What is an American Depository Receipt (ADR)?

An American depository receipt is like the deed to a property…

If you have a deed to a piece of real estate, you may never even see the property, but it’s still yours. The deed is a document that represents your ownership of the property, and you can sell it anytime by transferring the deed to someone else. Similarly, an American depository receipt represents your ownership of shares in a foreign company. You don’t have the stocks in your possession, but you own them, and you can sell them anytime by selling the ADR.

An American depository receipt (ADR) is a certificate issued by a US bank that represents ownership of a certain number of shares in a foreign public company. ADRs trade like common stock on American stock markets in US dollars. Their dividends pay out in US dollars. The actual shares are owned by a custodian bank in the country where the company is based. ADRs give US investors access to international companies without the hassle of dealing with foreign stock exchanges or cross-border transaction fees.

Banks buy shares of a foreign company in bulk and recast them as American depositary shares (ADSs). Banks bundle the ADSs into American depositary receipts (ADRs), which can represent one share, multiple shares, or even fractions of shares. The individual share price tracks the price of the underlying foreign share, but the ADRs are structured so they represent a price that US investors can understand. Once the ADRs are issued on US exchanges, retail investors can buy them through brokers just like other securities.

With sponsored ADRs, the foreign company agrees with a US bank to register its shares as ADRs with the Securities and Exchange Commission and trade on US markets. With unsponsored ADRs, a bank buys shares of a foreign company and creates ADRs with no involvement from the firm. Sponsored ADRs can be Level I, Level II, or Level III, depending on their level of compliance with SEC requirements. Unsponsored ADRs can only be Level I.

All sponsored ADRs must be registered with the SEC through a Form F-6. Holders of sponsored ADRs have voting rights (the right of shareholders to vote on company matters). Level I, Level II, and Level III have different SEC reporting requirements.

Level I:

• Can’t be traded on US exchanges, only on over-the-counter markets (OTC) — electronic markets run by a network of broker-dealers
• Can only be traded by institutional investors — financial organizations that make large investments
• Company must publish financial information on its website in English
• Company doesn’t have to comply with generally accepted accounting principles (GAAP) — accounting standards that dictate how publicly traded companies, governments, and other financial organizations must file their financial statements

Level II:

• Can trade on US exchanges
• Company must submit annual financial reports in English using SEC Form 20-F
• Must comply with GAAP

Level III:

• Can trade on US exchanges
• Company must submit annual financial reports in English using SEC Form 20-F
• Company must comply with GAAP
• Company can hold initial public offerings (IPO) — issue new shares as ADRs to raise capital on US exchanges

A bank can create unsponsored ADRs by buying foreign company shares to repackage as ADRs without that company’s collaboration. This is possible because of a 2008 SEC rule that automatically exempts certain types of foreign companies from registering their securities with the SEC. Depository banks keep voting rights for unsponsored ADRs. Unsponsored ADRs are usually created to meet demand from investors.

Retail investors can buy Level II and Level III ADRs (ADRs that comply with stricter SEC requirements) in US dollars from US brokers. These ADRs trade on American exchanges just like any other securities. Their dividends pay out in US dollars, and the foreign companies’ corporate actions are published in English. Sponsored ADR holders also have voting rights. Sometimes retail investors can buy Level I ADRs from brokers if the ADRs are exempt from Blue Sky Laws — state-level laws designed to protect investors from fraud. Exemptions usually happen if someone makes an unsolicited request to a broker to buy or sell a Level I ADR.

An ADR can represent multiple shares, one share, or a fraction of a share. The price per share often tracks the stock’s trading price in its home country, but the ADR price also depends on how many shares it contains. Say a foreign company’s shares trade at €0.50 on a domestic exchange, but shares of American companies in the same industry are trading at $10 on US exchanges. Assuming €0.50 equals $0.55 at the time of conversion, the depository bank may decide to bundle 20 shares into one ADR, so that the ADR at 20:1 is priced at $11 per ADR ($0.55 X 20 = $11). This can make the ADR appear more attractive to US investors. ADRs priced too low may seem risky to investors, while expensive ADRs may turn them away.

Depository banks can charge “pass-through” fees for handling ADRs. These fees are typically a few cents per share — The details should be in your ADR prospectus. The fees can be deducted from dividends or directly from your account, which would appear on your monthly statement.

Just like with regular stocks, you owe taxes on capital gains and dividends from ADRs. The country where the company is based may also withhold taxes, unless it has agreed not to in a treaty with the US. In some cases, the investor can reclaim this money or apply it as a credit against US tax liability.

Companies around the world sell shares in other countries as depository receipts (DR). DRs trading in America are called American depository receipts (ADR). DRs in other countries are called European depository receipts (EDRs), Indian depository receipts (IDRs), Japanese depository receipts (JDR), and so on, depending on the country they’re traded in. Global depository receipts (GDR) are DRs that can be sold in more than one country. GDRs typically list on a few specific exchanges, including in Luxembourg, London, Singapore, Frankfurt, and Dubai.

Pros

• Can be a convenient way to buy shares in a foreign company
• Can expose investors to markets with potential for growth and volatility (price fluctuations), which may give traders opportunities to profit
• Not having to deal with foreign currency exchange or cross-border transaction fees
• No language barriers

Cons

• Instability or trade sanctions in the country where a company is based could affect ADR value
• If the value of a country’s currency drops relative to the US dollar, or if inflation in the home country reduces the value of that currency, ADR investors can experience losses
• Can have complicated dividend tax issues

In the 1920s, American investors were interested in Selfridges, a luxury London department store. Likewise, Selfridges wanted to sell shares to US investors. Guaranty Trust Co, JP Morgan’s predecessor firm, came up with a solution by pioneering the first ADR in 1927. Guaranty Trust Co bought shares of Selfridges and held those shares in its name. Then it issued promissory notes that represented those shares using a US legal contract. Those promissory notes were issued in US dollars and traded as US securities in New York. Over the coming decades, Guaranty Trust, which merged with JP Morgan in 1959, created DR programs in France, Austria, Germany, Italy, Mexico, Japan, Spain, and more.

Over 2,000 foreign stocks trade on the US stock exchange via American depository receipts. Some examples are:

Alibaba Group Holding Ltd ADR — BABA

Alibaba is one of the world’s largest online and mobile e-commerce companies.

Nokia Oyj ADR — NOK

Based in Finland, Nokia — once known for its mobile phone business — sells telecommunications software and consumer electronics.

GlaxoSmithKline PLC ADR — GSK

Headquartered in England, GlaxoSmithKline is a pharmaceutical company that develops prescription medicines, vaccines, and other consumer health products.