What is an American Depositary Receipt – ADR?
A US deposit receipt (ADR) is a negotiable certificate issued by a US custodian bank representing a specified number of shares – or as little as one share – for investment in the shares of a foreign company. ADR is traded in the United States markets like any other security.
ADRs are a liquid and workable means for American investors to buy shares in companies abroad. Foreign companies also benefit from ADRs, as they facilitate the attraction of American investors and capital, without the hassle and costs of listing on American stock exchanges. The certificates also give access to foreign listed companies which would not otherwise be open to American investments.
Introduction to ADR of American certificates of deposit
How do American certificates of deposit – ADR work?
ADRs are denominated in US dollars, the underlying security being held by a US financial institution abroad. ADR holders do not have to transact in foreign currencies or worry about exchanging currencies on the foreign exchange market. These securities are cleared by the American settlement systems.
To offer ADRs, a US bank will buy shares in a foreign currency. The bank will keep the stock in stock and issue an ADR for internal trade. ADRs are listed on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX) or Nasdaq, but they are also sold over the counter (OTC).
US banks require foreign companies to provide them with detailed financial information. This requirement makes it easier for American investors to assess the financial health of a business.
Key points to remember
- A US deposit receipt (ADR) is a certificate issued by a US bank that represents foreign stocks.
- ADRs are traded on American exchanges.
- ADRs and their dividends are denominated in US dollars.
- ADRs are an easy and liquid way for American investors to hold foreign stocks.
Types of ADR
American certificates of deposit fall into two basic categories:
- A bank issues a sponsored ADR on behalf of the foreign company. The bank and the company conclude a legal agreement. Usually, the foreign company will pay the costs of issuing an ADR and keeping control over it. While the bank will handle transactions with investors. Sponsored ADRs are classified according to the degree of compliance of the foreign company with the regulations of the Securities and Exchange Commission (SEC) of the United States and with the American accounting procedures.
- A bank also issues an unsupervised ADR. However, this certificate has no direct involvement, participation or even authorization from the foreign company. Theoretically, there could be more than one unsponsored ADR for the same foreign company, issued by different US banks. These different offers can also offer variable dividends. With sponsored programs, there is only one ADR, issued by the bank working with the foreign company.
One of the main differences between the two types of ADR is where investors can buy them. All but the lowest level of sponsored ADRs register with the SEC and trade on major US exchanges. Non-sponsored ADRs will only be negotiated over the counter. In addition, non-sponsored ADRs never include the right to vote.
ADRs are further classified into three levels, depending on the extent to which the foreign company has entered the US markets:
- Level I – This is the most basic type of ADR in which foreign companies do not meet the required conditions or do not want their ADR to be listed on the stock market. This type of ADR can be used to establish a commercial presence but not to raise capital. Level I ADRs found only in the over-the-counter market have the most flexible requirements of the Securities and Exchange Commission (SEC) – and they are generally very speculative. Although they are more risky for investors than other types of ADR, they are a simple and inexpensive way for a foreign company to assess the value of its securities in the United States.
- Level II – As with level I ADRs, level II ADRs can be used to establish a commercial presence on the stock exchange and cannot be used to raise capital. Level II ADRs have slightly more SEC requirements than Level I ADRs, but they achieve higher visibility and trading volume.
- Level III – Level III ADRs are the most prestigious of the three ADR levels. With these, an issuer launched a public ADR offer on an American stock exchange. They can be used to establish a substantial commercial presence in the US financial markets and raise capital for the foreign issuer. They are subject to a full report with the SEC.
Prices and costs of US certificates of deposit
An ADR may represent the underlying shares on a one-for-one basis, a fraction of a share or more shares of the underlying company. The custodian bank will set the ratio of US ADR per home country share to a value that it believes will appeal to investors. If the value of an ADR is too high, this could deter some investors. Conversely, if it is too low, investors may think that the underlying securities look like riskier penny stocks.
The price of an ADR is generally parallel to that of the company’s stock on its home swap. For example, British Petroleum (BP) has an ADR, which trades on the NYSE. On April 17, 2019, it closed at $ 44.62. In this case, each ADR represents six BP shares. The actual price of the individual share is $ 7.43. In contrast, on the London Stock Exchange for the same closing, the company’s shares ended the day at 572 pence per share, or about $ 7.46 in US dollars.
ADR holders realize all dividends and capital gains in US dollars. However, dividend payments are net of currency conversion costs and foreign taxes. Usually, the bank automatically deducts the amount necessary to cover expenses and foreign taxes. As is the practice, American investors should request a credit from the IRS or a refund from the foreign government’s tax authority to avoid double taxation on realized capital gains.
Easy to follow and trade
Denominated in dollars
Available from American brokers
Offer portfolio diversification
Could face double taxation
Limited selection of companies
Unsupervised ADRs May Not Be SEC Compliant
Investor may incur currency conversion fees
History of American certificates of deposit – ADR
Before the introduction of American certificates of deposit in the 1920s, American investors who wanted shares of a company not listed in the United States could only do so on international stock exchanges – an unrealistic option for the average person to the time.
Although easier in today’s digital age, buying stocks on international exchanges still has potential drawbacks. A particularly discouraging obstacle is that of exchange rate problems. Another major drawback is the regulatory differences between the US and foreign exchanges.
Before investing in a company listed internationally, American investors must familiarize themselves with the various regulations of the financial authorities, otherwise they may misunderstand important information, such as the financial data of the company. They may also need to open an account abroad, as not all national brokers can trade internationally.
ADRs were developed due to the complexity of buying shares in foreign countries and the difficulties associated with trading at different prices and monetary values. ADRs allow American banks to buy a large batch of shares in a foreign company, consolidate shares into groups and reissue them on the US stock markets, the New York Stock Exchange and NASDAQ. The predecessor firm of J.P. Morgan (JPM), Guaranty Trust Co., was the pioneer of the ADR concept. In 1927, he created and launched the first ADR, allowing American investors to buy shares of the famous British retailer Selfridges and help the luxury store to access world markets. The ADR has been listed on the New York Curb Exchange. A few years later, in 1931, the bank presented the first sponsored ADR for the British music company Electrical & Musical Industries (also known as EMI), the eventual home of the Beatles. Today, J.P. Morgan and another American bank – BNY Mellon – continue to be actively involved in the ADR markets.
Real example of ADR
Between 1988 and 2020, German automaker Volkswagen AG traded over the counter in the United States as a sponsored ADR under the symbol VLKAY. On August 13, 2020, Volkswagen terminated its ADR program. The next day, J.P. Morgan established an unsupervised ADR for Volkswagen, which is now trading under the symbol VWAGY.
Investors who owned the old VLKAY ADRs were able to cash in, exchange ADRs for actual Volkswagen shares – traded on the German stock exchanges – or exchange them for the new VWAGY ADRs.