What is an American Depositary Receipt?

Imagine you have been tracking the stock of a popular international company for months. After doing thorough research and analysis about the company's business and financials, you conclude that the stock has potential for massive returns in the long term. 

 

Now, you want to buy some shares of that company. However, you hesitate to invest because it's listed on a foreign exchange. You don't want to deal with complex processes like currency exchange and opening a foreign brokerage account. That’s where American Depository Receipts (ADR) comes into the scene. 

 

ADRs allow US investors to buy or sell stocks in foreign companies with ease. They don't have to worry about exchanging US dollars for foreign currencies or going through the tiresome process of opening a foreign brokerage account. With the help of ADRs, US stocks investors can participate in the international market and benefit from the growth of a foreign company. 

An American Depositary Receipt (ADR) is a receipt or certificate that represents a fixed number of shares of a company from another country. A US depository bank issues these certificates, and you can buy and sell them on US stock markets. US ADRs stocks trade on US markets just like other regular US stocks you see every day. However, they are not exactly the same as actual shares but are mere depository receipts. They are bought and sold in US dollars, providing the US citizens an easy way to invest in companies from around the world.

 

Foreign companies use US market ADRs as a means of raising money from American investors and establishing trading presence in the country. In return, US citizens get the opportunity to access the equity of these companies. 

ADRs are issued by an American depositary bank when a foreign company wants to list its shares on a US stock exchange. For example, Infosys wants to list its shares on the New York Stock Exchange. The Indian firm works with a US depository bank, State Street Corporation, to create ADRs. The American depository bank buys shares of Infosys on Bombay Stock Exchange and then issues ADRs to investors in the US. The bank can also contact its business counterpart in India to buy the specified number of Infosys shares.

 

Now, Infosys ADR is available for US investors. Once they buy the Infosys ADR, they can sell it on a US stock exchange or the over-the-counter market. They can also surrender their ADRs in exchange for receiving Infosys shares. An ADR can represent a fraction of a share, a single share, or multiple shares. If Infosys issues dividends to its shareholders, inventors who have Infosys ADR in their portfolio become eligible for the payment which will be in dollars. Some of the popular Indian firms that have their US ADR stocks listed on US exchanges include Wipro, Infosys, Tata Motors, HDFC Bank, ICICI Bank and others.

 

ADRs can trade in the US both on national exchanges and in the over-the-counter (OTC) market. OTC is a decentralised system of trading securities that takes place outside of a formal exchange. In this, buyers and sellers connect directly with each other to negotiate prices and close trades of US ADR stocks.

Different foreign companies may have different ratios of shares attached to one ADR. However, each ADR representing shares of a company will be the same. When a company starts an American Depositary Receipts (ADR) list program, there are three types to choose from. Each type has different levels of listing exposure and reporting requirements.

1. Types of ADRs

There are two types of ADRs that US investors can trade:

 

• Sponsored ADRs: In a sponsored ADR, the foreign company that wants to sell shares enters into an agreement with a US bank. This deal lets the company sell its shares in the US. The bank then takes care of all the paperwork, selling the shares to people, and distribution of dividend earnings from the shares. The foreign company takes care of the costs involved in creating and issuing ADRs. They also control the ADRs after they have been issued. Sponsored US ADRs stocks can be traded on US stock exchanges.

• Non sponsored ADRs:  Now, non-sponsored ADRs are a bit different. They're created by brokers or dealers without the foreign company whose shares they represent being involved. These US market ADRs can be traded in US OTC markets without needing to go through the process of registering with the Securities and Exchange Commission. They are issued in response to market demands.

2. Levels of ADRs

There are three levels of American Depository Receipts (ADRs):

 

• Sponsored Level 1 ADR: Level 1 ADR is the first and simplest level. At this level, the company's ADRs can only be bought and sold in the OTC market and not on any US exchange. Also, the foreign company doesn't have to share a lot of information with the US Securities and Exchange Commission (SEC) or regularly issue reports about their business. However, it does need to publish an annual report on their website in English. These types of ADRs are considered to be risky among investors. They are used by foreign firms to show their presence in the US ADR stock market, but not to raise capital from US investors. For Level I issuers, it is required that their stock is listed on one or more stock exchanges in their home country.

• Sponsored Level 2 ADR: Similar to Level 1 ADRs, foreign companies can use Level 2 ADRs (American Depositary Receipts) to make their presence known in the US market, but they can't use them to get money from US investors. One benefit though, is that Level 2 ADRs can be listed on a stock exchange. However, the SEC, which oversees the securities and stock market in the US, keeps a closer eye on these types of ADRs. They have to be registered with the SEC, and the company has to file a special report every year. This report has to follow US accounting rules. The company also has to meet the requirements set by the stock exchange where they list their ADRs.

• Sponsored Level 3 ADR: Think of Level 3 as the gold standard. It's the highest level a foreign company can reach. At Level 3, the rules are even stricter, just like they are for US companies. At this stage, a foreign company can offer US Market ADRs to the public in the US to raise money from American investors through US stock exchanges. A lot of the major international firms with US ADRs stocks are at Level 3. That said, with great power comes great responsibility. So, foreign companies need to comply with the regulations set by US authorities that apply to US businesses. At Level 3, foreign companies need to fill out two forms: Form F-1 and Form 20-F. They also have to follow either US accounting rules (GAAP) or international ones (IFRS).

ADRs offer several benefits to investors, including:

 

• User-friendliness: One of the top advantages of ADRs for investors is their user-friendliness. For instance, a US investor wanting to invest in a Japanese company avoids the need for a Japanese brokerage account and the currency exchange headaches from USD to Euros.

• Diversification: ADRs provide access to a variety of geographic regions, industries, and markets. This can offer different growth potentials and risk aspects compared to the US market.

• Divided perks: All foreign company dividends are distributed in US dollars to ADR holders. This means investors don't have to worry about converting dividends from local currency to US dollars. The ADR issuer handles all currency-related matters.

• Greater transparency: ADRs operate under stringent US market regulations, ensuring more transparency. Also, US ADR holders receive timely notifications in English regarding any corporate actions against foreign firms, rather than late notices in a foreign language.

• Fees associated with ADRs: Investing in American Depositary Receipts (ADRs) comes with unique fees distinct from regular domestic stocks. The depositary bank charges a custody fee, typically ranging from 1-3 cents per share, to cover the costs of creating and managing ADRs. This fee, detailed in the ADR prospectus, is often subtracted from dividends or sent to the investor's brokerage firm.

• Tax Aspects of ADRs: ADRs have unique tax considerations. Dividends and capital gains are in US dollars, but they are net of currency conversion costs and foreign taxes, usually withheld by the depositary bank. To avoid double taxation on capital gains, American investors may seek a credit from the IRS or a refund from the foreign tax authority.

ADRs are US dollar-denominated certificates that track the price of a foreign company's shares. Though it represents the price of those shares, it doesn't give you the same ownership rights as you'd get if you actually owned the company's shares.

 

If an ADR is available on a stock exchange, you can buy and sell it just like any other share through a broker. Also, the price of the US ADR stock is in US dollars. It gives US investors a chance to invest in foreign companies and benefit from it, without having to deal with overseas accounts and different currencies.

American Depository Receipts (ADRs) can be a great choice for US investors who want to invest in foreign companies. They offer a number of benefits, including convenience, transparency, and liquidity. However, it is important to understand the risks involved before investing in American depositary shares. You should do your homework before you dive in. 

 

Do proper research about the foreign company's financials, its future prospects and what the future might look like in the country where the company is based. This will help you understand the things that may affect the company's results and share price.