American Depositary Receipts

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

First, you’ll need to contact a broker-dealer (BD) with access to the Japanese markets. Some American BDs 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 notable differences. For example, the Tokyo Exchange closes for lunch every business day between 11:30am and 12:30pm. If you needed to trade quickly, this might be a problem. FYI - American markets do not close for lunch.

After you find the right BD and know the basics of the Tokyo Stock Exchange, you’ll need to convert your US Dollars to Yen to pay for the shares. You may face a bad exchange rate (weak Dollar or strong Yen) or significant conversion fees.

Sounds complicated, right? American Depositary Receipts (ADRs) were established to avoid these problems. ADRs are created by domestic financial firms with foreign branches (e.g., an American bank with an office in Japan). Companies like JP Morgan (which made the first ADR in 1927) purchase large amounts of foreign stocks with high US demand. The stocks are placed into a trust account (we’ll talk more about trusts later), then the account is sliced into “receipts” for the stock. The receipts are then registered with the SEC and sold to American investors in US markets.

Investors who purchase ADRs don’t need foreign market knowledge, BDs with access to international markets, or money conversions. Honda Motor Corporation is an example of an 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.

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

ADR investors do 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. When the issuer declares a dividend, it is paid in foreign currency. The trust holding the stock then converts the dividend payment to US Dollars (so it can be paid to ADR holders). The conversion rate between the foreign currency and the US Dollar may not be favorable. Therefore, ADRs are still subject to currency exchange 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.