What is an American Depositary Receipt – ADR?
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Foreign investment by U.S. investors is growing at a rate of more than 10% each year, and reached a value of over $3.9 trillion back in 2010, and American Depository Receipts form an integral part of that.
As an investor, you know the deal – investing directly in foreign countries is often a bummer, with the many legal hurdles and currency risk exposure.
American Depository Receipts offer a way around that, a high-risk high-return option.
An American Depositary Receipt (ADR) is a certificate that is issued by an US bank which states that one or more shares of foreign stock are being held under your name at a depositary bank.
Just like how the regular stocks are traded in the market, American Depositary Receipts can be traded too and are listed on the NYSE (New York Stock Exchange) and NASDAQ.
Before the introduction of the American Depositary Receipt, if we wanted to purchase any stock from foreign companies, there was a large process involved.
You would have to transfer your money to a bank in that country, convert this money to their currency and only then could you purchase stocks.
This is a long process and would most often come back as a hit on your profits once taxes and exchange rate fluctuations were taken into account.
What the ADR does as a substitute for this is instead of you purchasing the stocks directly from the foreign company, a US bank will purchase it under your name, and you are given a piece of paper stating that these shares are yours.
All of these transactions are carried out in US Dollars to avoid all the currency conversion issues, and thus all the dividends earned and payouts are all made in US Dollars.
If the dividends you earned were from Euros, for example, this will be converted to dollars before being passed on to you.
The whole concept of the American Depositary Receipt was founded by Guaranty Trust Corporation, which is JP Morgan’s predecessor in 1927, which allowed people to purchase stocks of a British department store called Selfridges.
Due to the ease of the whole process, the popularity of using this service has increased since then and now there over two thousand Receipts available around the world.
HOW DOES AN ADR WORK?
If you are into investing, know the basics first. To understand the whole concept a little bit better, let’s use an example to simplify it.
Investors who are willing and able to buy these American Depositary Receipts can purchase them through dealers/brokers who in turn will obtain these receipts from one of two ways.
Either by purchasing ADR’s that are already issued or by creating new ADR’s.
Already Issued ADR’s can be bought over the counter or through NYSE / NASDAQ.
If the dealer has to create a new ADR, then there is another process involved. T
hey will first have to go to the issuer of the shares (Ex. Alibaba) and buy the shares directly from their home market.
These shares are then deposited in one of the depositary banks in that market, and the bank will then issue an ADR representing these shares to the broker.
Using Alibaba as an example, we can see that if the investor wants to make a new ADR with Alibaba, the broker will have to go to China to purchase the stocks directly from them and then deposit these stocks into a US Depositary Bank which will then be converted into an ADR under the investors’ name. Got it so far?
Creating new ADR’s is not always easy and will depend on factors such as market conditions, the price of the shares at that time and the availability of the shares for purchase.
Also, we spoke before about how using an American Depositary Receipt takes care of all the exchange rate and currency conversion problems, but there is still a catch when it comes to these things.
As we mentioned, any dividends that are paid by the foreign currency will be then converted to US Dollars before being passed on to the investor.
However, there is still a risk here as these dividends have the conversion cost and the foreign taxes involved in the transaction deducted from it and so any fluctuation that is made to the exchange rate will affect the value of the dividends too.
Example: As an investor, you have purchased shares from Alibaba at a value of 5 Yuan per share for 100 shares.
The currency exchange rate is now $0.15 per 1 Yuan which would make your annual dividend $75.
However, if the exchange rate were to depreciate in value to $0.10 per 1 Yuan, your annual dividend value will fall to $50.
Here is a great video by OTC Markets Group that you might want to watch.
TYPES OF AMERICAN DEPOSITARY RECEIPTS
Depending on your needs, you need to go for different ADR’s. We will take a look at the popular options below.
Sponsored American Depositary Receipt
A sponsored ADR is when a foreign company forms a contract with a US Depositary Bank through which they sell their shares to the US Market.
The US Depositary Bank is then responsible for the sale and distribution of shares, payment of the dividends, record-keeping, etc.
This also allows the foreign company to list their shares on the US Stock Exchanges.
Non-Sponsored American Depositary Receipt
This an ADR that is set up without the cooperation of the foreign company involved and is usually done by individual brokers/dealers who want to start a US Trading Market for those shares.
Before 2008, these ADR’s had to be registered through certain requirements that were a bit time-consuming.
However, the Securities and Exchange Commission amended a certain act that allowed these shares to be traded without registration if certain conditions were met.
Since that time, there has been a massive increase in the amount of Non-Sponsored ADR’s traded on over the counter markets, which are the only places that these ADR’s can be traded under the new act.
LEVELS OF AMERICAN DEPOSITARY RECEIPTS
Now that we know a little bit more about what an ADR is and what it can do, let’s look at the levels of ADR that are available in the market that depends on how deep the foreign company has accessed the US trading market.
Level 1 American Depositary Receipt
This is the most basic and the lowest level of ADR’s available in the market. This level is usually issued for those foreign companies that are not able to list their stocks on the stock exchange just yet or basically just do not want to.
This is mostly used by a foreign company in order to establish their presence rather than to raise capital. These ADR’s can only be traded through over the counter transactions as they are the least subject to the requirements set by the Security and Exchange Commission.
Like other publicly trading companies in the US Market, these foreign companies do not have to show a quarterly or annual report to the SEC in order to continue operations. This makes it an easier form of establishing ADR’s in the market.
These ADR’s are riskier for an investor to purchase due to the loose regulations but in terms of the company, it allows them to measure just how well their stocks are received in the US.
However, even though they do not need to be listed in the US Stock Exchange, in order for the ADR to be issued, they must first be listed in the Stock Exchange of their home country.
Also, if the foreign company decides that it wants to upgrade to Level 2, they will have to start selling on the US Stock Exchange after listing themselves.
Level 2 American Depositary Receipt
A Level 2 ADR is quite similar to the Level 1 ADR where they are mostly used only to establish a presence in the stock exchange and not properly listed and also, they cannot be used to raise capital.
The difference is that there are a few more regulations that are set on the Level 2 ADR’s such as filing a registration statement with the Securities and Exchange Commission and certain other documents.
Failing to comply with these regulations will demote the ADR back to Level 1 or may be delisted. In exchange, by moving the ADR up from Level 1 to Level 2 will give the company a higher trading volume and more visibility in the market.
This makes purchasing the ADR less risky than Level 1 as they have now signed off on certain forms that mitigate the risk passed on to the consumer of the ADR.
Level 3 American Depositary Receipt
Level 3 is the highest and most prestigious tier that a foreign company can enlist their ADR’s into. These ADR’s face a lot more regulations compared to the other two levels and everything that they do has to come with a full reporting to the Security and Exchange Commission.
They will have to sign off on more forms that will regulate their business in the country further, and even certain actions the foreign company takes back in their home country has to be reported, such as, any materials given by the company to their shareholders during this period.
In return, the company will be able to float their stocks into the market as a public offering and thus can gain a lot of financial capital from the stocks sold as well as gain a substantial presence in the trading market of the US Stock Exchange.
This is also the least risky form of stock purchasing for investors due to the constant monitoring done by the Security and Exchange Commission which can easily take away the rights of an ADR or demote it to a lower level if the foreign company goes against any of the rules set by them.
TERMINATING AN AMERICAN DEPOSITARY RECEIPT
Now that we have seen the different levels of an ADR let’s look at the procedures and impact of closing down an ADR.
Any ADR can be cancelled by either the issue (foreign company) or the depositary bank that created it for them.
Once either of this has happened, and the ADR has been requested to be terminated, the process of cancelling all the ADR’s issued will ensue.
The foreign company’s name will also be delisted from the US Stock Exchange immediately.
Just before the termination is set to take place, the investors who purchased these ADR’s must be informed first.
The foreign company will usually write to each of them stating the reason for the termination and requesting them to either give back their certification which shows their level of stock purchased or not to do anything at all.
If the investor who owns the ADR decides to give up their certificate, it will be replaced by certain foreign securities.
The owners can then find brokers who deal in these foreign markets to use these foreign securities in that region.
If the investor decides that they do not want to give up their certificate, then the depositary bank that the investor got the ADR through will hold on to it and will take the foreign securities from the foreign company and will collect the dividends that the investor receives through this and pay them back in this way.
They will, however, discontinue the sale of more ADR’s under the company’s name to these investors.
THE ADVANTAGES OF USING AN AMERICAN DEPOSITARY RECEIPT
So, what is it that makes ADR’s the preferred choice for many?
Easier to Purchase
An ADR is a much easier form of purchasing foreign stock for an investor compared to the normal process.
Any person who wants to can buy or sell these ADR’s just like purchasing normal stocks in the local US market.
They are also saving money at the same time through these transactions as the usual administrative and tax costs are much reduced by purchasing an ADR.
It’s not just the investors but the foreign company that supplies these ADR’s that benefit.
The company is given more exposure to the US market and can measure out just how well their shares are received and can gauge how well they will do if they become listed publicly in the US Stock Exchange.
The equity market in the US can be quite a wealthy market if tapped correctly, so if the foreign company is smart about the approach, they can raise quite a bit of capital and make their name more well-known among the investors in the US.
Helps to Diversify Portfolios
Purchasing ADR’s from foreign companies’ gives investors the chance to diversify their portfolios. Not all US companies are not involved in every industry or geographical area that could be beneficial to an investor.
Having these foreign ADR’s will give the investor more choice and better options to help them grow their business or earn better dividends than they would by just sticking to the local US companies.
Is More Convenient
There are also other benefits that an ADR has in terms of convenience, one of which is that an investor does not have to use a different broker than the one they were using all along.
They do not need another foreign account or have the need to find a new broker to carry out the ADR deals as their current broker should be more than capable to carry these out as the procedure is not too difficult to handle.
Save More Money
US investors can again save money and earn more because the whole ADR system is built around dollar pricing.
As we spoke about before, every transaction is done through dollars, and any dividends earned in foreign currency will be converted to US Dollars and then paid in US Dollars.
This makes forecasting, continuous transactions and reporting much easier for the local US investors.
Similar to Your Local Stock Exchange
Another advantage that an ADR has is that it is quite similar to local stock in the stock exchange as these trade at the same US market hours and so investors do not have to work separately to keep an eye on their ADR’s.
They also follow the same procedures and limitations set on the local stocks so that investors do not need to worry about treating the ADR’s differently but can instead manage it just like the local stocks in the market.
DISADVANTAGES OF AN AMERICAN DEPOSITARY RECEIPT
While ADR’s can work great for a business, there are a few points that you need to remember before using them.
Being Wary of the Exchange Rate Fluctuations
In the advantages, we mentioned that the investors could gain as all transactions are made using US Dollars.
However, this also comes with a risk in terms of exchange rate fluctuations where a depreciation in the rate will lead to losses.
The exchange rate is not always constant and usually, go through constant fluctuations.
Since an ADR will be dealing with companies from a variety of countries, there can be a lot of changes to the currencies of these different countries that can be difficult to track and will lead to losses.
You Don’t Have as Many Choices
There is a limited selection when it comes to ADR’s. An investor may want to purchase stocks from a certain big foreign company, but they may have to end up purchasing the stocks the normal way as this company may not have listed themselves as an ADR.
An ADR cannot be created without the permission of the company, so if that particular company has decided not to use this method, then the ADR will not be listed.
As of now, there are still quite a lot of these big companies that have not yet listed themselves in this way.
Stock Options May be Limited
Adding on to the previous point, there may be a few companies that have listed their ADR, but they may not have as many stock options available to trade especially in a big market like the US.
In turn, they will be very thinly traded, leading to less performing stocks.
SHOULD YOU GO FOR AN ADR?
An ADR is definitely a workable solution for purchasing stocks abroad compared to the procedures that an investor would have to go through otherwise.
There are certain risks involved, but any form of stock trading will always involve a risk so that is out-weighed by the benefits that an investor will receive by using this form of service.
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