What Are ADR Custodial Services for Investors?

American Depositary Receipts (ADRs) allow U.S. investors to gain exposure to foreign companies without directly engaging in international stock exchanges. These financial instruments simplify investing in non-U.S. entities by trading within the familiar framework of U.S. markets.

What are ADRs

An American Depositary Receipt (ADR) is a negotiable certificate issued by a U.S. depositary bank, representing a specified number of shares of a foreign company’s stock. These certificates trade on U.S. stock markets, such as the New York Stock Exchange (NYSE), Nasdaq, or over-the-counter (OTC) markets, just like domestic shares. Denominated in U.S. dollars, ADRs simplify transactions for American investors by eliminating the need for foreign currency exchange.

ADRs fall into two categories: sponsored and unsponsored. Sponsored ADRs are issued by a U.S. depositary bank on behalf of the foreign company, which is actively involved and typically covers issuance costs. Unsponsored ADRs are created by broker-dealers without the foreign company’s direct involvement or consent. Three main levels of sponsored ADR programs exist, each with differing regulatory requirements and trading venues.

Level I ADRs trade exclusively on the over-the-counter market, subject to the fewest U.S. Securities and Exchange Commission (SEC) reporting requirements. Foreign companies often use them to establish a trading presence without extensive compliance. Level II ADRs can be listed on U.S. stock exchanges like the NYSE or Nasdaq, requiring more stringent SEC registration and annual reporting, though they cannot raise new capital. Level III ADRs allow foreign companies to list on major U.S. exchanges and raise capital directly from American investors through public offerings, necessitating adherence to comprehensive SEC reporting rules similar to those for U.S. companies.

How ADRs Work

The process of ADRs begins with a U.S. depositary bank acquiring shares of a foreign company from its home market. The bank holds these foreign shares in custody, often through an overseas branch or a local custodian in the foreign company’s country. The depositary bank then issues ADRs to U.S. investors, with each ADR representing a specific number of the underlying foreign shares. This ratio can vary; one ADR might represent one foreign share, a fraction of a share, or multiple shares, a decision set by the depositary bank to make the ADR’s price appealing to U.S. investors.

Once issued, ADRs trade on U.S. stock exchanges or over-the-counter markets, functioning much like domestic shares. Investors buy and sell ADRs through their regular brokerage accounts. When the foreign company pays dividends on its underlying shares, the depositary bank collects these payments in foreign currency. The bank then converts the dividends into U.S. dollars and distributes them to ADR holders. This process simplifies dividend collection for U.S. investors, as they receive payments in their local currency without managing foreign exchange.

The Role of Custodial Services

The depositary bank that issues ADRs also provides custodial services for the underlying foreign shares. These services manage and oversee the foreign securities. A primary function is holding the foreign company’s shares, typically kept with an overseas branch or a local custodian in the foreign company’s home country. This custody arrangement safeguards the underlying assets that back the ADRs.

Custodial services include the collection and conversion of dividends. The depositary bank collects dividends paid by the foreign company in its local currency, converts them into U.S. dollars, and distributes these funds to ADR holders. This streamlines income receipt for investors. The bank also manages corporate actions related to the underlying foreign shares, such as stock splits, mergers, rights offerings, or tender offers. These events are accurately reflected in the ADRs, and the depositary bank ensures ADR holders receive correct entitlements or have the opportunity to participate.

Depositary banks provide financial reports and other relevant information from the foreign company to ADR holders, often including reports translated into English. This ensures investors have access to company disclosures. Depositary banks also facilitate voting rights for ADR holders where applicable, allowing investors to participate in shareholder meetings or cast votes on company matters. These custodial services simplify international investing by handling complexities that would otherwise fall to individual investors.