American Depositary Receipts (ADR) For Investors

How ADRs Work

ADRs represent shares of a foreign company’s stock that is traded on a U.S. exchange that is otherwise unavailable for domestic purchase. They trade similarly to stocks but do not work the same way since the underlying asset is a foreign stock. In order to market the ADR, the company contacts a U.S. financial institution or depositary located overseas. The foreign stock is packaged as an ADR. One ADR might represent a fraction of a share, an equal share, or multiple shares.

For example, Company A might have each foreign currency worth $0.50 in U.S. dollars. As a foreign stock, Company A trades at this rate, but when packaged as an ADR, it can lump in 100 shares meaning each ADR is sold for $50 per ADR share.

Tip: Investors need to know how many foreign shares go with each ADR. This information helps identify other metrics such as P/E ratios.

Investors buy ADRs on an exchange. Three levels of ADRs dictate how much SEC filing and reporting is needed.

• Level 1 ADRs trade over-the-counter (OTC) and have minimal SEC reporting requirements. They don’t need to file quarterly or annual reports.
• Level 2 ADRs do file annual reports with the SEC.
• Level 3s ADRs also file annual reports with the SEC but are stricter than Level 2 because they represent an initial public offering (IPO).

Note: Level 1 ADRs are riskier than Level 2 and Level 3 ADRs because they don’t have the strict reporting guidelines required by the SEC.

ADRs vs. Stocks

When buying an ADR, the process is often the same as buying a regular stock. Investors will use a stock symbol to purchase the ADR and may not even realize they are buying a foreign stock. There is no designation in the stock symbol that defines an ADR. When investors buy one, they buy what the package is, whether that is a fraction of a share, one share, or a bundle of shares of the underlying foreign stock.

This is different than buying a regular stock. With a regular stock, one share is always one share; there are no representations of other packaged units. Even though investors buy them in the same fashion as stock, ADRs are more volatile because their value is subject to the currency exchange rate. Investors may also incur additional fees and taxes to pay on ADRs that they don’t pay with regular stocks.

ADRs Fees & Taxes

Investors need to know that there are additional fees and taxes associated with many ADRs that aren’t associated with domestic stocks. A pass-through fee is paid periodically to compensate the depositary bank for its work as the custodian. Fees range from $0.01 to $0.03 per share and are outlined in the ADR prospectus.

Additionally, investors who buy ADRs need to be aware of the tax implications that come with investing in the foreign assets. Traditional stocks are subject to capital gains taxes and dividend taxes. This is also true for ADRs. There is also the possibility of automatic withholding on dividends that many foreign governments automatically employ. The amount is dependent on the foreign country’s tax rates and regulations.

Tip: Talk to a tax professional about the taxes on ADRs. Investors forced to withhold taxes on ADRs need to properly account for this with their domestic filings.

Sponsored vs. Unsponsored ADRs

There are two categories of ADRs that investors can purchase:

• Sponsored ADR: The depositary bank issues the ADR on behalf of the foreign company via a legal contract. The foreign company pays the depositary bank’s costs but is able to retain control over the ADR sales. Sponsored ADRs must comply with SEC filing requirements.

• Unsponsored ADR: These don’t comply with the SEC filing requirements and often trade on the OTC. The foreign company does not instigate the ADR and has no control over it. Several ADRs may exist for the same foreign company, leading to confusion in the market.

ADR Levels

There are three levels of ADRs. Each level represents how deep into the U.S. market the ADR is.

Level 1

Level 1 ADRs are created for trading purposes only. The foreign company is not establishing the ADR to raise capital. A foreign company may use a Level 1 ADR to determine how much U.S. interest is in the stock.

Because Level 1 ADRs have the lowest SEC requirements, they only trade on the OTC market. Trading here suggests that they are a high-risk investment.

Level 2

Level 2 ADRs trade on one of the many exchanges such as the S&P 500 or NASDAQ. These ADRs don’t raise capital either but provide an opportunity for U.S. investors to trade the asset.

Because these trade on the exchanges, there are more SEC requirements, including quarterly and annual reports.

Level 3

These ADRs have the strictest filing requirements because they take the foreign stock and release an IPO in order to raise capital in U.S. markets. The Level 3 ADR must file a Form F-1 to release the IPO and complete quarterly and annual reports.

Getting a Level 3 ADR suggests that the foreign company wants to establish a significant trading presence in the United States.

Pros & Cons of ADRs

Pros of American Depositary Receipts

• Easily accessible: Because ADRs trade on exchanges, they are easy for any U.S. investor to access.

• Diversification: ADRs allow investors to access foreign stocks where they can diversify their portfolios with alternate holdings.

• Trade in U.S. dollars: Takes the conversion confusion out of investing because the asset trades in U.S. dollars.

Cons of American Depositary Receipts

• Possible double taxation: Thanks to automatic withholding, investors could experience taxation by the foreign government and also domestically.

• Currency risk: Because the underlying asset of the ADR is a foreign stock, the asset has currency risk and is more volatile thanks to currency fluctuations.

• May not comply with SEC requirements: Unsponsored Level 1 ADRs don’t have SEC filing requirements and may be riskier for some investors.

ADRs in U.S. History

Before the creation of ADRs, U.S. investors could only invest in foreign stocks by converting currency and trading on a foreign exchange. This created many limitations for the average investor. The first ADR was created in 1927 by Guaranty Trust, the predecessor of J.P. Morgan. It allowed U.S. investors to buy shares of the then-famous British retailer, Selfridges.

Historical Example of an ADR

The first sponsored ADR was for a British music company known as Electrical & Musical Industries (EMI). This ADR was released in 1931 by Guaranty Trust for a company that saw international success for many decades. The ADR came after the company was formed by a merger of Columbia Graphophone Company and Gramophone Company. The stock was originally listed on the London Stock Exchange, and the ADR shares allowed U.S. investors to access the company on the U.S. exchange.

Bottom Line

ADRs are foreign stocks traded on U.S. exchanges in packaged receipts. This makes it easy for U.S. investors to access foreign companies and diversify their portfolios with international holdings.