American Depositary Receipts (ADRs)
Moving from equity derivatives to international equity, ADRs are the primary vehicle U.S. investors use to access foreign stocks without dealing with foreign exchanges.
Structure and Purpose
- An ADR is a negotiable certificate issued by a U.S. depositary bank representing a specified number of shares in a foreign company
- ADRs allow U.S. investors to buy foreign stocks that trade on U.S. markets and are denominated in U.S. dollars
- The actual foreign shares are held by a custodian bank in the company's home country
- One ADR may represent one share, a fraction of a share, or multiple shares of the foreign stock (the ADR ratio)
How it works:
- Foreign company's shares are deposited with a custodian bank overseas
- A U.S. depositary bank issues ADR certificates against those shares
- ADRs trade on U.S. markets just like domestic stocks
- Investors buy and sell ADRs in U.S. dollars through their regular brokerage accounts
Sponsored vs. Unsponsored ADRs
| Feature | Sponsored ADR | Unsponsored ADR |
|---|---|---|
| Issuer involvement | Foreign company enters agreement with a U.S. depositary bank | Created by a depositary bank without the company's participation |
| SEC reporting | Subject to SEC reporting requirements (varies by level) | Minimal SEC reporting; financial disclosures may not be translated |
| Where traded | OTC (Level 1) or U.S. exchanges (Levels 2 and 3) | OTC markets only |
| Transparency | Higher disclosure and investor protections | Less transparency |
| Voting rights | Typically passed through to ADR holders | Usually not passed through |
Exam Tip: Gotchas
- Unsponsored ADRs trade OTC only and have minimal SEC oversight. If a question describes an ADR with no company involvement and limited disclosures, it is unsponsored.
ADR Program Levels (Sponsored)
This is a frequently tested topic. The three levels differ in where they trade, their SEC requirements, and whether they can raise capital.
| Level | Trading Venue | SEC Registration | Can Raise Capital? | Key Filing |
|---|---|---|---|---|
| Level 1 | OTC market only | Minimal (Form F-6 only) | No | Exempt from full SEC reporting |
| Level 2 | Listed on U.S. stock exchange (NYSE, Nasdaq) | Must register with SEC; annual report required | No | Form 20-F (annual report) |
| Level 3 | Listed on U.S. stock exchange | Full SEC registration and reporting | Yes (can issue new shares to raise capital) | Form 20-F + Form F-1 (registration) |
Key details:
- Level 1 is the most common ADR program and has the least regulatory burden
- Level 2 requires the foreign company to meet exchange listing standards and file annual reports conforming to U.S. Generally Accepted Accounting Principles (GAAP) or International Financial Reporting Standards (IFRS) with reconciliation
- Level 3 is the highest level: the foreign company can conduct a public offering in the U.S. to raise new capital
Memory Aid:
Think of increasing levels as increasing commitment:
- Level 1 = Dip a toe in (OTC only, minimal reporting)
- Level 2 = Wade in (exchange-listed, annual reports)
- Level 3 = Dive in (full SEC, raise new capital)
Exam Tip: Gotchas
- Only Level 3 ADRs can raise new capital through a public offering in the U.S. Levels 1 and 2 only trade existing shares.
Key Risks of ADRs
Even though ADRs simplify foreign investing, they carry unique risks.
- Currency (exchange rate) risk: The underlying value fluctuates with the exchange rate between the U.S. dollar and the foreign currency, even though ADRs trade in U.S. dollars
- Political risk: Changes in the foreign country's government, regulations, or stability can affect the investment
- Inflationary risk: Inflation differentials between the U.S. and the foreign country affect real returns
Think of it this way: ADRs simplify foreign investing by letting you trade in dollars on U.S. exchanges. But the underlying shares are still priced in a foreign currency. If that currency drops against the dollar, your ADR loses value even if the foreign stock price stays flat.
Exam Tip: Gotchas
- ADRs do NOT eliminate currency risk. They remove the need for foreign exchanges, brokers, and settlement systems, but exchange rate fluctuations still affect the ADR's value. The exam frequently tests this distinction.
ADR Dividend Payments
- Dividends are declared in the foreign currency by the foreign company
- The depositary bank converts the dividend to U.S. dollars before paying ADR holders
- The investor bears the currency conversion risk: if the U.S. dollar strengthens against the foreign currency at conversion time, the dividend translates into fewer U.S. dollars
- ADR holders may be subject to foreign tax withholding on dividends
- Foreign taxes withheld may be eligible for a U.S. foreign tax credit (to avoid double taxation)
Exam Tip: Gotchas
- Foreign tax withholding on ADR dividends may qualify for a U.S. foreign tax credit. The investor does not simply lose the withheld amount; the credit helps avoid double taxation.
ADR Holders' Rights
- ADR holders generally have the right to receive dividends (converted to U.S. dollars)
- Voting rights depend on the terms of the depositary agreement:
- Sponsored ADRs typically pass through voting rights
- Unsponsored ADRs usually do not pass through voting rights
- ADR holders can sell their ADRs on the U.S. market at any time during trading hours