Mutual funds and exchange-traded funds offer American investors opportunities to diversify a portfolio through foreign securities and are the most common way for investors to gain global exposure. However, for individuals who prefer to purchase individual stocks of foreign companies, their options can be limited.

While some foreign companies are allowed to list their stocks on U.S. stock exchanges, very few meet the strict requirements imposed by securities regulations or pay the dual-listing fees. One alternative for U.S. investors looking to bypass the somewhat costly obstacles of purchasing a foreign company's stock on an overseas exchange is by investing in an American depositary receipt (ADR).

What Is an ADR?

An ADR is a certificate representing shares of foreign company stock held in a bank within the United States and denominated in U.S. dollars. Most are sponsored ADRs, meaning the foreign company is involved in creating the investment for U.S. investors. An ADR may represent the underlying shares on a one-for-one basis, or it can also represent a fraction of a share or multiple shares. The ratio of U.S. ADRs per home-country share is set by the depository bank at a value that appeals to investors. Although unsponsored ADRs exist, they are rare.

ADRs are offered to investors as either a level I, II or III issue. Each ADR category meets different regulatory standards and is offered to investors through different outlets.

Level-I ADRs

A sponsored ADR listed as a level-I issue requires the least amount of compliance and regulatory oversight, and investments are originated by the foreign company wishing to offer shares. An F-6 registration statement must be filed to meet the requirements of a level-I ADR offering, but the company is exempt from full SEC reporting requirements.

An ADR issued under a level-I program is controlled by the foreign company and the single depository bank it selects. Because of the minimal oversight and exemption from reporting requirements, level-I ADR issues are only traded on the over-the-counter market.

Level-II ADRs

Foreign companies issuing level-II ADRs are mandated to fulfill all registration and reporting requirements imposed by the SEC. This includes submitting the company's F-6 registration statement, SEC Form 20-F, and annual financial reports prepared in line with either generally accepted accounting principles (GAAP) or international financial reporting standards.

Companies must also comply with the Sarbanes-Oxley Act, which requires accounting and financial disclosure, as well as other reporting standards. Level-II ADRs are allowed to be listed on a major U.S. stock exchange such as the New York Stock Exchange or the Nasdaq Stock Market. Level-II ADRs provide the issuing foreign company greater exposure in the United States without needing to complete a public offering.

Level-III ADRs

Level-III ADRs are similar to level-II issues in terms of reporting requirements and listing on U.S. exchanges. However, foreign companies issuing level-III ADRs can also raise capital through a public offering of the ADR within the United States. This additional step requires the company to file a Form F-1 with the SEC to properly register the public offering.