What Is an American Depositary Receipt – ADR?
An American depositary receipt (ADR) is a negotiable certificate issued by a U.S. depository bank representing a specified number of shares—often one share—of a foreign company's stock. The ADR trades on U.S. stock markets as any domestic shares would.
ADRs offer U.S. investors a way to purchase stock in overseas companies that would not be available otherwise. Foreign firms also benefit, as ADRs enable them attract American investors and capital without the hassle and expense of listing on U.S. stock exchanges.
Introduction To American Depository Receipts ADRs
How Do American Depositary Receipts – ADRs -- work?
ADRs are denominated in U.S. dollars, with the underlying security held by a U.S. financial institution, often by an overseas branch. ADR holders do not have to transact the trade in the foreign currency or worry about exchanging currency on the forex market. These securities are priced and traded in dollars and cleared through U.S. settlement systems.
To offer ADRs, a U.S. bank will purchase shares on a foreign exchange. The bank will hold the stock as inventory and issue an ADR for domestic trading. ADRs list on either the New York Stock Exchange (NYSE), American Stock Exchange (AMEX), or the Nasdaq, but they are also sold over-the-counter (OTC).
U.S. banks require that foreign companies provide them with detailed financial information. This requirement makes it easier for American investors to assess a company's financial health.
- An American depositary receipt (ADR) is a certificate issued by a U.S. bank that represents shares in foreign stock.
- ADRs trade on American stock exchanges.
- ADRs and their dividends are priced in U.S. dollars.
- ADRs represent an easy, liquid way for U.S. investors to own foreign stocks.
Types of ADRs
American depositary receipts come in two basic categories:
- A bank issues a sponsored ADR on behalf of the foreign company. The bank and the business enter into a legal arrangement. Usually, the foreign company will pay the costs of issuing an ADR and retaining control over it, while the bank will handle the transactions with investors. Sponsored ADRs are categorized by what degree the foreign company complies with U.S. Securities and Exchange Commission (SEC) regulations and American accounting procedures.
- A bank also issues an unsponsored ADR. However, this certificate has no direct involvement, participation or even permission from the foreign company. Theoretically, there could be several unsponsored ADRs for the same foreign company, issued by different U.S. banks. These different offerings may also offer varying dividends. With sponsored programs, there is only one ADR, issued by the bank working with the foreign company.
One primary difference between the two types of ADRs is where investors can buy them. All except the lowest level of sponsored ADRs register with the SEC and trade on major U.S. stock exchanges. Unsponsored ADRs will trade only over-the-counter. Also, unsponsored ADRs never include voting rights.
ADRs are additionally categorized into three levels, depending on the extent to which the foreign company has accessed the U.S. markets:
- Level I - This is the most basic type of ADR where foreign companies either don't qualify or don't want to have their ADR listed on an exchange. This type of ADR can be used to establish a trading presence but not to raise capital. Level I ADRs found only on the over-the-counter market have the loosest requirements from the Securities and Exchange Commission (SEC) – and they are typically highly speculative. While they are riskier for investors than other types of ADRs, they are an easy and inexpensive way for a foreign company to gauge the level of U.S. investor interest in its securities.
- Level II – As with Level I ADRs, Level II ADRs can be used to establish a trading presence on a stock exchange, and they can’t be used to raise capital. Level II ADRs have slightly more requirements from the SEC than do Level I ADRs, but they get higher visibility and trading volume.
- Level III – Level III ADRs are the most prestigious. With these, an issuer floats a public offering of ADRs on a U.S. exchange. They can be used to establish a substantial trading presence in the U.S. financial markets and raise capital for the foreign issuer. Issuers are subject to full reporting with the SEC.
American Depositary Receipt Pricing and Costs
An ADR may represent the underlying shares on a one-for-one basis, a fraction of a share, or multiple shares of the underlying company. The depositary bank will set the ratio of U.S. ADRs per home-country share at a value that they feel will appeal to investors. If an ADR’s value is too high, it could deter some investors. Conversely, if it is too low, investors may think the underlying securities resemble riskier penny stocks.
Because of arbitrage, an ADR's price closely tracks that of the company's stock on its home exchange.
Holders of ADRs realize any dividends and capital gains in U.S. dollars. However, dividend payments are net of currency conversion expenses and foreign taxes. Usually, the bank automatically withholds the necessary amount to cover expenses and foreign taxes. Since this is the practice, American investors would need to seek a credit from the IRS or a refund from the foreign government's taxing authority to avoid double taxation on any capital gains realized.
Easy to track and trade
Denominated in dollars
Available through U.S. brokers
Offer portfolio diversification
Could face double taxation
Limited selection of companies
Unsponsored ADRs may not be SEC-compliant
Investor's may incur currency conversion fees
History of American Depositary Receipts—ADRs
Before American depositary receipts were introduced in the 1920s, American investors who wanted shares of a non-U.S. listed company could only do so on international exchanges—an unrealistic option for the average person back then.
While easier in the contemporary digital age, purchasing shares on international exchanges still has potential drawbacks. One particularly daunting roadblock is currency-exchange issues. Another important drawback is the regulatory differences between U.S. exchanges and foreign exchanges.
Before investing in an internationally traded company, U.S. investors have to familiarize themselves with the different financial authority's regulations, or they could risk misunderstanding important information, such as the company's financials. They might also need to set up a foreign account, as not all domestic brokers can trade internationally.
ADRs were developed because of the complexities involved in buying shares in foreign countries and the difficulties associated with trading at different prices and currency values. J.P. Morgan’s (JPM) predecessor firm Guaranty Trust Co. pioneered the ADR concept. In 1927, it created and launched the first ADR, enabling U.S. investors to buy shares of famous British retailer Selfridges and helping the luxury depart store tap into global markets. The ADR was listed on the New York Curb Exchange. A few years later, in 1931, the bank introduced the first sponsored ADR for British music company Electrical & Musical Industries (also known as EMI), the eventual home of the Beatles. Today, J.P. Morgan and another U.S. bank – BNY Mellon – continue to be actively involved in the ADR markets.
Real-World Example of ADRs
Between 1988 and 2018, German car manufacturer Volkswagen AG traded OTC in the U.S. as a sponsored ADR under the ticker VLKAY. In August 2018, Volkswagen terminated its ADR program. The next day, J.P. Morgan established an unsponsored ADR for Volkswagen, now trading under the ticker VWAGY.
Investors who held the old VLKAY ADRs had the option of cashing out, exchanging the ADRs for actual shares of Volkswagen stock—trading on German exchanges—or exchanging them for the new VWAGY ADRs.