American Depositary Receipt (ADR): What Is It?

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank representing ownership of shares in a foreign company’s stock. They offer U.S. investors an effective way to buy, hold, and sell foreign companies in an investment account with all transactions denominated in dollars. This removes the considerable complexity and cost associated with registering in individual countries and exchanging dollars for the local currency in order to buy and sell ordinary shares.

ADRs are created when a broker purchases securities of a foreign company directly in the local market and delivers the shares to a depositary bank (BNY Mellon, Citibank, etc.). This issues ADRs traded on U.S. Exchanges or in the OTC (over-the-counter) market. ADR securities trade freely at prices historically close to that of their underlying ordinary shares using the relevant foreign exchange rate.

Types of ADRs

There are two basic types of ADR securities: unsponsored and sponsored. An unsponsored ADR is typically established in response to market demand by depositary banks that do not necessarily have an agreement with the underlying company. A sponsored ADR program is established by one depositary bank that has a direct agreement with the foreign company whose shares the ADRs represent.

Additionally, sponsored ADRs are available in three levels (1, 2, and 3). Companies with Level 2 and 3 sponsored ADRs must register with the SEC and thereafter report their financial statements using accounting standards accepted by the SEC. Unsponsored or Level 1 ADRs are not required to register fully with the SEC; however, these companies must still have current financial statements and annual reports posted on their websites and issue material information via electronic press releases in English. Due to the cost of compliance and reporting, there are fewer Level 2 and 3 ADRs than Unsponsored and Level 1 ADRs.  Level 2 and 3 ADRs trade on U.S. exchanges, whereas unsponsored and Level 1 ADRs trade in the OTC market. Many investors believe that unsponsored and Level 1 ADRs are only for small foreign companies; however, this is not the case. Companies such as Nestle, Roche, Heineken, and Tencent all have Unsponsored or Level 1 ADRs.

ADR Taxes & Fees

While ADRs enable investors to bypass the complexity and cost associated with trading local market securities, they are not without their own fees. As compensation for administering the ADR, the depositary bank levies a depositary service fee (DSF). This is typically collected by subtracting a few cents from the dividend, often ranging from $0.01 to $0.03 per share. In addition, the depositary bank may apply other fees, such as a charge for converting the local shares to ADRs.

Dividends for ADR securities are based on the underlying local market security’s dividend distribution and the conversion ratio for local to ADR shares. While some countries withhold taxes on ADR dividends, U.S. investors are still liable for income tax on these dividends. However, they can claim the amount of foreign taxes withheld as a credit against the tax owed on the dividend income. The tax rates for short-term, long-term, and dividend income on ADRs are identical to those applied to U.S. common equity investments.

Pros:

• ADRs provide U.S. investors with an easier method of investing in foreign companies, as ADR shares are priced and pay dividends in U.S. dollars.
• ADR accounts do not require the client to set up and maintain sub-custodian trading accounts directly in the local markets which saves considerable time, effort, complexity, and expense.
• ADRs trade in unison with U.S. equity market hours, whereas ordinary shares trade when the local markets are open for business.
• Unsponsored ADRs increase the size of the investment universe.

Cons:

• Most ADRs are not as liquid as their corresponding local share, although this limitation can be circumvented in some cases by converting local ordinaries into ADRs.
• While the growth in the ADR market in the late 2000s and mid-2010s significantly increased the number of shares available, it remains smaller than the foreign equity universe.
• As discussed earlier, the same level of compliance and reporting is not required for all ADRs. ADR holders may be unable to participate in rights offerings unless the companies register them with the SEC. Unsponsored ADRs and many Sponsored Level 1 ADRs do not carry voting rights.
• Though not always the case, Unsponsored ADRs are generally less liquid than Sponsored ADRs.