American Depositary Receipts

If you want to invest in a company outside the United States - say, a Japanese company - you’ll usually have to do some extra work to buy its stock directly.

First, you’d need to contact a broker-dealer (BD) that can access Japanese markets. Some American BDs offer international trading, but not all do. You may also pay additional fees for this service.

Next, you’d want to understand the basics of the Japanese markets. In Japan, the Tokyo Stock Exchange is similar to the New York Stock Exchange (NYSE): it’s a major exchange where larger companies’ stocks trade. Even though the market structure is familiar, there are some practical differences. For example, the Tokyo Stock Exchange closes for lunch every business day from 11:30 a.m. to 12:30 p.m. If you needed to trade during that window, you couldn’t. American markets do not close for lunch.

Finally, after choosing a BD and understanding the market, you’d need to convert U.S. dollars into Japanese yen to pay for the shares. That conversion can involve an unfavorable exchange rate (a weak dollar or strong yen) and/or meaningful conversion fees.

American Depositary Receipts (ADRs) were created to reduce these obstacles. ADRs are created by domestic financial firms with foreign branches (for example, an American bank with an office in Japan). Firms such as JP Morgan (which created the first ADR in 1927) buy large amounts of foreign stock that has strong demand in the U.S. The shares are placed into a trust account (we’ll talk more about trusts later), and then that account is divided into “receipts” representing the stock. Those receipts are registered with the SEC and sold to American investors in U.S. markets.

Investors who buy ADRs generally don’t need detailed foreign market knowledge, a BD with direct foreign-market access, or personal currency conversions.

Honda Motor Corporation is an example of an ADR. Honda is based in Japan, and its stock primarily trades on the Tokyo Stock Exchange. However, Honda’s ADR (ticker symbol: HMC) trades on the NYSE and is priced in U.S. dollars. Buying it is similar to buying any other U.S.-listed stock.

Although ADRs trade like U.S. stocks, they have a few important differences.

First, most ADRs do not provide voting rights. The underlying shares are technically owned by the financial firm that created the ADR, so ADR investors typically aren’t treated as the foreign company’s direct shareholders. In addition, voting can be more practical for the financial firm to handle, especially when voting materials and procedures are in a foreign language.

ADR investors also do not receive pre-emptive rights, but they are compensated for their value. If rights are issued, the financial firm that created the ADR receives them. Those rights are then sold (liquidated) in the foreign market at their current market price, and the proceeds are distributed to ADR holders as dividends.

Like common stockholders, ADR holders have the right to receive dividends, but there’s an added risk. When the issuer declares a dividend, it’s paid in the foreign currency. The trust holding the stock then converts the dividend into U.S. dollars so it can be paid to ADR holders. If the exchange rate is unfavorable at the time of conversion, the dividend will translate into fewer U.S. dollars. So, even though ADR dividends are paid in U.S. dollars, ADRs are still subject to currency exchange risk.

In addition, a foreign government may withhold part of the dividend for tax purposes. If that happens, the IRS provides a tax credit to investors for the amount withheld by the foreign government.