What is ADR? | Definition, Types, Working, Pros vs Cons

Depository Receipts are an essential mechanism of raising capital for domestic companies from the international equity markets. They are primarily instruments of negotiation through which foreign investors purchase shares in domestic companies enlisted in local markets using local currency.

In exchange for that investment, they issue a claim denominated in a convertible currency, the US dollar. These claims are called depository receipts and are enlisted on the stock exchange.

There are primarily two kinds of depository receipts enlisted under the domestic stock exchange but denote the security issues of a foreign publicly listed enterprise. American Depository Receipt is one of them.

Key Takeaways

1. ADR refers to Alternative Dispute Resolution, a process used to resolve legal disputes without going to court.
2. ADR can be voluntary or mandatory, including mediation, arbitration, negotiation, and conciliation methods.
3. ADR is preferred because it saves time, money, and effort compared to traditional litigation, and it allows for more control over the outcome.

How does American Depository Receipt work?

An ADR or American Depository Receipt is a negotiable instrument or certificate that a US depository bank issues to denote a foreign company’s securities trading in the US stock market. These are denominated in US dollars and traded in the US stock markets like domestic shares.

Foreign companies need to provide all the critical pieces of information regarding their financial status to get their shares converted into ADRs by a US bank.

The bank then purchases those stocks on foreign exchanges and holds them as inventory to issue ADRs for trading in the domestic markets.

A company’s illustrious description of its financial health enables American investors to decide whether they want to invest in that company.

ADRs are a lucrative opportunity for US investors who want to hold shares in foreign markets, which is otherwise not accessible.

It also proves to be profitable for foreign enterprises, as they can attract the capital of American investors without undergoing the expense and hassles of getting listed on the US stock markets.

Some significant US stock exchanges where ADRs get listed include the New York Stock Exchange and the Nasdaq. However, they are also exchanged over-the-counter (OTC).

Types of American Depository Receipts

There are primarily two kinds of ADRs that are listed on the US stock markets:

1. Sponsored: These results from an agreement between a US bank and a foreign company. According to the agreement, the company will bear the expense of issuing ADRs. In contrast, the bank will deal with transactions with stakeholders.
2. Unsponsored: The US banks issue these without the participation or even permission of the foreign company. Unlike sponsored ADRs, these are traded only over the counter. Besides that, investors have no voting rights for sponsored ADRs.

Advantages of American Depository Receipt

The following are some significant advantages of an American Depository Receipt:

1. As they are issued in a local currency, investors and firms find them hassle-free to trade. To investors, they are a rare opportunity to own shares in foreign companies. For the firms, on the other hand, they are a more straightforward way to bring American investors.
2. US banks issue ADRs with the underlying security kept as inventory. Consequently, they are easy to track down.
3. ADRs are denominated in US dollars. Consequently, they can be traded easily in domestic markets.
4. ADRs can be availed from US brokers.
5. They allow investors to diversify their portfolios.

Disadvantages of American Depository Receipt

Despite their several benefits, ADRs have some inherent limitations:

1. They could be subject to double taxation.
2. The selection of companies under ADRs is relatively limited.
3. There are possibilities of incurring currency conversion fees from the investors’ point of view.
4. Most ADRs are unsponsored, which in turn are non-compliant with SEC regulations.

References

1. https://www.sciencedirect.com/science/article/pii/S1042443117304419
2. https://meridian.allenpress.com/accounting-horizons/article-abstract/28/3/579/52905