What Is American Depositary Receipt?
An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. bank that represents shares of a foreign company. These certificates allow U.S. investors to buy and sell shares of non-U.S. companies on American stock exchanges, making international investing more accessible. ADRs belong to the broader category of securities and are denominated in U.S. dollars, with their dividends also paid in U.S. currency. This structure simplifies the process for U.S. investors seeking exposure to overseas markets without directly engaging in foreign transactions.
History and Origin
The concept of the American depositary receipt emerged in response to the challenges U.S. investors faced when trying to invest in foreign stocks. Prior to their introduction, Americans interested in overseas companies often had to navigate complex foreign exchange processes, different regulatory environments, and unfamiliar settlement systems. The first American depositary receipt was pioneered by J.P. Morgan's predecessor, Guaranty Trust Company, in 1927. It allowed U.S. investors to purchase shares of the British retail company Selfridges Provincial Stores Limited, and was listed on the New York Curb Exchange, which was the precursor to the American Stock Exchange. This innovation provided a streamlined avenue for international equity investments, opening up U.S. capital markets to foreign companies.
Key Takeaways
- An American depositary receipt is a U.S. dollar-denominated security that represents shares in a non-U.S. company.
- Issued by U.S. depositary banks, ADRs allow foreign companies to access the U.S. capital markets and provide U.S. investors with an easier way to invest internationally.
- ADRs trade on U.S. exchanges or over-the-counter (OTC) markets, similar to domestic stocks.
- They simplify foreign investing by handling currency conversion and local market complexities for the investor.
- Investors holding ADRs are still exposed to currency risk and the specific risks of the underlying foreign market.
Interpreting the American Depositary Receipt
Understanding an American depositary receipt involves recognizing that it is a certificate representing ownership of underlying shares held by a custodial bank. Each ADR typically represents a specific number of foreign shares, which can be a single share, a fraction of a share, or multiple shares. This ratio is determined by the depositary bank to price the ADR at a level that is attractive and familiar to U.S. investors, often making it comparable to typical U.S. share prices13. The price of an ADR generally tracks the price of the foreign company's stock in its home market, adjusted for the ADR-to-share ratio and the prevailing exchange rate between the U.S. dollar and the foreign currency.
Hypothetical Example
Imagine a German automobile manufacturer, "Autobahn Motors," wants to make its shares accessible to U.S. investors. Instead of requiring U.S. investors to open a German brokerage account and deal with euros, Autobahn Motors partners with a U.S. depositary bank.
The U.S. bank purchases 1 million shares of Autobahn Motors directly on the Frankfurt Stock Exchange. These shares are then held in custody by the bank or its local sub-custodian in Germany. The U.S. bank then issues 1 million American depositary receipts, with each ADR representing one ordinary share of Autobahn Motors. These ADRs are then listed and traded on the New York Stock Exchange (NYSE) under a U.S. ticker symbol.
A U.S. investor, Maria, can now buy 100 Autobahn Motors ADRs through her regular U.S. brokerage account, just like she would buy shares of an American company. If Autobahn Motors declares a dividend in euros, the U.S. depositary bank receives these dividends, converts them into U.S. dollars, and distributes them to Maria, typically after deducting any applicable fees and foreign taxes. This process allows Maria to gain exposure to Autobahn Motors' performance and dividends without directly handling foreign currency or international settlement.
Practical Applications
American depositary receipts serve several practical purposes in the financial world. For U.S. investors, they provide a convenient and efficient way to achieve global diversification within their investment portfolio. They allow investors to access growth opportunities in foreign markets and gain exposure to companies that might not otherwise be available or easily tradable domestically. For instance, many well-known multinational corporations from Europe, Asia, and other regions use ADRs to list their shares in the U.S.12.
From the perspective of foreign companies, ADRs are a crucial tool for accessing the vast U.S. capital markets. By issuing ADRs, a foreign company can raise capital, increase its liquidity, and enhance its global visibility without the complexities and costs associated with a full listing on a U.S. exchange11. This can be particularly beneficial for companies looking to expand their investor base or raise funds for international operations. Additionally, ADRs facilitate reporting and compliance for foreign issuers, as they often fall under specific SEC reporting requirements, depending on the program level10.
Limitations and Criticisms
While American depositary receipts offer significant benefits, they also come with certain limitations and criticisms. A primary concern is currency risk. Although ADRs trade and pay dividends in U.S. dollars, their underlying value is tied to the foreign company's shares, which are priced in their local currency. Fluctuations in the exchange rate between the U.S. dollar and the foreign currency can impact the ADR's market value and the dollar value of dividends, even if the underlying foreign share price remains stable9.
Another limitation relates to fees and expenses. Investors may incur various fees, including depositary bank fees, custody fees, and currency conversion fees, which can erode returns8. These fees can be deducted directly from dividends or charged through the investor's brokerage account. Furthermore, the level of disclosure and regulatory oversight can vary significantly between different types of ADR programs (Level I, II, III, and unsponsored), potentially leading to less transparency for investors in lower-level or unsponsored programs7. There's also the risk of an ADR program being terminated by the issuing bank or the foreign company, which could force investors to liquidate their position or convert to ordinary foreign shares, potentially incurring additional costs or less favorable terms. Finally, regulatory changes, such as the Holding Foreign Companies Accountable Act (HFCAA), can pose a risk of delisting for ADRs of companies that do not comply with U.S. auditing standards, impacting their tradability in the U.S.6.
American Depositary Receipt vs. Global Depositary Receipt
The American depositary receipt (ADR) is often confused with the Global Depositary Receipt (GDR), but there's a key distinction in their scope. An ADR is specifically designed to facilitate the trading of foreign company shares within U.S. financial markets. It is issued by a U.S. bank and traded on U.S. exchanges or over-the-counter markets, denominated solely in U.S. dollars.
In contrast, a GDR allows shares of a foreign company to be traded in multiple international markets, typically beyond just the U.S. A GDR can be listed on exchanges in various countries, such as London, Luxembourg, or other European markets, in addition to or instead of the U.S. They can be denominated in different currencies, depending on where they are issued and traded. Essentially, while an ADR is a U.S.-centric instrument for foreign investment, a GDR offers broader, multi-market access for both issuers and investors.
FAQs
How do dividends work with American Depositary Receipts?
When a foreign company that issues an American depositary receipt declares a dividend, the U.S. depositary bank receives the dividend payment in the foreign currency. The bank then converts these funds into U.S. dollars and distributes them to the ADR holders. Fees and any foreign withholding taxes are typically deducted by the bank before distribution.5
Are American Depositary Receipts insured by SIPC?
The underlying shares held by the custodial bank for an American depositary receipt are typically not directly covered by SIPC (Securities Investor Protection Corporation) in the same way U.S. brokerage accounts are for cash and securities. However, your brokerage account in which the ADRs are held would generally be covered by SIPC, protecting against the failure of the brokerage firm itself, not against a decline in the value of the ADRs.4
Can American Depositary Receipts be converted into underlying shares?
Yes, American depositary receipts can generally be converted into the underlying foreign shares they represent. This process usually involves surrendering the ADRs to the depositary bank and paying certain fees. Conversely, investors who hold the foreign company's shares directly can deposit them with a depositary bank to receive ADRs.3
What are the different "levels" of American Depositary Receipts?
There are three main "levels" of sponsored American depositary receipt programs, which dictate the level of SEC registration and reporting requirements.
- Level I ADRs are the simplest, traded only on the over-the-counter market with minimal SEC reporting.
- Level II ADRs can be listed on U.S. exchanges (like the NYSE or NASDAQ) but require more stringent SEC reporting, including an annual report.
- Level III ADRs are the most comprehensive, allowing foreign companies to raise capital through public offerings in the U.S. and subjecting them to the most rigorous SEC reporting standards, similar to U.S. companies.2
Unsponsored ADRs also exist, which are initiated by a broker-dealer without the direct involvement or consent of the foreign company.1