InvestorQ : I hear a lot of discussion on American depository receipts (ADRs). Can you help me understand what are these ADRs and how are they useful to investors?
Arti Chavan made post

I hear a lot of discussion on American depository receipts (ADRs). Can you help me understand what are these ADRs and how are they useful to investors?

2 years ago

American depository receipts or ADRs are a form of equity security that was created specifically to simplify foreign investing for American investors. An ADR is issued by an American bank or broker. It represents one or more shares of foreign-company stock held by that bank in the home stock market of the foreign company. The ratio of foreign shares to one ADR will vary from company to company, but each ADR for any one company will represent the same number of shares. ADRs may be listed on a major exchange such as the New York Stock Exchange or may be traded over the counter (OTC). Those that are listed can be traded, settled, and held as if they were ordinary shares of U.S.-based companies. In addition to ADRs, Global Depositary Receipts (GDRs) give issuers exposure to the global markets outside their home market. GDRs are offered to investors in 2 or more markets and are most commonly used to raise capital in Europe and the United States. Both ADRs and GDRs are usually denominated in U.S. dollars, but may also be denominated in Euros.

ADR investors are not subject to non-U.S. stock transaction taxes. And for those countries that maintain tax treaties with the U.S., dividends are paid without foreign withholding. However, like investment gains or income from domestic securities, proceeds from an ADR holding may be subject to U.S. income or capital gains taxes and may be subject to backup withholding. Foreign companies that sponsor listed ADR programs in the United States issue financial reports in English, and these reports generally conform to U.S. accounting conventions. These companies also file required disclosure statements with the Securities and Exchange Commission. It is a stringent process and only the companies that meet all U.S. reporting and disclosure rules are permitted to raise capital directly from U.S. investors by issuing new stock specifically to be represented by ADRs. Companies that meet a more limited set of SEC reporting requirements are permitted only to sponsor ADRs that represent shares previously issued in their home markets.

There are different levels of ADR programs

When a company establishes an ADR program, there are 3 different types of programs, or facilities, from which it can choose. Levels differ in terms of their listing exposure and reporting requirements.

Level 1 is the lowest level of an ADR program. Under a Level 1 program, shares can only be traded on the OTC market and the issuing company has minimal reporting requirements with the U.S. Securities and Exchange Commission (SEC). The company is not required to issue quarterly or annual reports; however, it must publish in English on its website its annual report in the form required by the laws of the country of incorporation.

Level 2 ADRs can be listed on a U.S. stock exchange. But shares must be registered with the SEC, and the company is required to file an annual report (on Form 20-F, not Form 10-K) that conforms to U.S. generally accepted accounting principles (GAAP) standards. It must also meet the exchange's listing requirements.

Level 3 is the highest level of an ADR program and requires the issuing company to meet even stricter reporting rules that are similar to those followed by U.S. companies. With a Level 3 program, companies can issue shares to raise capital rather than just list existing shares on a U.S. exchange. Many of the largest companies with ADR programs are Level 3.

In rare cases, a U.S. bank or broker may create an ADR without the support of the company that issued the underlying stock. However, these securities—referred to as unsponsored ADRs—cannot be offered for sale to individual investors in the United States unless the foreign company files appropriate financial reports with the SEC or requests an exemption under Section 12g3-2(b). The SEC maintains a list of all 12g3-2(b)-qualified companies.

Understanding the risk factors of an ADR and other nuances

Because ADRs are issued by non-U.S. companies, they entail special risks inherent to all foreign investments. Some of the key risk factors are highlighted here:

· Exchange rate risk—the risk that the currency in the issuing company’s country will drop relative to the U.S. dollar

· Political risk—the risk that politics or regime changes in the issuing company’s country will undermine exchange rates or destabilize the company and its earnings

· Inflation risk—the risk that inflation in the issuing company’s country will erode the value of that currency

· Depending on the level of the ADR program, investors also may not have access to the amount of information available on domestic companies, although Level 2 and 3 listings must meet reporting requirements that approach that of domestic companies.

· Some ADRs are subject to periodic service fees, or "pass-through fees," intended to compensate the agent bank for providing custodial services. These charges, if any, generally run Rs.0.01 to Rs.0.03 per share. Information on any such fees should be available in the ADR prospectus. For ADRs that do levy this fee, it may be deducted from the dividend, if the company pays one, or it may appear as a separate fee on your monthly statement.