ADRs and Foreign Securities
American Depositary Receipts (ADRs) allow U.S. investors to participate in foreign companies without the complexities of international trading. Understanding ADRs is essential for Series 7 representatives recommending diversified portfolios.
What Are ADRs?
An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank representing shares of a foreign company held in custody abroad. ADRs trade on U.S. exchanges in U.S. dollars, making foreign investment accessible to American investors.
How ADRs Work:
- A U.S. bank purchases shares of a foreign company
- The shares are held by a custodian bank in the foreign country
- The U.S. bank issues ADRs representing those shares
- ADRs trade on U.S. exchanges like regular stocks
ADR Ratio: One ADR may represent one share, multiple shares, or a fraction of a foreign share. A 10:1 ratio means 10 ADRs equal 1 foreign share.
Sponsored vs. Unsponsored ADRs
| Feature | Sponsored ADRs | Unsponsored ADRs |
|---|---|---|
| Issuer Involvement | Foreign company participates | No company involvement |
| Depositary Banks | Single depositary bank | Multiple banks may issue |
| SEC Registration | Required for Level II and III | Not required |
| Trading Venue | Exchanges or OTC | OTC only |
| Shareholder Services | Company provides | Limited or none |
| Voting Rights | Typically passed through | Usually not available |
Sponsored ADRs are preferred because the foreign company is involved, ensuring better investor communications and services.
Unsponsored ADRs are created by depositary banks without company cooperation, leading to potential inconsistencies and limited shareholder rights.
ADR Levels
Sponsored ADRs are classified into three levels based on SEC registration requirements and trading privileges:
Level I ADRs
| Characteristic | Detail |
|---|---|
| Trading | Over-the-counter (OTC Pink Sheets) |
| SEC Registration | Exempt from full registration |
| Reporting | Minimal U.S. disclosure requirements |
| Purpose | Establish U.S. market presence |
| Capital Raising | Cannot raise capital in U.S. |
Level I is the simplest and least expensive way for foreign companies to access U.S. investors.
Level II ADRs
| Characteristic | Detail |
|---|---|
| Trading | Listed on NYSE, NASDAQ, or AMEX |
| SEC Registration | Must register with SEC |
| Reporting | Must file annual reports (Form 20-F) |
| Purpose | Gain exchange listing visibility |
| Capital Raising | Cannot raise new capital |
Level II provides greater visibility through exchange listing but requires more regulatory compliance.
Level III ADRs
| Characteristic | Detail |
|---|---|
| Trading | Listed on major exchanges |
| SEC Registration | Full SEC registration required |
| Reporting | Same as U.S. public companies |
| Purpose | Raise capital in U.S. markets |
| Capital Raising | Yes—can conduct public offerings |
Level III has the highest regulatory requirements but allows foreign companies to raise capital through U.S. public offerings.
ADR Level Comparison Summary
| Feature | Level I | Level II | Level III |
|---|---|---|---|
| Exchange Listed | No (OTC) | Yes | Yes |
| Capital Raising | No | No | Yes |
| SEC Registration | Exempt | Required | Full |
| U.S. GAAP/Reconciliation | No | Yes | Yes |
| Typical Investors | Retail | Institutional | All |
Currency Risk
Currency risk (exchange rate risk) is a significant consideration for ADR investors. ADRs are priced in U.S. dollars, but the underlying shares are valued in the foreign currency.
Impact of Currency Fluctuations:
- Foreign currency strengthens vs. USD → ADR value increases
- Foreign currency weakens vs. USD → ADR value decreases
Example: A German company's stock is unchanged in euros, but the euro strengthens 5% against the dollar. The ADR's value would increase approximately 5% in dollar terms.
This creates a dual risk/opportunity—investors face both company performance risk and currency exchange risk.
Dividends and Taxation
Dividend Conversion
Foreign companies pay dividends in their local currency. The depositary bank converts these to U.S. dollars before distributing to ADR holders. Conversion fees may reduce the dividend received.
Foreign Tax Withholding
Many countries withhold taxes on dividends paid to foreign investors. This creates potential double taxation—paying taxes to both the foreign country and the U.S.
Foreign Tax Credit: U.S. investors may claim a credit on their U.S. tax return for foreign taxes withheld, reducing or eliminating double taxation. The maximum credit equals the U.S. tax that would be owed on the foreign income.
Tax Treaty Benefits
The U.S. has tax treaties with many countries that reduce withholding rates. For example, the U.S.-UK treaty may reduce withholding from 30% to 15%.
Benefits and Risks of ADRs
Benefits
| Benefit | Description |
|---|---|
| Convenience | Trade in USD during U.S. market hours |
| Diversification | Access to international companies |
| Lower Costs | Avoid international trading fees |
| Familiar Settlement | T+1 settlement like U.S. stocks |
| Dollar Denominated | No need to convert currency |
Risks
| Risk | Description |
|---|---|
| Currency Risk | Exchange rate fluctuations affect value |
| Political Risk | Foreign government actions may impact |
| Information Risk | Less familiar with foreign companies |
| Liquidity Risk | Some ADRs trade thinly |
| Regulatory Differences | Foreign accounting standards may differ |
On the Exam
The Series 7 exam frequently tests:
- Distinguishing between ADR levels and their characteristics
- Understanding sponsored vs. unsponsored ADRs
- Recognizing currency risk as a key ADR consideration
- Knowing that Level III ADRs can raise capital while Levels I and II cannot
A foreign company wants to list its ADRs on the New York Stock Exchange and raise capital through a U.S. public offering. Which ADR level is required?
An investor owns ADRs of a British company. The underlying shares are unchanged in British pounds, but the pound weakens 10% against the U.S. dollar. What happens to the ADR value?
Which of the following is a characteristic of unsponsored ADRs?
2.1 Bond Fundamentals
Chapter 2: Debt Securities