Consentia on Law

Mechanics of American depository Receipts (ADR)

With the opening of Indian financial market in nineties, Indian corporates joined the worldwide rush to raise funds from issue of depository receipts. The question of how the corporate finance themselves and what options they have is not new, however the issue of shares through depository receipt mechanism has provided the corporates with a great option of raising funds from international markets with relatively low risks as compared to the other options available for the corporates in the international markets. In the depository receipt mechanism the issuer company actually issues its equity shares in another market by complying with certain terms and conditions as prescribed by their relevant market regulators. In the depository receipt mechanism, the overseas depository banks have their vital role to play because the issuer company is a non-resident company and they need to bring local intermediaries in order to issue their shares through depository receipt mechanism.  The history of American depository receipt (ADR) takes us to 1927, when J.P. Morgan introduced the concept of ADR for the first time in order to facilitate the trading of equity shares of a U.K. based company into the U.S. market.

What is an ADR?

According to Regulation 2(d) of Issue of foreign currency convertible bonds and ordinary shares (through depository receipt mechanism) Scheme 1993 “any instrument in the form of a depository receipt or certificate (by whatever name it is called) created by the Overseas Depositary Bank outside India and issued to non-resident investors against the issue of ordinary shares”.

Hence, in the light of above mentioned definition we can deduce that an American depository receipt (ADR) is a negotiable security representing ownership in some underlying shares of a non-US company, which can be traded on US stock exchanges. ADRs are denominated in US dollars and function on the lines of the shares of a US company in terms of trading and dividend payment.

EURO Issue (GDR’s)

As a part of globalizing the economy of India after 1991, Indian corporate world was permitted to float their securities in, and raise funds from the Euro markets. The shares issued in the form of depository receipt for trading in the international markets apart from United States of America are called as Global depository receipt (GDR).

ADR Mechanism

After getting introduced with the concept of ADR we must look upon the working of the ADR, in other words the ADR mechanism.

We can understand the working of ADR’s by taking example of a scenario. Suppose there is one Mr. A who buys shares of a Company X ltd. From the Indian stock market for example BSE. Now, A deposits those shares purchased by him to the custodian bank (Let us say Royal Bank of Scotland) who is registered as custodian of securities under the SEBI Custodian of securities Regulation, 1996. Thirdly, A makes an agreement with overseas depository bank (ODB) for example J.P. Morgan to issue ADR’s on behalf of A thereafter, The ODB requests confirmation from the Domestic custodian bank in order to ensure that securities are deposited as specified by A. After getting confirmation by the Domestic custodian Bank the overseas depository bank issues ADR to A. The ADR so issued are freely traded on stock markets similar to stocks of U.S. companies.

The non-resident entity issuing the securities under ADR mechanism does not necessarily participate in the arrangement. The depository (overseas depository bank) may have no direct connection with the company sponsoring ADR other than appearing on its records as a shareholder. There is no direct contractual relationship between the ADR holder and the company sponsoring ADR, but rather between the holder and the overseas depository bank. Although formal contracts or depositary agreements originally are prepared to observe the relationship between the depository bank and the ADR holder, modern ADR agreements include the terms of the arrangement on the ADR certificate itself.

Pricing and returns of ADR

Like all ADRs we can see this in Indian ADR prices that these are almost never equal to the price of Indian shares they represent, after adjusting for the exchange rate differences. Derivative instruments like ADRs trade at a premium or discount in relation to their underlying securities within the band of transaction costs so that there is no arbitrage opportunity. In the case of ADRs, however, the “transaction cost” barrier necessary to prohibit arbitrage is difficult to determine a priori, particularly in light of restrictions to cross-border investment, as is the case in India.

ADR’s issued by Financial sector companies, like those of HDFC and ICICI Bank, have enjoyed high premiums. As an industry financial companies probably have been able to sustain the highest and most stable premiums among the Indian companies who have issued ADR.

Returns of ADR appear to have unanticipated factors that brings fluctuations in prices. The return on the underlying stock, the US-India exchange rate, the BSE national index movements as well as the movement on two important US indices the S&P 500 and NASDAQ together account for less than half of the total market volatility of ADR returns in most cases.

The ADRs generally enjoy considerable premium over their underlying stocks, indicating effective market segmentation between the US and Indian markets. Infosys enjoys particularly high premiums but much of its premium is determined by the swings in the NASDAQ[1] index. US market indices also affect the premium on other ADRs from India, though it affects to a smaller extent.

Classification of ADR

ADR can be divided into two broad categories:

Unsponsored ADR: The unsponsored ADR is not issued by the company directly. The company has got no agreements with the custodian bank and depository bank. These ADR are sponsored by a third party Issuer. These are generally traded at over the counter (OTC) markets instead of regular stock exchanges.

Sponsored ADR

These ADR’s are sponsored by the company itself. Here the foreign company itself proposes to issue ADR’s and it does so by making an agreement with an overseas depository bank that will issue ADRs in the foreign market on the behalf of the issuer company.

There are three types of clearances under the sponsored ADR’s

a) Sponsored ADRs of Level 1: These are a type of sponsored ADR’s. These are traded only on the OTC market. The issuer company is supposed to comply with minimal US Securities and Exchange Commission (SEC) compliance requirements and is not required to publish reports in accordance to US GAAP standards.

b) Sponsored ADRs of Level 2: These ADR’s are of second level; these ADR’s are listed on a recognized US stock exchange and can be traded thereafter similar to ordinary U.S. Company’s shares. The stock exchanges where these ADR’s can be traded are New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX).

In such ADRs, the company is supposed to comply with higher level of SEC compliance requirements and is also required to publish annual reports in accordance with US GAAP or IFRS (International Financial reporting Standards).

c) Sponsored ADRs of Level 3: These ADR’s are of highest level in sponsored ADR’s categories. As such, it requires compliance to more stringent rules and regulations as compared to level 2 similar to the US companies. In this type of ADRs, the company rather than letting its shares from the home market to be deposited in for the ADR program, actually issues fresh shares in the form ADRs to raise capital from the US market.

Issue of shares by Indian Companies under ADR Mechanism

For Indian Companies the better way to raise funds from international markets with minimum risks is through ADR or GDR. In India issue of shares under ADR mechanism is governed by the “Issue of Foreign Currency Convertible Bonds and Ordinary Shares (Through Depository Receipt Mechanism) Scheme 1993” issued under Foreign Exchange Management Act.

Under the Scheme they have set guidelines for eligibility conditions, limits of foreign investment, issue structure, listing conditions, transfer and redemption and tax related guidelines.

According to regulation 3 of the Scheme An issuing company desirous of raising foreign funds by issuing foreign currency convertible bonds or ordinary shares for equity issues through Global Depositary Receipt is required to obtain prior permission of the Department of Economic Affairs, Ministry of Finance, Government of India. The Scheme also provides for Indian companies engaged in information technology software and information technology services are eligible to offer to their non-resident/resident permanent employees (including Indian and overseas working directors) global depository receipts against the issue of ordinary shares under the scheme subject to the operational guidelines/conditions issued from time to time by the Government. In this respect, the Scheme defines Software Company as a company engaged in manufacture or production of software where not less than 80 per cent of the company’s turnover is from software activities.

Under the Scheme, ordinary shares issued under depository receipt mechanism will be treated as foreign direct investment in the company sponsoring or issuing ADR. Also, the aggregate of the foreign investment made either directly or indirectly (through Depositary Receipts Mechanism) shall not exceed 51% of the issued and subscribed capital of the issuing company. Provided that the investments made through Offshore Funds or by Foreign Institutional Investors will not form part of the upper limit specified as above.


[1] NASDAQ stands for National Association of Securities Dealers Automated Quotations.

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