INTRODUCTION

Introduced to the financial markets in 1927, an American depositary receipt (ADR) number of shares in a foreign corporation . ADRs are bought and sold on American markets just like regular stocks, and are issued/sponsored in the U.S. by a bank or brokerage. A negotiable certificate issued by a U.S. bank representing a specified number of shares (or one share) in a foreign stock that is traded on a U.S. exchange. ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution overseas. ADRs help to reduce administration and duty costs that would otherwise be levied on each transaction.

Definition

A negotiable certificate issued by a U.S bank representing a specific number of shares of a foreign stock traded on a U.S. stock exchange ADRs make it easier for Americans to invest  in foreign  companies, due to the widespread availability of dollar-denominated price information, lower transaction costs, and timely dividend distributions. 

An American depositary receipt (ADR and sometimes spelled depository) is negotiable security that represents securities of a non-U.S. company that trades in the U.S. financial market.

Shares of many non-U.S. companies trade on U.S. stock through ADRs, which are denominated and pay dividends in U.S DOLLAR and may be traded like regular shares of stock. ADRs are also traded during U.S. trading hours, through U.S. brokers dealers. They simplify investing in foreign securities by having the depositary bank "manage all custody, currency and local taxes issues".

The first ADR was introduced by J.P.MORGAN in 1927 for the British retailer Selfridges on the New York Curb Exchange, the American stock exchange precursor.

They are the domestic equivalent of a global depository receipt (GDR). Securities of a foreign company that are represented by an ADR are called American depositary shares (ADSs).

ADRs were introduced as a result of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. For this reason, U.S. banks simply purchase a bulk lot of shares from the company, bundle the shares into groups, and reissues them on either the  New York stock exchange (NYSE), American stock exchange (AMEX) or the NASDAQ. In return, the foreign company must provide detailed financial information to the sponsor bank.

The depositary bank sets the ratio of U.S. ADRs per home-country share. This ratio can be anything less than or greater than 1. This is done because the banks wish to price an ADR high enough to show substantial value, yet low enough to make it affordable for individual investors. Most investors try to avoid investing in penny stocks, and many would shy away from a company trading for 50 Russian roubles per share, which equates to US$1.50 per share. As a result, the majority of ADRs range between $10 and $100 per share. If, in the home country, the shares were worth considerably less, then each ADR would represent several real shares.

There are three different types of ADR issues:

Level 1 - This is the most basic type of ADR where foreign companies either don't qualify or don't wish to have their ADR listed on an exchange. Level 1 ADRs are found on the over-the-counter market and are an easy and inexpensive way to gauge interest for its securities in North America. Level 1 ADRs also have the loosest requirements from the securities and exchange commission(SEC)  

Level 2 - This type of ADR is listed on an exchange or quoted on NASDAQ. Level 2 ADRs have slightly more requirements from the SEC, but they also get higher visibility trading volume.  

Level 3 - The most prestigious of the three, this is when an issuer floats a Public offering of ADRs on a U.S. exchange. Level 3 ADRs are able to raise capital and gain substantial visibility in the U.S. financial markets.

Depositary receipts

ADRs are one type of depository receipt (DR), which are any negotiable receipt that represent securities of companies that are foreign to the market on which the DR trades. DRs enable domestic investors to buy securities of foreign companies without the accompanying risks or inconveniences of cross-border and cross-currency transactions.

Each ADR is issued by a domestic custodian when the underlying shares are deposited in a foreign depository bank, usually by a broker who has purchased the shares in the open market local to the foreign company. An ADR can represent a fraction of a share, a single share, or multiple shares of a foreign security.

The holder of a DR has the right to obtain the underlying foreign security that the DR represents, but investors usually find it more convenient to own the DR. The price of a DR generally tracks the price of the foreign security in its home market, adjusted for the ratio of DRs to foreign company shares. In the case of companies domiciled in the united kingdom, creation of ADRs attracts a 1.5% stamp duty reserve tax charge by the UK government. Depositary banks have various responsibilities to DR holders and to the issuing foreign company the DR represents.

Sourcing ADRs

One can either source new ADRs by depositing the corresponding domestic shares of the company with the depositary bank that administers the ADR program or, instead, one can obtain existing ADRs in the secondary market. The latter can be achieved either by purchasing the ADRs on a U.S. stock exchange or via purchasing the underlying domestic shares of the company on their primary exchange and then swapping them for ADRs; these swaps are called "crossbook swaps" and on many occasions account for the bulk of ADR secondary trading. This is especially true in the case of trading in ADRs of UK companies where creation of new ADRs attracts a 1.5%stamp duty reserve tax charge by the UK government; sourcing existing ADRs in the secondary market (either via crossbook swaps or on exchange) instead is not subject to SDRT.

Risk involved

There are several factors that determine the value of the ADR beyond the performance of the company. Analyzing these foreign companies involves further scrutiny than merely looking at the fundamentals. Here are some other risks that investors should consider:

Political Risk - Ask yourself if you think the government in the home country of the ADR is stable? For example, you might be wary of Russian Vodka Inc. because of the characteristic instability of the Russian government.  

Inflationary Risk- This is an extension of the exchange rate risk. Inflation is the rate at which the general level of prices for goods and services is rising and, subsequently, purchasing power is falling. Inflation can be a big blow to business because the currency of a country with high inflation becomes less and less valuable each day.

ADVANTAGE OF AMERICAN DEPOSITORY RECEIPT

The advantages of ADRs are twofold. For individuals, ADRs are an easy and cost-effective way to buy shares in a foreign company. They save money by reducing administration costs and avoiding foreign taxes on each transaction. Foreign entities like ADRs because they get more U.S. exposure, allowing them to tap into the wealthy North American equities markets.

Finding Investors

American Depositary Receipts provide a foreign corporation an alternative to cross listing the company. Multinational corporations that require large amounts of money for investment often register stocks on exchanges in several countries. The multinational corporation then has to meet the requirements to trade on each nation's exchange, including the financial reporting and disclosure requirements and the regulations which apply to offering shares. According to the University of Massachusetts, Boston, foreign corporations are less willing to sell shares on American stock exchanges because of laws that regulate financial instruments.

Registration Exemptions

Exemptions from the Securities and Exchange Act apply to some American Depositary Receipts. According to the University of Cincinnati, a foreign corporation may not have to register stock shares in the United States if less than 300 Americans hold shares in the company. American Depositary Receipts allow people in the United States to invest in the company without going through the full registration and reporting process. The corporation must still follow the registration and reporting requirements for the main exchange on which its stock trades.

Diversification

American Depositary Receipts provide U.S. investors the opportunity to diversify their portfolios. Some organizations, such as government agencies, pensions, and other firms that are required to make conservative investments, might not want to directly purchase stocks on foreign exchanges. With an ADR, the U.S. investor makes a contract to purchase a claim on the ownership of a foreign stock from a United States bank, which is subject to U.S. regulations.

Liquidity

Stocks that trade using American Depositary Receipts have more liquidity than stocks that trade on the foreign exchange alone, which means there are more opportunities to buy and sell claims on these shares.

According to the University of Houston, many exchanges in foreign countries are subject to restrictions on the inflows and outflows of foreign capital. Since the stock never changes ownership on the foreign stock exchange when trading through an American Depositary Receipt, traders can bypass foreign investment restrictions

DISADVANTAGE

1) Foreign exchange risk  It is important to bear in mind that although your investment is valued in US dollars, and dividends are paid in that currency, the underlying investment is still exposed to foreign exchange fluctuations which can significantly increase the overall volatility of your financial return.  Investors should be wary of investing in countries which have historically experienced large swings in exchange rates, hyper-inflationary economies or currency revaluations.   Even so, you will still be exposed to changes in the value of the US dollar.

2) Selection choice  Unfortunately, not every foreign company makes it stock available through this method, often because they do not feel it is necessary to access US markets in this way.  You may, therefore, encounter a situation where there is a sector or geographical area that you wish to invest in, but your first choices do not offer this type of investment vehicle.

3) Illiquidity  Even if a company does offer this type of instrument, trading may be thin (especially if the company is not well-known in the United States) and, as a result, it could be difficult to either acquire or dispose of the investment in accordance with your desired timelines.  Accordingly, these investments may not be suitable unless you are looking to hold them for the long-term.

4) Diversification risk  As with other investments, it is important to diversify appropriately. If you lack sufficient capital to invest in a reasonable number of these instruments (e.g. more than 20), then you will not be adequately diversified.  As noted above, because of scarcity and illiquidity of these instruments, diversification is made somewhat more difficult to accomplish.

5) Withholding and other taxes  As the underlying investment is overseas, the country where the business operates may withhold taxes on dividend payments.  In the UK, American Deposit Receipts also attract a 1.5% stamp duty reserve tax. Although, in most cases, you will be able to receive a tax credit to offset these amounts, there will still be a timing delay compared to receiving dividends on a gross basis from a domestic company.

6) Additional fees The holding vehicle for the underlying shares incurs a number of incremental expenses in managing the entire process, compared to regular stocks, and will pass these on to the investor – usually by deducting them from dividends.

7) Documentation flow  A relatively minor point, but one to be aware of, is that the flow of regulatory documents, such as proxies, may be delayed as they are routed via the holding company of the underlying shares.  In most cases, this is not expected to cause significant issues.

ADR termination

Most ADR programs are subject to possible termination. Termination of the ADR agreement will result in cancellation of all the depositary receipts, and a subsequent delisting from all exchanges where they trade. The termination can be at the discretion of the foreign issuer or the depositary bank, but is typically at the request of the issuer. There may be a number of reasons why ADRs terminate, but in most cases the foreign issuer is undergoing some type of reorganization or merger.

Owners of ADRs are typically notified in writing at least thirty days prior to a termination. Once notified, an owner can surrender their ADRs and take delivery of the foreign securities represented by the Receipt, or do nothing. If an ADR holder elects to take possession of the underlying foreign shares, there is no guarantee the shares will trade on any U.S. exchange. The holder of the foreign shares would have to find a broker who has trading authority in the foreign market where those shares trade. If the owner continues to hold the ADR past the effective date of termination, the depositary bank will continue to hold the foreign deposited securities and collect dividends, but will cease distributions to ADR owners.

Usually up to one year after the effective date of the termination, the depositary bank will liquidate and allocate the proceeds to those respective clients. Many US brokerages can continue to hold foreign stock, but may lack the ability to trade it overseas.