American depositary receipts: Meaning, Criticisms & Real-World Uses

What Is American Depositary Receipts?

American depositary receipts (ADRs) are negotiable certificates issued by a U.S. depositary bank that represent a specified number of underlying shares in a foreign company. These certificates allow shares of non-U.S. companies to trade on U.S. stock exchanges, simplifying the process of investing in international equities for American investors. As a component of International Investing, ADRs enable U.S. investors to gain exposure to overseas markets without the complexities of direct cross-border transactions. ADRs are denominated and pay dividends in U.S. dollars, and they can be traded like regular shares of stock during U.S. market hours through U.S. broker-dealer firms. ADRs also benefit foreign companies by providing them access to the U.S. capital markets without the full expense and regulatory burden of directly listing their shares on U.S. exchanges¹⁵.

History and Origin

The concept of American depositary receipts originated in the early 20th century, driven by the desire of U.S. investors to access foreign companies and the need for foreign firms to tap into the American capital base. The first ADR was introduced in 1927 by J.P. Morgan's predecessor, Guaranty Trust Company, for the British retail company Selfridges. This groundbreaking financial instrument allowed American investors to purchase shares of the prominent British retailer directly on the New York Curb Exchange, the precursor to the American Stock Exchange¹⁴. This innovation addressed the challenges of international investing, such as foreign custody, currency conversion, and different settlement procedures, by creating a U.S.-based, dollar-denominated security that mirrored the foreign shares.

Key Takeaways

American depositary receipts (ADRs) are U.S.-denominated certificates representing shares of a foreign company, facilitating investment in international equities for U.S. investors.
They are issued by a U.S. depositary bank, which holds the underlying foreign shares in custody.
ADRs trade on U.S. stock exchanges or over-the-counter (OTC) markets, clearing and settling according to U.S. market conventions.
Dividends from ADRs are paid in U.S. dollars, simplifying income distribution for investors.
ADRs allow foreign companies to access the U.S. capital markets and raise capital without undertaking a full U.S. stock exchange listing.

Interpreting American Depositary Receipts

Interpreting American depositary receipts involves understanding their relationship to the underlying foreign stock and the specific program structure. The price of an ADR typically tracks the price of the foreign security in its home market, adjusted by a predetermined ratio and prevailing currency exchange rates. For example, one ADR might represent a single share, a fraction of a share, or multiple shares of the foreign company's stock. This ratio is set by the depositary bank to achieve a price per ADR that is more appealing to U.S. investors, avoiding very high or very low per-share prices.

Investors should examine the type of ADR program, as this dictates the level of financial reporting and regulatory oversight. Sponsored ADRs, where the foreign company actively participates and complies with Securities and Exchange Commission (SEC) requirements, generally offer greater transparency and investor protections than unsponsored ADRs¹², ¹³. Understanding these aspects is crucial for evaluating an ADR's value and the associated risks.

Hypothetical Example

Consider a hypothetical U.S. investor, Sarah, who wishes to invest in "GlobalTech," a leading technology company based in Japan. GlobalTech's shares trade on the Tokyo Stock Exchange. Instead of opening a brokerage account in Japan, dealing with yen, and navigating foreign market regulations, Sarah can purchase GlobalTech American depositary receipts.

Suppose the ADR ratio is 1:10, meaning one GlobalTech ADR represents 10 shares of GlobalTech stock traded in Japan. If GlobalTech's shares are trading at ¥1,000 per share in Tokyo and the exchange rate is ¥150 to $1, then the equivalent value of one ADR would be:

\text{ADR Value} = \text{(Shares per ADR)} \times \text{(Foreign Share Price)} / \text{(Exchange Rate)} \\ \text{ADR Value} = 10 \text{ shares} \times ¥1,000/\text{share} / ¥150/\$1 = \$66.67

So, one GlobalTech ADR would be priced around $66.67 in the U.S. market. Sarah can buy these ADRs through her regular U.S. brokerage account. When GlobalTech declares a dividend in yen, the depositary bank will convert those yen dividends into U.S. dollars and distribute them to Sarah, after deducting any applicable fees or foreign taxes. This simplifies the investment for Sarah, allowing her to participate in GlobalTech's growth without direct exposure to the Japanese market's operational complexities.

Practical Applications

American depositary receipts serve several key practical applications for both investors and foreign companies. For investors, ADRs provide a straightforward means to achieve portfolio diversification by accessing international markets and companies that might otherwise be difficult or costly to invest in directly. Th¹¹ey enable U.S. investors to trade foreign stocks during U.S. market hours using U.S. currency and settlement systems, eliminating the need for foreign brokerage accounts or foreign currency conversions for trading purposes.

F¹⁰or non-U.S. companies, ADRs offer a crucial pathway to tap into the deep and liquid U.S. capital markets. By issuing ADRs, a company can increase its global visibility, attract a broader investor base, and potentially raise capital more efficiently. Different "levels" of sponsored ADR programs exist, each with varying degrees of SEC oversight and market access, allowing foreign firms to choose the program that best suits their needs. For instance, Level I ADRs are traded over-the-counter with minimal reporting, while Level III ADRs are listed on major U.S. exchanges and require more comprehensive SEC filings, similar to U.S. domestic companies, often used for raising new capital. Th⁸, ⁹e U.S. Securities and Exchange Commission details these regulatory frameworks, emphasizing how ADRs facilitate U.S. investor access to non-U.S. companies while providing foreign companies access to U.S. capital.

#⁷# Limitations and Criticisms

While American depositary receipts offer significant advantages, they also come with certain limitations and criticisms that investors should consider. One primary concern is currency exchange rates risk; although ADRs trade in U.S. dollars, their value is inherently linked to the underlying foreign shares. Fluctuations in the exchange rate between the U.S. dollar and the foreign company's local currency can impact the ADR's value, even if the underlying share price remains stable in its home market.

A⁵, ⁶nother limitation is the potential for double taxation on dividends. While ADR holders receive dividends in U.S. dollars, these payments may be subject to foreign withholding taxes in the company's home country, in addition to U.S. taxes. Investors may need to seek tax credits from the IRS or refunds from foreign governments to avoid this double taxation. Fu⁴rthermore, the liquidity of some ADRs, particularly unsponsored or thinly traded programs, may be lower compared to actively traded U.S. domestic stocks, which could affect an investor's ability to enter or exit positions efficiently. Un³sponsored ADRs, specifically, may not comply with the full suite of SEC rules and regulations, as they are issued without the foreign company's direct involvement or permission, potentially leading to less transparent financial reporting for investors.

#²# American Depositary Receipts vs. Global Depository Receipts

American depositary receipts (ADRs) and Global Depository Receipts (GDRs) are both types of negotiable certificates issued by banks that allow investors to own shares of foreign companies. The key distinction lies in their primary trading markets. ADRs are specifically designed for the U.S. financial markets, allowing foreign shares to be traded on U.S. stock exchanges or over-the-counter in U.S. dollars and cleared through U.S. settlement systems. In contrast, GDRs are broader in scope; they enable foreign companies to list their shares on two or more international markets, typically London or Luxembourg, in addition to potentially the U.S. market. Wh¹ile an ADR provides a single point of access to a foreign company's shares within the U.S., a GDR offers a more expansive international reach, allowing a company to raise capital and facilitate trading across multiple global financial centers with one fungible security.

FAQs

What is the role of a depositary bank in an ADR program?

The depositary bank is a U.S. financial institution that issues American depositary receipts. It holds the underlying shares of the foreign company in custody, handles dividend payments, converts them into U.S. dollars, and manages other corporate actions.

Are all American depositary receipts the same?

No, ADRs can differ significantly. They come in various "levels," such as Level I, Level II, and Level III, as well as unsponsored ADRs. These levels dictate the degree of Securities and Exchange Commission (SEC) compliance, where they can be traded (e.g., over-the-counter or on major stock exchanges), and whether the foreign company actively sponsors the program.

Do I get voting rights with an American depositary receipt?

It depends on the specific ADR program and the foreign company's arrangements. In many sponsored ADR programs, holders of American depositary receipts may have voting rights, which are typically exercised through the depositary bank. However, unsponsored ADRs often do not provide voting rights to investors.

Are there fees associated with American depositary receipts?

Yes, investors in ADRs may incur certain fees. These can include custody fees charged by the depositary bank for holding the underlying shares and managing the program. These fees are typically outlined in the ADR prospectus and might be deducted from dividends or passed through to the investor's broker-dealer.

How do American depositary receipts help with portfolio diversification?

American depositary receipts simplify portfolio diversification by providing U.S. investors with easy access to shares of non-U.S. companies. Instead of navigating foreign markets, currencies, and regulatory environments, investors can buy ADRs through their regular U.S. brokerage accounts, gaining exposure to international industries and economies.