Guide to American Depositary Shares ADS

Core Description

• American Depositary Shares (ADS) allow investors to access foreign companies through U.S. markets, simplifying investment in overseas equities by settling in U.S. dollars.
• Each ADS represents a set number of a company’s ordinary shares, and their price and dividends reflect the value of those shares, adjusted for exchange rates and fees.
• ADS present both opportunities and risks, including diversified exposure, currency impacts, voting limitations, fees, and tax complexities.

Definition and Background

American Depositary Shares (ADS) are U.S. dollar-denominated equity securities issued by a U.S. depositary bank, each representing a predetermined number of a foreign company’s ordinary shares held by a local custodian. ADS trade on U.S. exchanges such as NYSE and Nasdaq, or over the counter (OTC), providing American and international investors convenient access to companies listed abroad.

Historical Context

The concept of ADS began in 1927, when J.P. Morgan introduced the first depositary receipt. This enabled U.S. investors to trade shares in a London retailer without the need for foreign accounts or dealing with international settlement procedures. Over time, as U.S. securities regulations evolved, ADS programs became more standardized, particularly following the implementation of laws like Sarbanes-Oxley and the broader adoption of International Financial Reporting Standards (IFRS).

Regulatory and Practical Structure

A foreign company places its local shares with a custodial bank in its home country. In return, a U.S. depositary bank issues ADS, each representing a specific number of these local shares. Investors can buy and sell ADS on U.S. platforms in dollars, receive dividends in dollars, and benefit from U.S. disclosure standards. However, the underlying exposures, risks, and entitlements mirror the foreign shares. The key distinction is that the American Depositary Receipt (ADR) is the physical certificate, while the ADS is the tradable equity.

Calculation Methods and Applications

Understanding the mechanics of ADS is important for assessing their value and managing investment risks.

ADS Ratio and Pricing

Each ADS is linked to a specific number of the issuer’s ordinary shares—this is known as the ADS ratio (for example, 1 ADS = 2 ordinary shares). The ratio is set to target price bands familiar to U.S. investors and may change due to stock splits, rights issues, or reorganizations.

Price Calculation Example:

• Local share price: 2,400 JPY
• ADS ratio (N): 2 shares per ADS
• USD/JPY exchange rate: 150
• Parity ADS price = 2,400 × 2 ÷ 150 = USD 32.00
• After accounting for a USD 0.02 depositary fee and a USD 0.03 spread, an indicative ADS price is approximately USD 31.95

Dividends

Dividends for ADS holders are calculated as follows:

Dividend per ADS = dividend per ordinary share × N × (1 - withholding tax) - depositary fee

The depositary bank receives the dividend in the local currency, manages tax withholding and fee deduction, then converts the net amount into U.S. dollars for distribution to ADS holders.

Creation and Cancellation

Authorized participants can exchange local shares for ADS (“creation”) or vice versa (“cancellation”) to keep ADS prices closely aligned with the underlying shares, after factoring in FX, custody, and bank fees. Significant price gaps between the two typically result in arbitrage, which helps maintain parity.

Case Application: Toyota ADS

For illustration, suppose Toyota’s ordinary shares trade at 2,400 JPY, the ADS ratio is 2, and the USD/JPY rate is 150. Using the formula, the parity price is USD 32.00 per ADS. If a dividend of 50 JPY per share is declared, each ADS entitles the holder to a pre-tax payout of 100 JPY, reduced by withholding tax and converted to USD.

Comparison, Advantages, and Common Misconceptions

ADS vs. ADR

• ADS are the underlying tradable equity; the ADR is the official certificate. In practice, these terms are often used interchangeably.

ADS vs. Global Depositary Receipts (GDR)

• GDRs function similarly but are available outside the U.S., often denominated in other currencies and cleared through networks such as Euroclear. ADS settle in U.S. dollars and under U.S. regulation.

ADS vs. Ordinary Shares

• Directly buying ordinary shares in a foreign market exposes investors to local trading rules, currency settlement, and possible inaccessibility for U.S. brokers. ADS centralize these functions for investor convenience.

ADS vs. ETFs and Other Instruments

• ADS provide company-specific exposure, while ETFs offer baskets of securities with differences in tax, liquidity, and voting structures.

Advantages

• Access and Convenience: U.S. investors can purchase international shares in dollars, during U.S. market hours, and with English-language disclosure.
• Liquidity: ADS are often more liquid than their counterparts in the issuer’s home market, supported by U.S. market makers.
• Consolidated Infrastructure: Corporate actions, proxy voting, and payouts are managed by the depositary bank.
• Visibility for Issuers: Listing ADS can increase a company's profile and broaden its investor base.

Disadvantages and Misconceptions

• Currency Exposure: Although traded in USD, returns for ADS holders also depend on exchange rates with the foreign currency.
• Fees and Taxes: Depositary and conversion fees, along with foreign tax withholding on dividends, can impact returns.
• Voting Rights: Voting power is usually limited and exercised through the depositary, which may involve additional procedures.
• Liquidity and Disclosure Gaps: Certain unsponsored or lightly traded ADS may have wider bid-ask spreads and less timely information.
• Common Misconception: There is a belief that ADS always provide higher liquidity than home shares, but this is not universally the case. Liquidity depends on program level, issuer profile, and market conditions.

Practical Guide

Choosing an ADS

• Sponsored Levels I–III: Level I trades OTC with basic disclosures. Level II and III are listed on major exchanges and require full SEC filings, providing additional transparency and liquidity.
• Check Ratios and Costs: Verify the ADS-to-ordinary share ratio, evaluate potential fees, and review the depositary agreement for corporate action processes.
• Evaluate Liquidity: Consider trading volumes, bid-ask spreads, and market depth. Prefer higher levels and established names for active trading.

Trading and Settlement

• Use Regulated U.S. Brokers: Ensure your broker discloses ADR fees and supports corporate actions and dividends.
• Monitor Timelines: While ADS settle like U.S. stocks, local holidays and foreign market actions can impact timing.
• Be Aware of FX Impact: Despite trading in USD, price performance and dividend payments reflect underlying currency movement.

Tax Considerations

• File Correct Forms: Use IRS Form W-8BEN to possibly reduce withholding tax based on tax treaties.
• Track Tax Credits: For foreign tax paid on dividends, claim credits in annual filings if eligible.

Corporate Actions and Voting

• Read Deposit Agreements: Be aware of deadlines and instructions for rights or bonus issues and voting.
• Deadline Awareness: Submission deadlines for voting or participating in corporate actions may differ from those for holding domestic shares.

Case Study: SAP ADS (Hypothetical Example)

Suppose an investor seeks exposure to SAP, a German software company. The SAP ADS trades on NYSE with a 1:1 ratio to its European ordinary share. When SAP announces a 2 EUR dividend per share, the depositary converts this (after applying a 26.375% German withholding tax and a USD 0.02 per ADS fee) into USD for payout. If EUR/USD is 1.10, after conversion and fees, each ADS holder receives approximately USD 1.61 per ADS in dividends.

Managing Currency Risk

• If your base currency is not USD or if you are concerned about exchange rate changes between USD and the issuer’s currency, consider using hedging tools (such as FX forwards, options, or currency-hedged ETFs).

Execution Tips

• Use limit orders when trading less liquid ADS to control execution price.
• Monitor relevant news and be mindful of both U.S. and foreign market trading hours, particularly around corporate events.

Resources for Learning and Improvement

• SEC Investor.gov ADR Page: Provides clear explanations and regulatory background.
• EDGAR Database: Access Forms F-6, 20-F, and 6-K for issuer disclosures.
• BNY Mellon’s ADR University, JPMorgan adr.com, Citi Depositary Receipts: Contain free guides and statistics on ADS programs.
• NYSE and Nasdaq Guides: Explain listing and trading requirements.
• IOSCO Reports: Offer regulatory perspectives on cross-border listings.
• Academic Research: Articles in journals such as The Journal of Finance and The Accounting Review on ADR pricing and cross-listing.
• Broker Resources: Many brokers publish ADR fee schedules and educational materials.
• ETF and Index Provider Documents: Useful for comparing ADS portfolios to other international investment products.

FAQs

What exactly is an ADS?

An American Depositary Share (ADS) is a tradable security issued by a U.S. bank, representing ownership of a specific number of shares in a foreign company.

How are dividends and voting rights handled on ADS?

Dividends are distributed in U.S. dollars by the depositary after conversion from the foreign currency and deduction of taxes and fees. Voting rights are usually available through the depositary, but participation requires timely instructions and may differ from directly holding local shares.

What are the main costs and risks of investing in ADS?

Primary costs include depositary fees, currency conversion fees, and foreign withholding taxes. Main risks involve exchange rate fluctuations, limited voting power, potential liquidity constraints, and differences in corporate governance.

How do I buy or sell an ADS?

ADS can be traded through any U.S.-authorized broker that supports international products, in the same way as domestic stocks.

Is there a risk of ADS prices diverging from the underlying share price?

Yes, but creation and cancellation processes, along with arbitrage, usually keep prices closely aligned, after accounting for FX rates, fees, and market conditions.

What documents should I review before investing?

The deposit agreement, Form F-6 prospectus, and SEC filings (e.g., 20-F, 6-K) provide details on rights, fees, and obligations for each ADS program.

Can I use tax credits for overseas withholding taxes on ADS dividends?

Typically yes, subject to IRS requirements. Consult a tax advisor or broker for specific guidance.

Do all foreign companies use ADS for U.S. listings?

No, some choose to list ordinary shares directly in the U.S. or issue GDRs in other markets. ADS are most common for non-U.S. companies seeking to access U.S. investors while maintaining their home-country share structure.

Are ADS and ADR the same?

ADS refers to the underlying shares, whereas ADR is the certificate. However, the terms are often used interchangeably in practice.

Conclusion

American Depositary Shares (ADS) help connect U.S. investors with foreign companies by providing simplified, U.S. dollar-denominated access to global equities through established U.S. market infrastructure. They facilitate trading, dividend collection, and regulatory compliance, increasing international diversification for investors. However, it is important to understand the impact of foreign exchange rates, fees, tax matters, and the specific structure of each ADS program when making investment decisions. By consulting reliable resources and staying informed on the mechanics and conditions of ADS programs, investors can make well-informed decisions as part of a diversified investment strategy.