance with GAAP or IFRS standards. Any materials distributed to shareholders in the issuer’s home country must be submitted to the SEC as Form 6-K.
Examples of foreign companies that have managed to enter this ADR level include Vodafone, Petrobras, and China Information Technology.
Advantages of American Depositary Receipts
The issuer of the ADRs can access the capital available in the market in the U.S. and get a diversified base of shareholders (U.S. shareholders).
ADR makes it easy for the issuer to go for merger and acquisition activities as they can use ADR as the currency for the acquisition.
For the investor, ADRs are easy to use as they can buy and sell the shares of the other country’s company like their own company. Also, there is no need for a new broker or to open a foreign brokerage account as investors can use the same broker they normally deal with.
Investor gets the opportunity to diversify their investment portfolio on a global scale.
Everything is as per the U.S. working. The investors purchase ADRs in U.S. dollars; dividends are given in dollars, traded during the normal trading hours in the U.S., and are subject to settlement procedures as American stocks.
It gives more accessibility of research and information to the investors, and investors can customize their portfolio according to their requirements like which countries they are interested in or which sector, etc.
Disadvantages of American Depositary Receipts
The unsponsored ADRs may not comply with the Securities and Exchange Commission (SEC).
The investors might have limited companies for the selection as all the foreign companies are not available as ADRs.
An investor needs enough capital investment ; otherwise, creating a properly diversified portfolio will not be possible.
The investor might face double taxation if the dividend is taxed differently, as ADR dividends received may be subject to the tax in the company’s home country.
Example of American Depositary Receipts
Between 1988 and 2018, German car manufacturer Volkswagen AG traded OTC in the U.S. as a sponsored ADR under the ticker VLKAY. In August 2018, Volkswagen terminated its ADR program.
The next day, J.P. Morgan established an unsponsored ADR for Volkswagen, now trading under the ticker VWAGY.
Investors who held the old VLKAY ADRs had the option of cashing out, exchanging the ADRs for actual shares of Volkswagen stock—trading on German exchanges—or exchanging them for the new VWAGY ADRs.
Thus, we can conclude that the American Depositary Receipts allow the investors of the U.S. to trade in the shares of foreign companies easily and conveniently. Furthermore, they also enable the investors to diversification of their portfolio as they can invest in companies not based in their home country America.
With the help of American Depositary Receipts, investors invest in companies located in emerging markets where they can maximize their profit out of the money invested. So, the American Depositary Receipts remove the restrictions of the Americans from investing only in their home country.