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A comprehensive essay on What is American Depositary Receipt (ADR) and how it is traded.

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What is American Depositary Receipt (ADR)?

A brief introduction
Before we hit the topic I would like to introduce you to a couple of terms which is so popular yet so vague – negotiable security. A negotiable security can be defined as one that may be freely bought, sold or transferred. Coupons, treasury bonds, stocks are all examples of negotiable security.
The second term that you must be familiar with is the DR or the Depositary receipts. These are negotiable securities that are traded in a foreign market. This is done to enable investors to buy foreign stocks without going through the hassle of currency exchange and related formalities.

What are ADRs?
ADR or American Depositary Receipt is a negotiable security that denotes the non-American companies that trade in the American financial market. The shares of these companies are known as American Depositary Shares or ADS. Just like any other shares that are sold or bought in the American markets, ADRs are also traded in the markets. The OTC ADRs are traded in the extended trading hours of the market.

Selfridges, a British retailer was the first ADR and it was introduced by JPMorgan in the year 1927.

The ADRs are issued by a particular Depositary bank. The underlying securities are under the safe custody of the foreign bank that acts as a custodian. The transaction requires a stock broker who purchases the shares in the open market local to the foreign company. The price of the ADR is along the same trend as the price pattern of the foreign security that it tracks in its local market.

Programs of ADRs
The company that chooses to set up an ADR program has to initially decide the time frame, the effort and the resources at its disposal for the specific program. There are varied programs and facilities that are on the offer.

The different programs include:
Unsponsored ADR: These are traded on the over-the-counter or OTC market. In this type of program shares are issued on a demand basis and the foreign company whose ADR is sold thus enters into no formal agreement with the Depositary bank.

Sponsored Level I ADR
: These are also traded in the OTC market that functions post the regular trading hours. In this type of ADR the company is associated with one Depositary that acts as the transfer agent for the shares traded. The reporting system in this type is kept at the minimum level and the company need not issue quarterly or annual reports in compliance with the U.S.GAAP (denoting the generally accepted accounting principles). The only restriction is that the company must have a security listed in the local stock exchange and publish its annual report as per that country’s laws. This report must be made available on its website for the benefit of the investors in America.

Sponsored Level II ADRs
: The foreign company that wishes to enter this program must file a registration statement with the U.S.SEC (Securities and Exchange Commission). A form (20F) has to be filed annually. The information required to be filled in this form are not as strict as for domestic US companies. This report must be submitted within six months of the company’s fiscal year end. In this type of program the shares are listed on any of the U.S. stock exchanges, though this implies that the company must meet the listing requirements.

Sponsored Level III ADRs:
While the level II offers the listing facility the level III offers the offering facility. This program is the highest level a foreign company can sponsor. The rules to be followed in this case are stricter than the level I and level II. In the level III the foreign company is allowed to raise capital and therefore must actually issue shares. Therefore, it must file form F-1, which is the prescribed format of the offer prospectus. In addition they must also file the form 20-F and adhere strictly to the U.S.GAAP standards. All the material information that the company gives in the local market should be filed with SEC by way of form 6K. Some of the level III companies include Vodafone and British Telecommunications.

Restricted programs
: These are companies that allow trade between few individuals and not to outsiders. Under the restricted program there are two types of issuance of shares, one under Rule 144-A and the second under Regulation S. The shares issued against Rule 144-A is known as privately placed and the Regulation S is offshore. In the offshore the restriction is for U.S. public and these shares can be registered and issued by offshore non-U.S. residents.
How are ADRs sourced?
There are many ways of purchasing ADRs. If you wish to buy ADRs the new receipts can be bought by depositing the underlying shares of the company at the depositary bank or buying it in the secondary market. Again, the secondary market purchase can be done by directly buying the ADRs on the U.S. stock exchange or buying the underlying securities from the primary market of the country of its origin and then exchanging them for the ADRs. This type of exchange is called crossbook swaps. This method is most popular as it does not attract the SDR tax (Stamp duty reserve tax).
How to terminate ADRs?
Like the mechanism to source ADRs follow a pattern so does the termination process. Most of the terminations occur when the foreign issuer (the company) is set for corporate restructuring which include the likes of merger, demerger or company split, etc. Termination leads to the delisting from all the exchanges where the shares were hitherto listed. All the depositary receipts will stand cancelled post which the trading in these shares is disallowed. But prior to delisting the shares from the exchanges the holders are informed in writing generally 30 days in advance. This would mean that the holders have to surrender their ADRs and, in return, receive the shares that underlie the ADRs. If the holder does not collect the shares and leave it with the depositary bank, the dividend redistribution will not happen and will remain with the bank. It is, therefore, better to surrender the ADR and get the shares of the foreign company and sell them in the U.S. exchange where those shares are traded.