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ADR's

There are numerous ways American investors can participate in the international markets. The simplest is purchasing a U.S. company with a large international presence. Exchange traded funds and mutual funds are also excellent ways to invest overseas. Generally, funds are classified as global funds (includes U.S. companies), international funds (excludes U.S. companies), regional funds, country funds, and index funds. 

However, for the more experienced investors looking for specific company diversification, or to participate in some of the faster growing overseas companies, depositary receipts are available.

Depositary receipts are the result of repackaging a foreign companyís locally traded shares into an internationally traded security. There are three types of deposited receipts:

         American Depositary Receipts (ADR) are traded in the United States.

         European Depositary Receipts (EDR)  are traded in Europe.

         Global Depositary Receipts (GDR) are traded in the US, Europe and other foreign markets.     

ADRís are created when an investment bank coordinates purchasing local shares of a foreign company, stores them overseas with a custodian bank and issues ADRís in the United States. The depositary bank issues the ADR certificates that are backed by the foreign shares that are held by the foreign custodian bank. ADRís are traded on the U.S. exchanges and on the over the counter market. ADR purchases and sales are conducted with U.S. dollars. Dividends paid on the foreign shares are also passed through to the ADR holders in U.S. dollars. Some countries require withholding tax on the dividends distributed. The ADR holder will get the net amount of the dividend, and at year-end will receive a 1099-Div form, showing the amount of foreign tax withheld.

There is also a conversion ratio between ADRís and the foreign shares. Each ADR represents a specified number of foreign shares. 

Pros and Cons of ADRís

Pros:

         ADRís are traded in U.S. dollars and trade on the U.S. stock exchanges.

         Conversion ratios are established to price ADRís comparable with U.S. stocks.

         Securities are safeguarded by the foreign custodian in a cost efficient manner.

         ADRís provide exposure to the U.S. capital markets, as well as a U.S. currency that can be used for acquisitions. ADRís are also used as compensation to motivate U.S. employees.

         ADRís can mitigate the risk of a falling U.S. dollar.

Cons:

         The price of foreign shares that are traded in their local currency, adjusted for exchange rates and conversion ratios, can vary materially from the U.S. dollar ADR share price. In China, for example, ďoutsidersĒ are paying a higher price then the ďlocalsĒ for the same claim on a companyís cash flow and assets. I shy away from ADRís that have this type of distortion.

         ADRís that are traded in the OTC markets must comply with their home marketís accounting rules, not U.S. accounting standards, and are exempt from the Sarbanes-Oxley legislation.

         Financial reporting by the foreign company may be untimely and hard to come by.

         Dividends paid on the foreign shares are passed through to the ADR holders in U.S. dollars, but foreign taxes may be withheld.

Types of ADRís

There are two types of ADRís: company sponsored and unsponsored ADR programs. The distinguishing feature is who pays the depositary expenses, the sponsoring company or the ADR holder.

There are also three levels of ADR shares:

  • Level I Ė These ADRís can only be established using existing foreign outstanding shares and are only allowed to trade on the over the counter market or on pink sheets. No new capital is allowed to be raised as a Level I ADR.  This is an inexpensive way for a foreign company to get the liquidity and exposure of the U.S. capital markets. The foreign company must file form F-6 with the SEC, which describes the terms of the ADRís and limited information on the issuer. The annual SEC form 20-F is not required.
     
  •  Level II Ė With Level II ADRís the issuing company is getting broad exposure to all the US major exchanges: NYSE, AMEX and NASDAQ. These ADRís are established with existing foreign shares outstanding. Like level I shares, the issuing company cannot raise new capital. With level II shares, the issuer must meet the requirements of the exchange that it is listed on. It also must have partially reconciled its financial statements to U.S. GAAP. The foreign company is required to file forms F-6 and the annual 20-F with the SEC.

         Level III Ė These ADRís are used to raise additional capital. SEC form F-1 and F-6 is required. The issuer must also meet the listing requirement of the exchange that itís listed on. Additionally, SEC form 20-F is filed annually. Financial statements must reconcile to GAAP. Level II and III ADRís are required to meet the Sarbanes-Oxley Actís corporate governance requirements.

Regarding how to select an ADR, your selection criteria are the same as with U.S. stocks, but with an added foreign currency risk exposure. 

Young adults, however, need to be careful here. The urge to jump in is great, especially with a falling dollar, and tremendous growth overseas. Nevertheless, be mindful of the three rules for international investing: research, research, and research!

 

 

 

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