American Depositary Receipts (ADR)
A simplified way for American investors to buy and sell non-US stocks and securities.
What Is an American Depositary Receipt (ADR)?
American Depositary Receipts, or ADRs, are a simplified way for American investors to buy and sell non-US stocks and securities.
It has made it easier for American investors to deal in stocks that do not belong to their home stock markets. As a result, global exposure has increased for these investors ever since.
An American bank or a broker issues an ADR. It portrays one or more than one stock that the bank in the home stock market of that foreign country holds.
An interesting thing to note about ADRs is that the number of foreign shares to be exchanged for one ADR may vary from company to company. However, each ADR remains the same for any one company, which will represent the same number of shares.
They can be traded over big exchanges like New York Stock Exchange (NYSE) or negotiated over the counter (OTC).
The ones that are listed on the exchange can be traded just like the ones that are listed on any American exchange.
They represent the most familiar companies globally, like Infosys, GlaxoSmithKline, Wipro, etc. These were some of the examples of some companies, along with other companies, that can list their stocks on US exchanges through ADRs.
American Depositary Receipts are an easy and liquid way for investors in the US to invest in foreign stocks of their choice.
ADRs and Taxes
As for the taxing perspective, ADRs are not subjected to non-US stock transaction taxes.
For the countries that maintain tax treaties with the US, the dividends on those stocks are delivered without foreign withholding.
However, capital gains and/or losses are always subject to some taxation on behalf of the government. Thus, the investors could be taxed for their capital gains or losses while dealing with these receipts and may be subject to backup withholding.
Note
Foreign companies listed on the stock exchanges must issue their financial reports to the United States and conform to the US accounting standards for the same.
These foreign companies are also required to file necessary disclosure statements with the SEC to get their financial track records and backgrounds inspected thoroughly.
Those companies that meet all the requirements of US reporting and disclosure regulations are permitted to raise their capital from US investors directly by issuing ADRs.
The companies that partially meet the requirements of rules and regulations of the Securities and Exchange Commission are allowed to sponsor the ADRs that represent shares issued in their home markets.
Since they are issued by companies that do not belong to the US, they entail some special risks with their investments.
Some risks include the exchange rate, political risks concerning the US and other countries, and inflation risks.
The exchange rate risk dictates the risk of the dropping of the other currency as compared to that of the dollar. In addition, political risks include the treaties and agreements between the two countries leaders that may destabilize that company's earnings.
Three levels of these receipts determine the extent to which the investor can acquire information regarding the company of the stocks they are investing in. We will talk more about it in our next sections.
Investors are also charged periodic service fees for some ADRs to compensate for the services some banks and brokers provide. The fee information should already be mentioned on the prospectus to avoid any conflicts of interest.
The ones that charge these fees get deducted directly from the dividends the company pays to the investors or may also appear separately as a fee on the monthly statement from the receipts.
How American Depositary Receipts (ADRs) Work
These receipts are denominated in dollars and are held by a US financial institution in the branch located in the country to which the company belongs.
One of the best advantages of the receipts is that the investors need not worry about exchanging foreign currency to transact the trade as the prices are settled and cleared by the US settlement systems.
The banks must purchase the stocks from foreign exchange and store them with them. Thereon, the American receipts are issued for their domestic trading.
As mentioned above, these receipts are listed on big exchanges like New York Stock Exchange (NYSE) or NASDAQ and sold over the counter (OTC).
Note
The banks must acquire proper financial statements for their due diligence by the investors to assess the company's financial health and invest their money wisely.
To create a new ADR, the bank has to purchase the stocks from the foreign company in the issuer's home stock market and then deposit the shares in a depository Bank in the overseas market. This is why it is called a depository receipt.
The bank then launches the ADR at the value that equals the value of the shares deposited with the overseas bank. From thereon, the dealer or the broker takes the receipts to the US market to sell them.
Its creation depends solely on the price, availability, and demand of the stocks of the foreign company in the US financial market.
The dividends or the yield from the receipts are paid in US dollars to the investors who purchased them. However, the dividends paid by the foreign company are paid in their native currency.
The banks or the brokers and dealers are later required to convert them into US denominations after consideration of currency conversion costs and taxes in accordance with foreign taxing rules.
This procedure is to make the process of investment for the US investors without the burden of currency exchange. As mentioned, foreign companies must report their financial records to US banks for due diligence by the investors.
Types of American Depositary Receipts
There are broadly two types of American depository receipts. These are the sponsored and the unsponsored ADRs.
Let us talk about them in detail below.
1. Sponsored ADR
Under a sponsored agreement, the foreign company issuing shares to the US public enters a deal with the US depository bank to sell its shares into the US market.
Under such an arrangement, the US Bank is responsible for all the record-keeping of that receipt, like sale, distribution of the shares to the public, and the dividend yield from the shares, etc.
Note
The sponsored receipts can also be listed on the US stock exchanges.
2. Unsponsored ADR
Brokers or dealers construct a non-sponsored receipt without involving foreign companies directly.
The non-sponsored ones are not listed on the US stock exchanges. Still, they are traded over the counter (OTC) without the obligation to register with the Securities and Exchange Commission (SEC).
But it was not always the same. Before 2008, brokers and dealers were required to apply before they were allowed to trade in the US. However, an amendment took place, and the SEC exempted brokers and traders from this obligation to foreign issuers in the US.
ADR Levels
ADRs are bifurcated into three levels based on the extent to which a foreign company could gain exposure to the US market. Each of the levels comes with different types of characteristics that make them distinct.
Let us look into each of the three levels briefly.
1. Sponsored Level 1
Level 1 is the primary level of sponsored receipts at which the ADRs can be issued for sale in the US market. This is the easiest and most standard level for foreign companies.
Under Level 1 of sponsored, foreign companies have to meet the least reporting requirements with the Securities and Exchange Commission (SEC) and, thus, cannot be traded in the US exchanges.
They are traded over the counter, where the brokers and/or dealers enter into customizable agreements with the US investors. The companies are not required to issue quarterly or yearly reports like the other companies that have an obligation to do so.
2. Sponsored Level 2
Level 2 receipts demand more reporting requirements from the SEC than the first level of sponsored receipts. The foreign company that opts for the second level gains more exposure to the US stock markets.
For this, the company must file a registration statement with the SEC.
The company is mandated to file Form 20-F to conform with the GAAP or IFRS to trade in the US.
Note
Form 20-F is an SEC filing that has to be submitted to the Securities and Exchange Commission to provide SEC with the necessary information before they indulge in the US markets.
It is a counterpart of Form 10-K submitted by US companies trading publicly in the country. Form 20-F serves the same purpose but on an international level. Suppose the foreign company fails to provide the conditions. In that case, it may be delisted or demoted to Level 1.
3. Sponsored Level 3
The sponsored level 3 is the most elevated level for any foreign company to get sponsored through. At this level, a foreign company can raise capital from US investors by floating a public offering of receipts through the medium of US exchanges.
This points to the fact that level 3 provides the most divulgence into the US markets. The company must file Form-1 as a prospectus and Form 20-F for the annual reports following GAAP or IFRS.
Any company offerings circulated to the investors in the foreign company's home country must be submitted to the SEC in the state of Form 6-K.
American Depositary Receipts (ADR) FAQs
ADRs can be withdrawn either on behalf of the issuer or the depository bank that helped establish it in the first place. When a receipt is terminated, it results in its delisting from the US stock exchanges where the stock was previously traded.
Before the termination occurs, the foreign companies are required to write to the owners of the receipts and give them the option to switch their receipts for foreign securities that symbolize the receipts.
A prospectus documents that foreign companies must conform to enter the US market. They must disclose their financial reports and well-being so that the investors know the financial health of the company they purchase the receipts from.
GAAP, or generally accepted accounting principles, is a collection of familiar accounting rules and standards companies follow to prepare their financial reports.
Under GAAP, there are majorly four principles that are being followed. These are
- The cost principle
- The revenues principle
- The matching principle
- The disclosure principle
The IFRS or international financial reporting standards are also accounting standards that mention the rules to account for particular transactions and events.
IFRS is developed and maintained by the international accounting standards board (IASB).
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