American Depository Receipts

Hint: You can buy ADRs on moomoo.

Diversifying your portfolio is crucial to managing risk. Investing in several markets across the globe minimizes potential losses in your portfolio. If you invest only in U.S. stocks, a domestic crash could deal a heavy blow to your portfolio. But a rise in your foreign investments may offset the crash.

The best part about investing in foreign stocks is the potential profits. Indian and Southeast Asian markets have proved to be highly lucrative for investors. India’s stock market boomed in 2021. To minimize your risk, American Depository Receipts (ADRs) could be a great way to diversify your portfolio.

BSE Sensex Index (India) — Source: TradingView

What is an American Depository Receipt?

An American Depository Receipt is a negotiable certificate that a U.S. depository bank issues and specifies the number of shares held in a foreign company’s stock. ADRs trade on U.S. stock markets. They are a form of equity security.

Benefits of an American Depository Receipt

Besides diversifying your portfolio, ADRs offer you a simple way to invest in foreign markets. ADRs also make it easy for non-U.S. companies to access U.S. capital markets.

Represent ownership of a foreign stock: ADR investors are owners of a foreign stock. An American bank or a broker issues an ADR, which stipulates the number of foreign shares that the institution holds in the foreign market. Each ADR represents the same number of shares. Some ADRs pay dividends. 

Trade on American stock exchanges: The New York Stock Exchange and the Nasdaq list ADRs. To offer ADRs, a U.S. bank purchases shares on a foreign exchange. It holds the stock as inventory and issues ADRs for domestic trading. You can also buy ADRs over the counter (OTC). That process involves trading securities via a broker-dealer network. You can trade, settle and hold all listed ADRs as if they were U.S. stocks.

Priced in dollars: ADRs are denominated in U.S. dollars. You don’t have to transact in foreign currency and bother with foreign exchange. The U.S. markets price and trade ADRs in dollars, clearing them through a domestic settlement system.

Liquid way to invest in foreign companies: U.S. investors can easily purchase ADRs without using international brokers and potentially exchanging their dollars. Liquidating those securities is just as simple and efficient. Investors don’t have to endure a lengthy and arduous process. 

Drawbacks of an ADR

The proceeds you receive from ADR holdings could be subject to U.S. income or capital gains taxes. It can also be subject to backup holding. And you can be double taxed. Your dividends and capital gains realized from ADRs are in U.S. dollars. 

A U.S. bank withholds the amount needed to cover conversion expenses and foreign taxes. To avoid double taxation, you need to request a credit from the IRS for capital gains realized. Or you can request a refund from the foreign government’s taxing authority for the same gain. 

Types of American Depository Receipts

A foreign company wishing to offer U.S. investors its shares has to choose between three different programs. The level that a foreign company belongs to depends on the extent it has accessed U.S. markets. A bank can issue sponsored or unsponsored ADRs on behalf of a foreign company.

Sponsored: A domestic bank and a foreign company enter into a legal agreement. The U.S.  bank is responsible for the sale, distribution of the shares, dividends and recordkeeping. Usually, the foreign company retains control of an ADR and pays the costs of issuing it when the bank transacts with investors. 

The foreign company’s degree of compliance with the U.S. Securities and Exchange Commission (SEC) regulations and U.S. accounting procedures determine the sponsored ADRs categorization. Banks working with foreign companies issue only one ADR that’s part of the sponsored program. Sponsored ADRs trade on U.S. stock exchanges.

Unsponsored: A foreign company doesn’t participate in, permit or get involved in an unsponsored ADR certificate. Even brokers and dealers can issue the shares. That could result in several U.S. banks and brokers offering different unsponsored ADRs for the same foreign company. Various dividends may accompany these offerings. 

ADRs trade over the counter and don’t include voting rights. Registration with the SEC is not required. Brokers trading ADRs before 2008 had to submit a written request to trade them in the U.S. The 2008 SEC Amendment exempted foreign issues that met certain regulations.

Level I: Companies that don’t want their ADRs listed on exchanges prefer Level I. Foreign companies can use it to establish a trading presence in the OTC market. They can’t use it to raise capital. Level I is the only facility that offers unsponsored ADRs. 

Companies in Level I have minimal reporting requirements to the SEC. They need to file a Form 6. Information about the issuer isn’t available on the SEC’s EDGAR system. But the foreign company must publish that information on its website. These companies aren’t required to issue quarterly or annual reports. 

These ADRs are usually highly speculative. They’re riskier than other ADRs, but they’re a cheap method for foreign companies to determine U.S. investors’ interest in its security.

Upgrading to Level II is possible when the issuing company decides to sell on U.S. exchanges.

Level II: Companies on Level II cannot use ADRs to raise capital, but they can trade on U.S. stock exchanges. Their bigger exposure and trading volume mean they must comply with more SEC regulations than Level I issuers.

The issuer has to register with the SEC using Form 6. The foreign company must file annual reports on Form 20-F to the SEC by generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS) standards. The issuer can be delisted or downgraded to Level I if it fails to comply with all requirements.  

Level III: Issuers on Level III enjoy the most privileges. It’s the highest level that a foreign company can sponsor. Besides establishing a bigger trading volume, Level III issuers can raise capital on U.S. exchanges. They can float a public offering of ADRs. But they’re required to meet stricter reporting rules, similar to ones that U.S. companies follow.

The foreign company must file a registration statement on Form F-1, F-3 and F-4 to offer ADRs. Also, it must file annual reports on Form 20-F. If the issuer distributes materials to shareholders in its home country, it must submit Form 6-K.

Numerous big corporations are on Level III. Some examples of foreign companies on this level are Vodafone Group (NASDAQ: VO) and Grifols (NASDAQ: GRFS).

Compare ADR Brokers

Besides providing the latest market news and trading signals, Benzinga also offers ADR broker reviews. ADRs make it easy for U.S. investors to purchase foreign-company stocks domestically. But Benzinga simplifies that process further by offering insights into the best ADR brokers.

Choosing the right ADR broker for your needs helps you avoid unnecessary fees and time-wasting. 

What is a DRS?

A Direct Registration System (DRS) enables electronic registration of securities in an investor’s name on the issuer’s books. That process enables the electronic transfer of shares between a transfer agent and a broker. The brokerage firm holds the security in book-entry form — you don’t receive a certificate.

DRS enables investors to hold securities differently. It originated in 1996 because investors didn’t want their stocks registered in the firm’s name in case it bankrupted. That enabled investors to buy or sell from a transfer agent. They could arrange trades through the DRS via their favorite broker.

Investors who hold securities in a DRS book-entry position receive statements from the issuer or its transfer agent to confirm security ownership. Then, investors can transfer their DRS book-entry position to a bank or a broker.

Are ADRs the same as treasury bonds?

No. U.S. investors use ADRs to purchase foreign-company stocks on domestic exchanges and OTC markets. A Treasury bond is government security that the U.S. federal government issues. It matures in 20 or 30 years and receives interest every 6 months until maturity.

At maturity, Treasury bondholders receive the face value of the bond. They can hold the bond until maturity or sell it before then. Treasury bonds are regarded as risk-free because the U.S. government backs them via its ability to tax citizens. 

T-bonds usually provide a lower return rate than equities that pay dividends. They are also exposed to inflation risks. Selling them before maturity could result in a loss since the sales price may be lower than the purchase price. Buying a Treasury bond is similar to buying ADRs.