What do you understand by the term American Depository Receipts (ADRs)? Explain its types and mechanism with the help of an example.

Answer 2(c) An American Depository Receipt (ADR) is a negotiable security representing ownership on 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. Types of ADRs: ADRs can be classified into two broad categories: Unsponsored ADRs: In such ADRs, the company has got no agreement with the custodian or depository bank for the issuance of ADRs. These are traded on the Over-The-Counter (OTC) market and are issued according to the market demand forces. Unsponsored ADRs can be issued by a number of depository banks. Each depository services only the ADRs issued by it. Sponsored ADRs: These are the ADRs which are sponsored by the company itself. In this case, the foreign company itself wants to issue ADRs and it does so by designating a depository bank that will issue ADRs in the foreign market on its behalf. It is of the following types: Level 1 Sponsored ADRs: These are the lowest level of sponsored ADRs. These are traded only on the OTC market. The company is supposed to adhere to minimal US Securities and Exchange Commission (SEC) requirements and is not required to publish reports in accordance to US GAAP Standards. Level 2 Sponsored ADRs: In level 2 ADRs, the ADRs are listed on a recognized US stock exchange and can be traded thereafter. The stock exchanges in which these ADRs can be traded are New York Stock Exchange (NYSE), NASDAQ, and the American Stock Exchange (AMEX). In such ADRs, the company is supposed to adhere to a higher level of SEC Regulations and is also required to publish annual reports in accordance with US GAAP or IFRS (International Financial Reporting Standards). Level 3 Sponsored ADRs: These are the highest level of sponsored ADRs. As such, it requires adherence to stringent rules and regulations similar to 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. The mechanism of the working of an ADR The following example would give a clear understanding of the mechanism of the working of an ADR and the parties involved. Suppose there is a broker, say Mrs. X. She buys the shares of a company, say Reliance Industries Limited (RIL) from the BSE Ltd. She then goes to his custodian bank, say ICICI, to hold the shares for the issuance of ADRs. She then goes to another bank, called the Depository bank, say JP Morgan and asks them to issue ADRs on the basis of shares in the custody of ICICI. In case of sponsored ADRs, the company (RIL in this case) can itself have a designated depository for issuance of ADRs, bypassing the custodian. JP Morgan then confirms the shares held by ICICI and issues ADRs to Mr. X. An ADR issued can represent a fraction of a share (say 1 ADR = ½ a share of RIL), 1 single share or multiple shares (say 10 shares of RIL make 1 ADR). These ADRs then can be traded on the US stock exchanges in a way similar to the trading stocks of US companies.