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 or over-the-counter markets, depending on the program, 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
• ADRs are registered with the SEC under the Securities Act of 1933 on Form F-6, whether the program is sponsored or unsponsored

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.
• Example: a German company's shares are unchanged at 100 euros. At $1.10 per euro, those shares convert to $110. If the euro weakens to $1.00 per euro, the same 100-euro shares convert to only $100, even though nothing changed in euro terms.
• 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.
• Eurodollar bonds, Yankee bonds, and currency ETNs are not equity. These three appear as common distractors in ADR questions. A Eurodollar bond is a dollar-denominated bond issued outside the U.S. A Yankee bond is a dollar-denominated bond issued inside the U.S. by a foreign entity.
• Both bonds are debt: the investor lends money and earns interest, with no ownership stake in the company. A foreign currency ETN tracks exchange rates, not company stock. None of these gives equity exposure to a foreign company the way an ADR does.
• ADRs need 1933 Act registration; a Eurodollar bond sold outside the U.S. does not. The 1933 Act's registration requirement reaches offers and sales inside the U.S., so a bond offered and sold only abroad falls outside it. Government and municipal securities are exempt securities, so they are not registered either.

Sponsored vs. Unsponsored ADRs

Exam Tip: Gotchas

• Unsponsored ADRs trade OTC only; sponsored does not always mean exchange-listed. Sponsored Level 1 programs also trade OTC. In an EXCEPT question about unsponsored ADRs, choose the false characteristic: listing on the NYSE or Nasdaq.
• Unsponsored does not mean unregistered. The ADRs are registered with the SEC on Form F-6. That form describes the deposit terms; it does not provide financial information about the foreign company.

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 or OTC market 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.

What Should You Check on Exam Day?

• Can you explain why an ADR still carries currency risk even though it trades in United States dollars?
• Do you know why foreign tax withholding on ADR dividends does not mean double taxation?
• Can you explain why Eurodollar bonds, Yankee bonds, and currency ETNs are not equity like an ADR?
• Do you know where unsponsored ADRs trade?
• Do you know that every ADR is registered under the Securities Act of 1933, and why a Eurodollar bond sold abroad is not?