Alibaba (Binjiang campus pictured above) has traded on the NYSE as an ADR since 2014.
Danielinblue, CC-BY-SA-4.0 via Wikimedia Commons; Canva
Most well-known public companies in the U.S. trade on one of the two major American stock exchanges—the NYSE or the Nasdaq. As you may have noticed, however, major foreign companies trade on these exchanges as well despite many not being “officially” listed. So just how does this work?
What Are American Depositary Receipts & How Do They Work?
An American depositary receipt (ADR) is essentially a certificate that represents one or more shares of stock in a foreign company that typically trades on an exchange overseas. These certificates are issued by American banks, trade on major U.S. stock exchanges, and are transferable and negotiable, so they behave just like typical shares of any publicly traded domestic stock—for the most part.
In essence, ADRs are exchange-traded placeholders for shares of foreign stock. They allow American investors to buy, sell, trade, and even short foreign companies quickly and easily on American stock exchanges. They also allow domestic investors to avoid some of the cost and hassle of trading shares of foreign companies directly on a foreign stock market using foreign currencies, as ADRs are bought and sold exclusively in U.S. dollars.
How Do Banks Issue ADRs?
In order to create ADRs for a foreign stock, an American bank must first purchase shares of that stock directly on the foreign exchange where it is listed. The bank then holds these shares and issues ADRs in their place. The bank then puts these ADRs into circulation on the American stock market so that they can be bought and sold easily by U.S. investors.
When an American bank creates ADRs out of foreign shares, it may do so at a 1:1 ratio, meaning that each ADR share is equivalent to one share of the foreign company’s stock. Alternatively, a bank can create ADRs that represent shares at a different ratio like 2:1, 3:1, or 10:1, such that a single ADR share represents multiple shares of the underlying company’s stock.
American banks that issue ADRs for foreign companies are responsible for procuring detailed and accurate financial information about those companies and making it available to American investors.
ADR Example: Alibaba
Alibaba, a massive Chinese e-commerce company, is one of many foreign stocks that trade on U.S. exchanges as ADRs. Like U.S.-based Amazon, Alibaba is a largely digital retail giant that sells products directly to consumers and hosts a platform for retailers to sell their goods.
Alibaba’s ADR shares were created by Citi, a large American investment bank, and issued via IPO on the New York Stock Exchange in 2014. The Alibaba ADR was able to issue shares via IPO because it is a level III sponsored ADR (more on this later).
The shares can be freely traded by American investors, and like many popular U.S. stocks, they boast high liquidity and small bid-ask spreads. Because Alibaba’s ADR shares do not represent direct ownership in the company, however, they do not come with the voting rights typically bestowed to holders of a company’s common stock.
What Are the 2 General Types of ADRs?
There are two general categories of American depositary receipts—sponsored and unsponsored—and they differ in the degree to which the underlying foreign company is involved in the creation and issuance of the tradable receipts.
A sponsored ADR is one that is created cooperatively (via a legal agreement) between an American bank and the foreign company the ADR shares represent. In this situation, the foreign company “sponsors” the creation of the ADRs, typically by paying for the cost of their creation and maintaining some control over them. If an ADR is sponsored, it is the only ADR for the company in question.
Most—but not all—sponsored ADRs comply with all SEC regulations and U.S. accounting principles and trade on major U.S. exchanges like the NYSE and Nasdaq. Sponsored ADRs can (but often don’t) come with voting rights.
If an American bank purchases shares of a foreign company and then issues ADRs based on those shares without the participation or permission of the underlying foreign company, the ADR is considered unsponsored.
Banks that issue unsponsored ADRs pay for the process themselves, and any number of banks can create ADRs based on shares of the same company. So, while sponsored ADRs are the only of their kind, there can be multiple (different) unsponsored ADRs for a single company.
Unsponsored ADRs can only trade on the over-the-counter (OTC) market—not on major exchanges like the NYSE and Nasdaq. Additionally, they never come with voting rights.
What Are the 3 Levels of Sponsored ADRs?
Level I: Level I ADRs are subject to the least amount of oversight and the loosest SEC requirements. They only trade OTC, so they are more speculative and less liquid than ADRs that trade on major exchanges. Level I ADRs can only be used to establish trading in the American markets—not to raise capital. Level II: Level II ADRs are subject to more oversight and must register with and report to the SEC much like publicly traded American companies. They are allowed to trade on major exchanges and thus enjoy better liquidity and visibility than level I ADRs. Like level I ADRs, however, they cannot be used to raise capital via a public offering. Level III: Level III ADRs, like level IIs, are subject to SEC reporting, registration, and regulation, but unlike level IIs, they can raise capital via public offerings—much like Alibaba did via its 2014 IPO on the NYSE. In order to raise capital this way, the sponsoring company must file form F-1 with the SEC.
Do ADRs Charge Fees?
Most ADRs do come with a small, custodial fee charged by the depositary bank to compensate itself for the expenses associated with creating and managing the ADR. Typically, this “pass-through” fee ranges from around one to three cents per share, charged either quarterly or annually.
Before buying shares of an ADR, examine its prospectus for a full overview of any associated fees.
Do ADRs Pay Dividends?
If a foreign company pays dividends, its ADR equivalent usually does as well. However, these dividends are typically paid out in the company’s local currency, so local taxes may be incurred. Next, the American bank that issued the ADRs must convert these dividends into U.S. dollars, which also costs money.
Both taxes and conversion fees are typically taken out of dividend payments by the American depositary bank before they are passed along to ADR investors in U.S. dollars. These dividends can then be taxed further by the U.S. government unless the investor requests a credit from the IRS to avoid being taxed twice on the same income.
How Is ADR Income Taxed?
Any capital gains resulting from the sale of ADR shares are taxable at the relevant rate (depending on whether the shares were held for longer than a year) just like capital gains resulting from the sale of American stock shares.
As mentioned above, dividends from ADRs are often taxed in their country of origin before being passed along to the depositary bank and then ADR holders. If this occurs, ADR holders may need to file for a credit with the IRS to have the foreign tax deducted from what they owe in the U.S.
Do ADRs Come With Voting Rights?
ADR shares may or may not come with the voting rights typically endowed to common equity holders. In some cases, ADR holders may be able to communicate voting instructions to the depositary bank that issued the ADRs. The bank, who actually owns the shares, can then vote on the ADR holder’s behalf.
In many cases, however, ADR shares do not bestow voting rights, as they do not represent actual ownership in the underlying company.
How Can You Tell if a Stock Is an ADR?
The best way to tell for sure if a particular stock is an ADR or not is to look up its ticker symbol in an ADR database. J.P. Morgan and BNY Mellon both maintain searchable online ADR databases that are free to use. Simply search a company’s ticker symbol—if a result page for the company populates, it is an ADR.
J.P. Morgan ADR DatabaseBNY Mellon ADR Database
ADR vs. GDR: What’s the Difference?
A global depositary receipt, or GDR, is a general term used to refer to shares of any foreign company that are held by a local bank somewhere else in the world and traded publicly as depositary receipts on a stock exchange in the country where that bank is located.
So, while ADRs can only be traded on American exchanges, GDRs may trade on exchanges in the U.S. and elsewhere in the world.