American Depositary Receipts — Rule 144A Depositary Receipts

Buying stock in a foreign company is not only another way to diversify your portfolio, but some of the best growth opportunities may be in other countries, especially developing nations, such as China or India. However, investing directly in foreign companies is expensive, risky, and problematic because of the foreign language, and different foreign exchange and accounting rules. American Depositary Receipts simplifies investing in a foreign company.

First created in 1927 by J.P. Morgan, to make it easier for Americans to invest in the British retailer Selfridge, American Depositary Receipts (ADR), also sometimes called American Depository Receipts, are certificates which represent the stocks of a foreign company, but are listed on American stock exchanges or over-the-counter, and all transactions are in U.S. dollars, and all communications are in English. This makes it easier for Americans to invest in foreign companies without worrying about currency exchange rates, foreign stock exchange rules, and foreign languages. Price information is more readily available and transaction costs are lower.

One ADR certificate may represent 1 or more shares of the foreign stock, or if the stock is expensive, then the ADR may represent a fraction of a share, so as to give the ADR an initial moderate price, or be in the range of similar securities on the exchange where the ADR will be listed. The ratio of company stock to its ADR can range from 100,000:1 to 1:100. Because many ADRs don't have a one-to-one ratio between the depositary receipts and the shares of stock, financial ratios are often not included in stock listings.

Rule 144A Depositary Receipts are special ADRs that can only be sold to Qualified Institutional Buyers as a private placement and are not subjected to the same rules and regulations as ADRs. A Qualified Institutional Buyer is an institutional investor that can trade privately placed unregistered securities with other qualified institutional buyers. Consequently, these cannot be bought on the public exchanges or over the counter.

Depositary receipts can, of course, be created and sold in other countries, using the native language for communications and the native currency for monetary exchanges, and thus, are sometimes called Global Depositary Receipts (GDR) or European Depositary Receipts (EDR) if such receipts are sold in Europe. Companies can create and sell depositary receipts in several countries to broaden their base of investors, to increase awareness of their company, to raise capital, and to provide more liquidity. Receipts can also be used as currency for mergers and acquisitions in those countries where receipts are available, or as stock option alternatives for employees of a U.S. subsidiary of the foreign company.

How ADRs are Created — Sponsorship Levels 1, 2, 3

ADRs may be sponsored or unsponsored; however, unsponsored ADRs are increasingly rare and cannot be listed on the major American stock exchanges because they are not registered with the SEC, and lack other necessary qualifications. An unsponsored ADR is created by a U.S. investment bank or brokerage that buys the shares in the country where the shares trade, deposits them in a local bank—the custodian bank, which is often a branch of a U.S. bank, called the depositary bank (aka depository bank). The depositary bank then issues shares that represent an interest in the stocks and handles most of the transactions with the American investors, serving both as transfer agent and registrar for the ADR. The shares of the foreign stock that are held in the custodian bank are called American Depositary Shares (ADS), although this term is sometimes used as a synonym for ADRs.

Most often, the company will sponsor the creation of its own ADR, in which case it is a sponsored ADR. There are 3 levels of sponsorship.

A Level 1 sponsored ADR is created by the company to extend the market for its securities to this country, but without needing to register with the SEC, or conforming to generally accepted accounting principles (GAAP). Consequently, this ADR can only be traded in the OTC Bulletin Board or Pink Sheets trading systems, usually by institutional investors. These ADRs have more risk, and it is more difficult to compare a Level I ADR with other investments, because of the differences in accounting.

Level 2 and Level 3 sponsored ADRs must register with the SEC, and financial statements must be reconciled to GAAP. A Level 2 ADR requires partial compliance with GAAP, while a Level 3 ADR requires complete compliance. A Level 3 sponsorship is required, if the ADR is a primary offering and is used to raise capital for the company. Only Level 2 and Level 3 sponsored ADRs can be listed on the New York Stock Exchange, the American Stock Exchange, or NASDAQ.

How ADRs Work

The price of ADRs in the secondary market are, of course, determined by supply and demand, but the price will not deviate too much from the price of the underlying stock. If the ADR is trading at a higher price than the equivalent foreign shares of the company, then more shares of the company will be bought and held in the custodian bank, and more ADRs will be created. If the ADR trades below the equivalent price, then some ADRs will be canceled, and the corresponding shares of the company will be released by the custodian bank. This maintains parity between the price of the ADR and the foreign shares, after accounting for the currency exchange rate.

When dividends are paid, the custodian bank receives it and withholds any foreign taxes, exchanges it for U.S. dollars, then sends it to the depositary bank, which then sends it to the investors. The depositary bank, being a U.S. bank, handles most of the interaction with the U.S. investors, such as rights offerings, stock splits, and stock dividends, but sponsored ADR investors may receive communications, such as financial statements, directly from the company. The largest United States depositary banks are the Bank of New York, J.P. Morgan, and Citibank.

Note, however, that although ADR transactions are in U.S. currency, there still is a currency exchange risk. If the dollar falls, for instance, then the amount of dividend in U.S. dollars will be reduced, and the market price of the ADR will drop. There is also political risk because the ADR still derives its value from the foreign stock, which could be adversely affected by unfavorable changes in the politics or the law of the country.

The Bank of New York ADR Index

The Bank of York, a major issuer of depositary receipts, publishes a real-time, market-capitalization ADR index. The Composite ADR index lists all ADRs of more than 450 companies from 39 countries listed on the NYSE, AMEX, and NASDAQ. There are also numerous subsets of the Composite ADR index:

3 Regional Indexes4 Market Indexes3 Sector Indexes8 Select Indexes
  1. Europe
  2. Asia
  3. Latin America
  1. Developed
  2. Emerging
  3. Euroland
  4. Telebras
  1. European Telecom
  2. Latin Telecom
  3. European Oil and Gas
  1. International 100
  2. Europe 100
  3. Developed Markets 100
  4. Asia 50
  5. Emerging Markets 50
  6. Latin America 35
  7. International Telecom 35
  8. BRIC Select

There are also 39 country indexes.

Index Adjustments and Rebalancing — New depositary receipts are added quarterly, and removed when delisted. The index is rebalanced quarterly—after the 3rd Friday of March, June, September, and December—but is also rebalanced anytime the market capitalization of an ADR changes by at least 10%.

ADR Risks and Disadvantages

ADRs do have some risks besides the risk that affect all stocks. Currency fluctuations are a major risk. Even though the American investor can deal in US dollars, the value of the ADR will fluctuate along with the currency exchange rate between the US dollar and the currency of the company's country. Another major risk is political risk. The enactment of unfavorable tax laws or other laws that may have an adverse effect on the flow of capital or on investments can also lower the value of the ADR. Political instability and corruption can also have a major influence on ADR prices. Generally, ADRs from more stable countries, such as Japan, will tend to fluctuate less than ADRs from unstable countries, such as Russia.

Another drawback to some ADRs is that some have agreements that allow brokers to charge additional fees in addition to the regular transaction charges, which will lower potential returns.

Nonetheless, for the astute investor, there are many more opportunities in the foreign markets than in the domestic market and ADRs do simplify investing in the foreign markets.