American Depositary Receipts (ADRs)
So far, every equity security we've covered has been issued by a U.S. corporation. But what if you want to invest in a foreign company without dealing with foreign exchanges and currencies? That's where ADRs come in.
What Are ADRs?
- American Depositary Receipts (ADRs) are certificates issued by a U.S. depositary bank representing shares of a foreign company
- Trade on U.S. exchanges in U.S. dollars
- Dividends are paid in U.S. dollars (the depositary bank converts from the foreign currency)
- Allow U.S. investors to invest in foreign companies without using foreign brokers or exchanges
Key Risks
- Currency (exchange rate) risk - changes in foreign exchange rates affect both the ADR's value and dividend payments
- Foreign tax withholding - foreign governments may withhold taxes on dividends (investors may claim a foreign tax credit on their U.S. tax return)
- Political risk - foreign government actions can affect the underlying company
Exam Tip: Gotchas
- ADRs trade in U.S. dollars but still carry currency risk. The underlying shares are denominated in a foreign currency, so exchange rate changes still affect the ADR's price and dividend payments.
- Foreign tax withholding does not mean double taxation. Investors can typically claim a foreign tax credit on their U.S. return to offset taxes withheld by the foreign government.
Sponsored vs. Unsponsored ADRs
| Feature | Sponsored | Unsponsored |
|---|---|---|
| Created with | Foreign company's cooperation | Without issuer involvement |
| Listing | May trade on major U.S. exchanges (NYSE, Nasdaq) | Over-the-counter (OTC) markets only |
| SEC reporting | Higher-level programs file with SEC | Minimal SEC requirements |
| Investor protection | More transparent | Less investor protection |
| Depositary bank role | Company selects one depositary bank | Multiple banks may issue ADRs |
Sponsored ADR Levels
Sponsored ADRs come in three tiers:
| Level | Where It Trades | SEC Registration | Can Raise Capital? |
|---|---|---|---|
| Level 1 | OTC market only | Minimal | No |
| Level 2 | Major exchanges (NYSE, Nasdaq) | Full registration | No |
| Level 3 | Major exchanges | Full registration + prospectus | Yes (public offering) |
Exam Tip: Gotchas
- Only Level 3 ADRs can raise capital. Levels 1 and 2 allow trading but not new public offerings.
- Unsponsored ADRs trade OTC only. They lack the foreign company's direct involvement and offer less investor protection than sponsored programs.
Think of it this way: A U.S. bank buys shares of a foreign company and then issues certificates (ADRs) that represent those shares. You buy and sell the certificates on a U.S. exchange in dollars, but behind the scenes, the actual shares are still priced in a foreign currency. That is why currency risk remains even though you never touch foreign money directly.