American Depository Receipts (ADRs)

American Depository Receipts (ADRs) are stocks of foreign companies that trade on US exchanges. They are not really stocks but I will come back to that slightly latter. For the moment, let's consider them as stocks. The first question that we need to tackle is: why are foreign companies listing their shares in USA? Well! the answer is: to access the largest capital market in the world. The size of the US capital market is around 40% of the total size of the world capital market. Capital markets comprise of both equity and fixed income markets. The size of the US equity market is $32 trillion out of the $85 trillion global market; and the size of the US fixed income market is $39 trillion out of the $100 trillion globally. The numbers for both the markets are as on 2019.

The second question is: why cannot US citizens just invest in stocks of other countries by opening accounts with brokers in other countries. Well! they cannot do that so easily for four reasons - first, the US Securities and Exchange Commission (SEC) does not provide a blanket permission to US citizens and residents to directly invest in stocks of other countries as they want to protect its citizens and residents from fraudulent companies situated outside their jurisdiction; second, the foreign companies regulators may prohibit such investments from US; third, it is illegal under US SEC rules for foreign companies or brokers to contact a U.S. investor and solicit an investment unless the broker is registered with the SEC; fourth, the US investor will face foreign exchange risk on his investment.

Due to the above complexities involved, its not worth the effort for US citizens to directly invest in foreign securities by opening accounts with foreign brokers. Luckily, there are other methods which are very simple. US investors can gain exposure to international investments through any of the following ways:

1. U.S. registered mutual funds
2. U.S. registered ETF
3. American Depository Receipts (ADRs)
4. U.S. traded foreign stock

The following paragraphs provide a brief of the above.

U.S. registered mutual fund
There are different kinds of U.S registered mutual funds that invest in foreign securities, including: global funds (that invest primarily in foreign companies, but may also invest in U.S companies); international funds (that invest in companies outside of the United States); regional or country funds (that invest primarily in a particular region or country); or international index funds (that seek to track the results of a particular foreign market or international index). Investing through US registered mutual funds may reduce some of the potential risks of investing internationally because mutual funds may provide more diversification that most investors could achieve on their own and they are subject to U.S. regulations protecting investors.

U.S. registered exchange-traded funds (ETFs)
A U.S. registered exchange traded funds can offer similar benefit as U.S. registered mutual funds. A share in an ETF that tracks an international index seeks to give an investor exposure to the performance of the underlying international or foreign stock or bond portfolio along with the ability to trade the ETF shares like any other exchange-traded security. An actively managed ETF that invests in non-U.S. assets can also give an investor international exposure along with the same ability to trade the ETF shares like any other exhchange traded security.

U.S. traded foreign stock
Although most foreign stocks trade in the U.S. markets as ADRs, some foreign companies list their stocks directly on the U.S. exchanges. For example, many canadian stocks are listed and traded both on Canadian and U.S. exchanges.

American Depository Receipts (ADRs)
Apart from the above three methods, the ADR method is the fourth method that can be used for international investing. ADRs were created so that investors could avoid the complexities of buying foreign stocks. If you want to buy a foreign stock that's not offered as an ADR, you have to exchange your U.S dollars for foreign currency, open a foreign brokerage account, and then purchase the foreign security on a foreign exchange (which maybe on a different time zone). In addition, the exchange rate on the U.S. dollar would change throughout this whole process. ADR route of investing avoids this whole process and makes the entire process of investing in foreign stocks just like investing in local stocks.

ADRs allow U.S. investors to invest in non-U.S. companies and give non-US companies easier access to the U.S. capital markets. Many non-U.S. issuers use ADRs as a means of raising capital or establishing a trading presence in the U.S. The non-U.S. company may sometimes be referred to as a "foreign private issuer". The first ADR was created in 1927 by a U.S. bank to allow U.S. investors to invest in shares of a British department store. Currently, there are more than 2,500 ADRs available representing shares of companies located in more than 40 countries.

An ADR is a negotiable certificate that evidences an ownership interest in American Depository Shares (ADS), which, in turn, represents an interest in the shares of a non-U.S. company that have been deposited with a U.S. bank. It is similar to a stock certificate representing shares of a stock. The terms ADR and ADS are often used interchangeably by market participants. ADRs trade in U.S. dollars and clear through U.S. settlement systems, allowing ADR holders to avoid have to transact in foreign currency.

How are ADRs created and traded

ADRs are created when a non-US company (foreign company from US perspective) or an investor who holds the underlying foreign securities delivers them to either a "depository" bank in the U.S. or a custodian in the foreign company's home country. The depository or custodian, upon receipt of such shares, creates negotiable receipts which are called as American Depository Receipts or ADRs, in short. These receipts can be traded just like shares. They are, generally, listed on stock exchanges and traded.

The ADRs are quoted in US dollars so that US investors can buy them with their own currency without any foreign exchange involved.

One ADR represent a certain number of equity shares in the foreign company. For example, one ADR can represent 1 share in the foreign company, or 10 shares in the foreign company or 0.5 shares of the foreign company. The ratio of the ADR to the underlying foreign share depends on various factors and the investment bank or the depository or custodian creating such ADRs take care of such issues.

ADRs are, generally, two-way fungible securities - that means investors holding foreign stocks can convert them into ADRs or investors holding ADRs can convert them back into foreign stocks.

Types of ADRs

There are two types of ADRs, as follows:

1. Sponsored ADRs
2. Unsponsored ADRs

Sponsored ADRs
Sponsored ADRs are those for which the foreign company has negotiated directly with the U.S depository bank.

Unsponsored ADRs
Unsponsored ADRs are those which have been created without the foreign company's cooperation. Any registered broker or investment banker can create such unsponsored ADRs when they wish to create a U.S. trading market in such foreign security.

Levels of ADRs

There are three levels of ADRs, as follows.

1. Level 1
2. Level 2
3. Level 3

Level 1
The Level 1 type ADR establish a trading presence in the U.S. but cannot be used to raise capital. It is the only type that may be unsponsored and, as a result, may be traded only on the "over-the-counter market". Since the foreign company has not participated in the creation of this type of ADR, no information about the it would be available on the SEC's EDGAR system. Investors may be exposed to higher risks in this kind of an ADR compared to other ADRs as the SEC has no jurisdiction on such issuer and cannot protect the investors in case of any fraud.

Level 2
The Level 2 type ADR can be listed on national exchanges and traded just like local stocks but it cannot be used to raise capital. This type of ADR must have to be sponsored in nature, particularly because retail investors would be trading when the ADRs are listed on stock exchanges. The foreign company is required to register and file annual returns with the SEC.

Level 3
The Level 3 type of ADR can be used not only to establish a trading presence, but also to raise capital. This type of ADR can only be a sponsored ADR. The foreign company is required to register and file annual returns with the SEC.

Are there any fees to ADRs apart from brokerage?

The depository bank or the custodian may charge certain fees, called as custody fees, for the work it performs on the ADR. The fee includes services rendered by the depository bank such as registration, compliance, dividend payment, communication and record keeping.

One common practice is to deduct these fees from the gross dividends paid to the ADR holders, whenever dividends are declared. Typically, the depository will announce both the gross dividend rate and the net dividend rate after deduction of the ADR custody fees. If no dividends are declared, then the fees is collected from the banks or users directly. It is possible that the depositories may collect other fees apart from custody fees, such as relating to distribution of dividends, foreign currency exchange, voting of shares and other such aspects.

END OF MY NOTES