Definition, Structure, Examples, How to Invest

  • A US Depository Receipt is issued by a bank and represents shares in a foreign company.
  • US investors use ADRs to invest in foreign companies, bypassing the complexities of the foreign market.
  • There are more than 2,000 ADRs representing companies located in more than 70 countries.
  • Read more Personal Finance Insider stories.

Let’s say you heard that Adidas is creating a network for 50,000 college athletes to be paid sponsors of its brand and want to buy shares of the company because of the potential it generates for profit. Then you discover that Adidas shares are traded in Frankfurt and you are in the US.

Enter US Depository Receipts, more commonly known as ADRs. An ADR is the mechanism through which you can take an international security and convert it into a US one, traded on the major US exchanges. In other words, the ADRs will allow you to buy Adidas, just like any other US traded stock. .

“It acts, so to speak, as a wrapper for an underlying foreign stock,” says Jason Paltrowitz, executive vice president of corporate services at OTC Markets Group, which facilitates the trading of US and global securities, including ADRs. “You create a receipt, or wrapper, that converts it into a US dollar-denominated security that is traded and settled in the US.”

How do ADRs work?

The first ADR was issued in 1927 to allow US investors to invest in a British department store, according to the Securities and Exchange Commission. There are more than 2,000 ADRs traded on US exchanges, representing companies located in more than 70 countries.

An ADR is a negotiable certificate that represents ownership of American Depositary Shares, which in turn represent an interest in shares of a non-US company that have been deposited in a US bank. Think of it like you would a stock certificate, which represents shares of stock. ADRs are traded in dollars and cleared through US settlement systems, allowing holders to avoid the need for foreign exchange and the complexities of doing business abroad.

The ratio of foreign shares to ADRs varies by company. For example, one ADR of Chinese online retailer Alibaba is equal to one underlying share of Alibaba, while one ADR of Toyota represents 10 of the underlying shares of the Japanese automaker. Some ADRs may even represent a fraction of a company’s shares. The use of such indices allows the ADRs to be priced at an amount more appropriate to US market prices.

ADRs are issued by a bank when the non-US company, or an investor who owns shares in the foreign company, delivers them to the bank or bank custodian in the foreign company’s home country. Having possession of the shares allows the bank to turn around and issue the ADR to US investors. The ADRs are then traded on major exchanges such as the New York Stock Exchange and Nasdaq, or can be sold over the counter.

Over the past decade, there has been less need for ADR in more developed markets as the cost and complexity of international securities transactions have decreased. However, developing nations like India and Brazil still see a lot of demand from institutional investors looking to use ADRs to avoid the hassles of local markets.

Different Types of American Depository Receipt Programs

ADRs can be classified as “sponsored” or “unsponsored”.

Sponsored ADRs are issued with the cooperation of the foreign company. The foreign company will work directly with the US bank to arrange for record keeping, shareholder communications, dividend payments and other services, according to the SEC.

An unsponsored ADR is one that is established without the assistance of the foreign company, as may be the case when a broker-dealer wishing to establish a US commercial market issues an ADR. Most ADRs are not sponsored, according to Paltrowitz.

While an ADR can be issued without the cooperation of a foreign company, it cannot be created unless the non-U.S. company is subject to or specifically exempt from the disclosure requirements of the U.S. Securities Exchange Act. 1934.

ADR levels

In addition to their classification as sponsored and unsponsored, ADRs are also classified by the degree to which the underlying foreign company has access to US markets. Tiers differ based on your listing exposure and reporting requirements.

  • Tier I ADR it can only be traded on the OTC market and no capital can be raised for the foreign company. As the only type of ADR that may be unsponsored, the disclosure requirements are minimal and information about the issuer would only be available on its website.
  • Tier II ADR may be listed on a US stock exchange, but may not be used to raise capital. The underlying company must register and file annual reports with the SEC.
  • Tier III ADR can be listed on a US stock exchange and used to raise capital for the foreign issuer. Reporting requirements are similar to those met by US companies, and therefore this level represents the majority of notable foreign companies.

Approximately 70% of ADRs are Tier 1 ADRs, according to Paltrowitz. It’s the best deal for the company because the rules essentially exempt it from SEC registration, Sarbanes-Oxley compliance, and more. As an example, the French food company Danone used to be listed on the New York Stock Exchange, but when the Sarbanes-Oxley Act passed, they were delisted.

“They felt that outreach in France was as good, if not better, than outreach in the United States,” Paltrowitz said. “And the reality is that there is now this connectivity that knows the world is getting smaller and they didn’t want to take on the added cost, the added risk, and the duplicate reporting requirements from two regulators.”

Commissions associated with ADRs

As with any investment, there are costs associated with investing in ADRs. There are the fees charged by the depository bank, usually called custody fees. The custody fee generally covers the cost to the custodian bank of holding the non-US shares, registration, compliance, and other record-keeping services. These fees, which typically amount to between 1 and 3 cents per share, can sometimes be paid through a dividend withholding in which the depositary bank subtracts the fees from gross dividends paid by the bank to ADR holders.

Your brokerage firm may also charge fees in addition to the bank that holds the ADRs, according to Holmes Osborne, director of Osborne Global Investorsan


Money Management

signature.

Dividends paid by ADRs are also sometimes subject to double taxation, but the Internal Revenue Service has a foreign tax credit that US taxpayers can use to offset taxes paid to a foreign government. In addition, any investment gains from the ADRs would be subject to


Capital gains

taxes.

Pros and Cons of American Depository Receipts

As our Toyota example shows, the biggest benefit of investing in ADRs is the ease with which investors can invest in foreign companies. Some of the biggest names in business are foreign entities, and ADRs allow US investors to look abroad for new and different investment opportunities.

That said, the very nature of ADRs also presents certain risks. Because ADRs represent foreign investments, you will be inherently exposed to currency exchange rate risks that may affect the value of your underlying investment. In addition to exchange rate issues, there are also political and inflationary risks in the foreign country to consider.

When and how to invest in ADRs

ADRs are your gateway to the world, without the headache of being set up to do the work of buying foreign exchange. While there may be higher costs involved, if you avoid ADRs, you’ll be avoiding companies like Nestle, the world’s largest food company, Holmes says.

“It’s the only way to invest in some of the best companies in the world: Diageo, Heineken, Volkswagen, Toyota,” says Holmes. “The list goes on and on.”

ADRs can also help Americans diversify their portfolios.

“This really makes sense as there are only 350 million Americans versus 7 billion people worldwide,” says Christine Armstrong, executive director of wealth management and financial advisor at Morgan Stanley Wealth Management. “When you do the math, the United States may be the economic powerhouse, but we are a much smaller piece of the pie. Looking outside of the United States has many benefits.”

If you want to participate, doing so is as simple as buying a share through your brokerage account. Just be sure to carefully research the ADR before you buy to make sure it fits your investment goals and risk tolerance. If in doubt, consult an investment professional.

Previous post Book Review: The Devil Never Sleeps
Next post How bad is the bond market carnage? This unlikely sector is down 10% as inflation squeezes yields.
%d bloggers like this: