By Phil Kernen
American Depositary Receipts (ADRs) have been around for almost 100 years, and are an efficient mechanism for investors to buy stock in foreign companies whose shares only trade outside U.S. markets. While ADRs trade like stocks, specific characteristics differ, so it is important to understand why they exist and how they work.
Why they exist
Foreign firms choosing to list their shares in U.S. markets cite several benefits: cheaper cost of capital, increased shareholder base, greater liquidity, and enhanced prestige. And NBER research found that foreign firms listed in the U.S. have higher valuations than foreign firms not listed in the U.S. But a public listing comes with compliance requirements and higher costs, including exchange, SEC registration, legal, and accounting fees. Creating depository receipts can be far more manageable and cost-efficient.
How they work
A predecessor to JPMorgan created the first ADR in 1927 to benefit Selfridges, a British department store. The foreign company contracts with a U.S. bank that agrees to buy and hold a certain number of shares in the foreign stock market. Backed by the foreign shares, the bank then issues ADRs into the U.S. stock markets on a listed exchange like the New York Stock Exchange or NASDAQ, or they may trade in over-the-counter (OTC) markets. ADRs trade in U.S. dollars, but they still are exposed to exchange rate risk that the currency in the foreign company’s country will drop relative to the U.S. dollar.
While it seems logical to offer one ADR per share of stock, the ratio may have reason to differ, such as currency relationships, and the ADR pricing accounts for the different proportions. Suppose a foreign company has a local currency share price of 150, and the exchange rate is 150/1, meaning a U.S. dollar price of $1 per ADR and a comparatively down-market image. If the company used an ADR ratio of 10:1 instead, each representing ten foreign company shares, the ADR would have a more typical $15 share price. Ratios can go in both directions. ADRs from French digital automation and energy management company Schneider Electric is worth 0.2 foreign shares, while Shell ADRs are worth two foreign shares.
Sponsored vs Unsponsored
ADRs can be sponsored or unsponsored. Sponsored ADRs include a legal agreement between the foreign company and the bank, with the former paying the costs of issuing the ADR and retaining control, while the latter handles transactions with investors. Less commonly, financial institutions, usually broker-dealers, can issue unsponsored ADRs, reflecting no direct involvement, participation, or permission from the foreign company. A second or third bank can issue unsponsored ADRs for the same foreign company, though the commercial reasons for doing so may not always be clear. Unsponsored ADRs usually do not extend shareholder benefits or voting rights.
Regulatory classifications
Though ADR issuance is less costly than a full listing on public exchanges, the SEC requires regulatory compliance and classifies ADRs into three levels based on how much reporting is expected.
Level 1 ADRs – are only used to establish a trading presence in U.S. markets (not used to raise new capital), have minimal SEC reporting requirements, and only trade on the over-the-counter markets.
Level 2 ADRs – like Level I, these are only used to establish a trading presence in U.S. markets and not to raise new capital. However, their regulatory requirements are greater, filing annual reports with the SEC and trading more broadly on national securities exchanges.
Level 3 ADRs – are required to file registration statements and annual reports with the SEC and may be used to raise capital by issuing new shares for a foreign company.
Over the last four decades, roughly one-third of foreign company initial public offerings in U.S. markets have been ADRs. They serve as a useful mechanism for U.S.-based investors looking to obtain broader exposure to foreign companies without having to transact in foreign markets.
Disclosure: This is for informational purposes only and any reference to a specific asset, does not constitute a recommendation to buy or sell that asset. The reader should not assume that an investment in the securities identified or described, was or will, be profitable. For a complete list of disclosures, please click https://mitchcap.com/
