American Depositary Receipts: Buy Foreign Stocks in Dollars

Key Takeaways

• American depositary receipts are certificates issued by a US bank representing foreign shares, traded in dollars on US exchanges.
• Over 2,000 ADRs from 70+ countries currently trade, representing everything from Level I OTC pink sheets to fully SEC-reporting Level III listings.
• Investors often ignore that a rising foreign stock can still produce an ADR loss if the local currency falls sharply against the dollar.
• Level I ADRs trade over the counter with minimal SEC reporting and are not equivalent to exchange-listed Level II or III programs.

What It Is

An ADR is a negotiable certificate issued by a US depositary bank. The bank holds the underlying foreign shares in custody overseas and issues receipts in the US that trade in dollars. Each ADR represents a defined number of ordinary shares, which can be one, many, or a fraction, depending on how the program is structured.

The SEC's Office of Investor Education notes that more than 2,000 ADRs currently trade, representing companies from over 70 countries. The first ADR was created in 1927 to give US investors access to a British retailer.

The Intuition

Foreign listings create friction for US investors. Trading hours differ, brokers may not have direct access, and dividends arrive in a foreign currency. ADRs solve that by wrapping the foreign share in a US security. The investor sees a ticker that trades on NYSE, Nasdaq, or OTC, quoted in USD, settling in two business days like any US stock. The depositary bank handles the mechanics of holding the underlying shares abroad and converting dividends into dollars.

How It Works

ADRs come in two broad flavors: sponsored and unsponsored.

A sponsored ADR is created with the cooperation of the foreign company, which signs a deposit agreement with a single US depositary bank. Sponsored ADRs can be listed on major exchanges and are the standard path for serious foreign issuers.

An unsponsored ADR is created by one or more US depositary banks without the foreign company's formal involvement. Unsponsored ADRs trade only over the counter and carry less consistent disclosure.

Sponsored ADRs come in three levels, each with different disclosure and listing rights:

• Level I: Over-the-counter only. Minimal SEC reporting. Establishes a US trading presence but cannot raise new capital.
• Level II: Listed on NYSE or Nasdaq. Must file Form 20-F annually with the SEC and reconcile financials to US standards. Cannot raise new capital.
• Level III: Listed on a major exchange and used to issue new shares to US investors. The highest disclosure tier, comparable to a US IPO.

Dividends paid by the foreign company are received by the depositary, converted to USD at the prevailing exchange rate, and distributed to ADR holders, usually net of a custody fee. Depositary banks charge these fees, sometimes called depositary service fees, to cover recordkeeping, dividend processing, and corporate action handling. Fees are typically a few cents per share per year and are disclosed in the prospectus.

Worked Example

Suppose a UK-listed company trades at 40 GBP in London. A US depositary bank establishes a Level II ADR program where 1 ADR equals 2 ordinary shares. If the spot rate is 1.25 USD per GBP, each ADR should reference about 40 x 2 x 1.25 = 100 USD worth of underlying stock.

The company pays a 2 GBP annual dividend per ordinary share. Per ADR, that is 4 GBP. The depositary converts to USD at the prevailing rate, say 5.00 USD gross. The UK typically applies no withholding on dividends paid to non-residents, but in other jurisdictions a foreign withholding tax of 15 to 30 percent might apply. The depositary then deducts a small custody fee, perhaps 0.02 USD per ADR, and pays the remainder to the holder.

Common Mistakes

• Assuming the ADR price tracks only the stock. It tracks the foreign share price times the exchange rate. A rising foreign stock can still produce an ADR loss if the local currency falls sharply against the dollar.
• Ignoring depositary fees. Custody fees are small but real. They are deducted from dividends or, for non-dividend payers, charged periodically. Over years they compound.
• Treating unsponsored ADRs as equivalent to sponsored. Unsponsored programs have thinner disclosure and can have multiple competing depositaries for the same stock. Liquidity and spreads are usually worse.
• Forgetting foreign withholding tax. Some countries withhold on dividends paid to US holders. The holder may be able to claim a foreign tax credit on their US return, but the cash yield net of withholding can be materially lower than headline.
• Confusing Level I with exchange-listed ADRs. Level I ADRs trade on the OTC pink sheets with looser reporting. The underlying company may not file audited statements that meet US standards.

Frequently Asked Questions

Q: What are American depositary receipts in simple terms? An ADR is a US-traded certificate, denominated in dollars, that represents a specified number of shares in a foreign company held in custody by a US depositary bank. It lets US investors own Toyota or Nestle without a foreign brokerage account.

Q: How do American depositary receipts affect investment decisions? ADRs add currency exposure to equity exposure: even if the underlying stock rises, a falling local currency can produce a flat or negative ADR return. Investors also face depositary fees deducted from dividends and potential foreign withholding tax on income.

Q: What is a real-world example of an American depositary receipt? A UK company trading at 40 GBP with a Level II ADR program where 1 ADR equals 2 ordinary shares would reference roughly $100 of value when the pound is at 1.25 USD. A 2 GBP per share dividend converts to roughly $5 per ADR minus withholding and depositary fees.

Q: How can investors use American depositary receipts effectively? Stick to Level II or Level III sponsored ADRs on major exchanges where the company files Form 20-F with the SEC. Check the depositary agreement for fee structure and research the foreign withholding tax rate, which can meaningfully reduce dividend income.

Q: How are American depositary receipts different from ordinary foreign shares held directly? ADRs trade in USD during US market hours with standard T+2 settlement through US brokers. Directly held foreign shares trade in local currency during local market hours, requiring a foreign brokerage account, currency conversion, and different settlement mechanics.

Sources

1. SEC Office of Investor Education and Advocacy. "Investor Bulletin: American Depositary Receipts." https://www.sec.gov/files/adr-bulletin.pdf
2. Investor.gov. "American Depositary Receipts (ADRs)." https://www.sec.gov/fast-answers/answersadrshtm.html
3. Fidelity Learning Center. "Understanding American Depositary Receipts (ADRs)." https://www.fidelity.com/learning-center/investment-products/stocks/understanding-american-depositary-receipts
4. Cleary Gottlieb. "Guide to Public ADR Offerings in the United States." https://www.clearygottlieb.com/~/media/organize-archive/cgsh/files/publication-pdfs/guide-to-public-adr-offerings-in-the-united-states.pdf

Disclaimer

This article is educational content only and is not financial advice. Nothing here is a recommendation to buy, sell, or hold any security. Consult a licensed advisor before making investment decisions.