American depositary receipts (ADRs) | Equity securities & trading | Common stock

If you didn’t already know, there are businesses outside of the United States (shocking, right?). Let’s say you wanted to invest in one of those businesses; specifically, a Japanese business. You’ll need to do a fair amount of work to invest in their stock.

First, you’ll get in contact with a broker-dealer who has access to the Japanese markets. Some US broker-dealers offer access to international investments, but not all of them. Also, you may have to pay extra fees for this service.

Next, you’ll need to learn the basics of the Japanese markets. In Japan, the Tokyo Stock Exchange is similar to the New York Stock Exchange (NYSE). It’s where stocks of larger companies trade in Japan. While their markets are familiar to ours, there are a few differences you may need to be aware of. For example, the Tokyo Exchange closes for lunch every business day between 11:30am and 12:30pm. If you really needed to buy or sell stock quickly, this may be a problem.

FYI - American markets do not close for lunch.

After you find the right broker-dealer and know the basics of the Tokyo Stock Exchange, you’ll convert your US Dollars to Yen to pay for the shares. This may present a problem, especially if there’s a bad exchange rate (weak dollar or strong yen - see below for more on currency exchange risk) or if there are significant fees through your broker-dealer for the conversion.

Sounds complicated, right? American Depositary Receipts (ADRs) were established in order to avoid these problems. ADRs are created by domestic financial firms with foreign branches. Companies like JP Morgan (which created the first ADR in 1927) purchase large amounts of foreign stocks that have high US demand. These foreign stocks are then placed into an account, which is usually structured as a trust (we’ll talk more about trusts in a future chapter).

From there, the financial firm “slices” up the account into a bunch of “receipts” for the stock. The receipts are then registered with the SEC and then sold to US investors in US markets.

Sidenote

Registration with the SEC

You should know this process from the SIE exam, plus we’ll do a deep review of the securities registration process in the primary markets chapter. For now, let’s recap some of the basics. When an investment is sold publicly, it typically needs to be registered with the Securities and Exchange Commission (SEC) prior to sale. The Securities Act of 1933 is a law that requires most issuers to register their securities with the SEC.

What is involved with registration? Filing a bunch of paperwork with the SEC, essentially. It’s the issuer’s responsibility to publicly divulge any “material” information about that security. Through this process, the public is able to make an informed investment decision if they choose to buy the security.

In the primary markets chapter, we’ll discuss more about who must register their securities, exemptions from registration, and more about the general process.

Definitions

Material: Any information that would influence an investment decision; important information about an investment

In some cases, the foreign issuer will work with the bank creating and issuing the ADR, essentially encouraging the creation of the ADR. Having an expanded audience of investors is almost always a good thing for issuers. If they need to raise additional capital later, the issuer can consider selling additional securities in their country and in the United States. With more investors aware of their existence, they have more access to money.

When the issuer works together with the bank to create the ADR, they form a sponsored ADR. Only sponsored ADRs can be exchange traded and come with translated financial documents. Unsponsored ADRs are created without the assistance or knowledge of the issuer, may only trade in the OTC markets, and their financial disclosures are not translated. Here’s an example of an untranslated financial disclosure form from Ageas, a Belgian insurance company with an unsponsored ADR trading in the US.

Luckily for investors purchasing an ADR (sponsored or unsponsored), there’s no need to know how a foreign exchange works, deal with a foreign securities broker-dealer, or convert money into a foreign currency. Honda Motor Corporation is an example of a sponsored ADR. Honda is based out of Japan and its stock primarily trades on the Tokyo Stock Exchange. However, Honda’s ADR (ticker symbol: HMC) trades on the NYSE and in US Dollars. Purchasing their shares is as easy as buying any other American stock.

Definitions

Ticker symbol: A set of characters that represent an investment. Every publicly traded stock has its own unique ticker symbol, which makes it easy to track a stock without typing out the full business name. Examples of ticker symbols:

TSLA = Tesla Inc.
BAC = Bank of America Corporation
MCD = McDonald’s Corporation

Although ADRs look and feel like any other American stock, they do come with some unique characteristics. First, most ADRs do not provide voting rights. Because the shares are technically owned by the financial firm that created the ADR, the investor isn’t actually viewed as an owner of the foreign stock. It’s much easier for the financial firm to vote on the shares themselves, especially when the vote takes place in a foreign language.

ADR investors will not receive pre-emptive rights, but are compensated for their value. The financial firm responsible for initially creating the ADR receives rights if they are issued. Those rights are then liquidated in the foreign market for their going market price and the proceeds are allocated to ADR holders as dividends.

Like common stockholders, ADR holders maintain the right to receive dividends, but there’s an added risk to be aware of. When a dividend is declared by the issuer, it is paid in the foreign currency. From there, the financial firm that created the ADR will convert the dividend payment to US Dollars.

Although the investor receives the dividend in US Dollars, the conversion rate between the foreign currency and the US Dollar may not be favorable. This is why ADRs are still subject to currency (exchange rate) risk even though payment is made in US Dollars. Additionally, the foreign government may withhold part of the dividend payment for tax purposes. If this occurs, the IRS provides a tax credit to investors for any foreign government tax withholding.

Sidenote

Currency (exchange rate) risk

When exchanging from one currency to another, risk can be involved. If you’ve heard the term “strong currency” or “weak currency,” (for example, the US Dollar is strong in Vietnam), then you’ve encountered this concept.

Let’s explore this idea with an example. Assume you invest in Honda’s ADR. Honda is a Japanese company and does a majority of its business in the Japanese Yen. When Honda makes a dividend payment, it makes the payment in Yen.

Behind the scenes, the yen is converted to US Dollars. If the US Dollar strengthened (or, if the Yen weakened - the same thing) just prior to the dividend payment, it would hurt your return. With a stronger Dollar, it takes more Yen to purchase the same Dollar. Because of currency exchange risk, the dividend payment results in fewer US Dollars.

Bottom line: when investing in foreign securities, currency exchange risk (also known as foreign currency risk) applies. In general, the risk applies in these circumstances:

The currency being exchanged out of weakens
The currency being exchanged into strengthens

To summarize, ADRs create an easy way for investors to purchase shares in foreign companies in US Dollars and in US markets. They come with their own unique characteristics and risks but provide a simple solution for investors seeking investments from around the globe.

Key points

American depositary receipts (ADRs)

US-registered receipts for foreign investments
Created by domestic financial firms with foreign branches
Trade in US dollars in US markets
Subject to currency exchange risk
No voting or pre-emptive rights
Foreign government tax withholding creates a US tax credit