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Understanding Different Levels of ADR Stocks

American Depository Receipts (ADR) are securities issued by U.S. banks that represent an ownership stake in a foreign company listed in the U.S. financial markets. The asset class allows investors to access foreign stocks without the complexity of dabbling in international markets.

ADRs were created to streamline investors’ access to foreign stocks. Without ADRs, investors wishing to invest in foreign stocks would need to exchange U.S. dollars for foreign currency, open a foreign brokerage account and then purchase the security on a foreign exchange.

With an ADR structure in place, a foreign company or investor who holds the underlying securities delivers them to a “depository” bank in the U.S. or a custodian in the company’s home country. The depository bank then issues the investor an ADR certificate that represents his or her ownership stake in the foreign company. From there, investors can trade their ADR shares in U.S. markets or over-the-counter just as they would trade a domestic company’s shares.

ADRs themselves are typically the units by which investors buy and sell on U.S. exchanges. They can be terminated or cancelled by the foreign issuer or depository bank that created them. When an ADR is terminated, it’s delisted from the U.S. exchange markets – but not before giving investors the opportunity to swap them for foreign securities.

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ADR Levels

Not all ADRs are created equally. The structure of the asset class can be grouped into three categories:

Level 1

Level 1 ADRs are traded over-the-counter, which means they can’t be accessed on American exchanges. This is the only level of ADR that can go unsponsored, which means the underlying foreign company doesn’t participate in the issuance of the ADR. As such, they have minimal SEC reporting requirements and aren’t required to comply with the generally accepted accounting principles (GAAP). This information gap makes Level 1 ADRs harder to compare to U.S. companies.

Examples of Level 1 ADRs include Air China (AIRYY), Airbus (EADSY) and UOL Group (UOLGY).

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Levels 2 and 3

Level 2 and Level 3 ADRs require the issuer to register and file annual reports with the SEC. The reporting guidelines for Level 3 are stricter than the Level 2 guidelines, as Level 3 ADRs have the added advantage of raising capital by going for an initial public offering on U.S. exchanges. As a result, they have to comply with strict compliance requirements as stipulated by the SEC. You can find additional information here.

A prime example of a Level 2 ADR is SAP AG (SAP)

Level 3 ADRs include Petroleo Brasileiro (PBR) and Mesoblast Ltd (MESO).

Be sure to read this article to know more about ADR stocks.

Fees and Other Considerations

While ADRs have several benefits, they’re also subject to additional fees when compared with traditional stocks. These include “pass-through fees” that go to depositary banks for serving as custodians. Fees typically range from $0.01 to $0.03 per share.

ADR investors are not only subject to capital gains taxes at home, but foreign tax regimes that vary significantly from country to country. Many foreign companies automatically withhold taxes on dividends paid by companies within their borders. Although the U.S. has tax treaties with many countries, this is one area of uncertainty that could add up to higher costs.

Some ADRs also face low liquidity, which impacts the bid/ask spread of the asset. Delays in currency conversion may also impact access to your funds.

Worried about ADR taxation? Check out this article to better understand taxation of ADRs.

The Bottom Line

American Deposit Receipts are a great way to gain exposure to foreign markets, but only when done properly. Be sure to weigh the opportunities and risks before venturing down this path

Be sure to visit our complete recommended list of the Best Dividend Stocks.