Rush of Unsponsored ADRs/DRs a Headache for Japanese Companies

One of the frustrations of any newsletter (such as JapanInvestor), investment advisor or broker who specializes in Japanese stocks and wants to reach US investors is the dearth of Japanese stocks that trade on US markets as ADRs (American Depository Receipts). Of the more than 3,800 stocks that trade on exchanges in Japan, only 18 trade on the New York Stock Exchange, 5 on the NASDAQ and 37 trade over-the-counter (OTC).

As any experienced investor is aware, an ADR is actually a "warehouse" receipt representing ownership in the underlying shares of a foreign company. When you buy an ADR, you don't technically own the foreign stock directly, you own a piece of paper that entitles you to one or more shares of a foreign stock being held on your behalf at a depository bank. But not all ADRs are created equal. In terms of publicly traded ADRs, there are basically four types; a) unsponsored, b) Level I, c) Level II (listed) and Level III (offering).

• Unsponsored ADRs are a form of Level I ADRs that trade over-the-counter and are issued in response to market demand. The program is unsponsored because the there is no formal agreement with the depository bank(s) issuing the shares and the company whose underlying shares are the basis for the ADR.

• Level I is the most common form of existing ADR, as it is the most convenient way for a foreign company to have its shares trade in the U.S. US investors however need to keep in mind that this level of ADR has minimal reporting requirements with the SEC and is not required to issue quarterly or annual reports in compliance with US accounting standards (GAAP). The company only needs to have its stock listed on one or more exchanges overseas and must publish its financial results in English based on the accounting standards of its home country.

• Level II, or listed ADRs, require that the foreign company file a registration statement with the SEC and are under SEC regulation. As a result, the foreign company has to file a detailed Form-20F--basically the equivalent of the US Form 10-K annual report--and to comply with US GAAP.These ADRs trade essentially just like a US company's stock.

• In Level III ADR programs, foreign companies have to adhere to essentially the same strict rules that US companies have to follow. In a Level III listing, the foreign company is not only taking some of its underlying shares from its home market and depositing them with the depository bank to be traded in the US as ADRs, it is also issuing shares to raise capital in the US market, and is therefore required to file a Form-1 offering prospectus for the shares, as well as a Form 20-F annual report that is compiled according to US GAAP. Any information disclosed to shareholders in the company's home market must also be filed with the SEC through a Form 8K.

ADRs and GDRs (global depository receipts) have become increasingly popular. As of mid-2008, there were more than 2,250 depositary programs representing more than 1,800 companies from over 70 countries listed on global stock exchanges. According to the Bank of New York Mellon (BK), in the first half of 2008, 52 billion shares of ADRs changed hands, representing trading value of $2.07 trillion.

The frustration for Japan equity specialists as well as the main depository banks like JPMorgan (JPM), Bank of New York Mellon and Deutsche Bank (DB) is that Japanese companies have generally been disinterested in issuing or sponsoring ADRs, ostensibly because of the additional regulatory requirements, costs of translating financials into English, other costs of maintaining a sponsored ADR program, and the litigation risk from individual shareholders. In addition, the main foreign institutional investors in these companies usually prefer to trade in size directly on the Japanese stock exchanges.

But recent changes (October 2008) in SEC rules regarding unsponsored Level I depository receipts (ADRs) have resulted in an explosion of unsponsored ADRs and have become a headache for Japanese companies. US despository banks can now register unsponsored ADRs on the equity securities of any non-US company that automatically qualifies for an exemption from US registration by meeting certain ongoing trading and web disclosure requirements. The main SEC requirement for a depository bank to issue such an ADR is that the company must merely have a security listed on one or more stock exchanges in a foreign country (jurisdiction) and that it publishes English annual reports that conform with the disclosure (and accounting) requirements of the country where the company is incorporated or domiciled. As a result, depository banks have now issued unsponsored ADRs on 228 Japanese companies, often without the knowledge or the approval of the company whose underlying stock is represented by these ADRs.

The headache for Japanese (or any foreign company) is that these unsponsored ADRs could subject them to US regulatory and liability risk. The hundreds of new unsponsored ADRs that now trade in the US OTC market have historically had a low profile among US investors, but that could change due to a separate new rule designed to improve trading liquidity and price transparency of foreign company ADRs. By creating these unsponsored ADR programs and raising the profile of these programs, the depository banks are increasing the possibility that any one issue will attract more than 300 US investors, which is ostensibly one threshold for the SEC to require registration and increased regulation.

Another headache is the risk that trading in these securities will fall under the requirements of the Financial Industry Regulatory Authority (FINRA) that is now in effect in the US that requires real-time dissemination of trade information in foreign OTC securities, ostensibly including unsponsored ADRs.

The depository banks’ interpretation of the new SEC rule is that the 300 US investor limit has been relaxed, and that these securities are exempt under the SEC’s revised Rule 12g3-2(b), which exempts foreign companies from having to register their securities if they meet certain requirements. Before October 2008, foreign firms wishing to create ADRs that traded OTC had to formally apply for exemption, but many in the securities industry, including the depository banks, the Security Traders Association and the Securities and Financial Markets Association lobbied to eliminate the paper filing process. While ostensibly automotically exempted under the new SEC rules, the SEC would still like to require foreign securities to register if their average US daily trading volume exceeds 20% of their worldwide trading volume.

Japanese (and other foreign) companies were neither informed or advised of such risks. The US depository banks are indirectly imposing an obligation to continue promptly posting English disclosures on their websites, as the SEC requires English documents to be posted on the same day as non-English ones - and translating long Japanese documents is both expensive and time-consuming. Moreover, Japanese companies have no control over these securities, which potentially could amount to a sizeable portion of their shareholder base, and will have difficulty determining how many US shareholders they have. To add insult to injury, the SEC will not permit a company to establish a sponsored ADR if an unsponsored version already exists. To establish a sponsored ADR, the company and its depository may have to pay fees to one or more other banks to cancel an existing unsponsored ADR.

Depository banks of course believe the SEC's rule change will boost volume in ADRs. According to R. Cromwell Coulson, CEO of Pink OTC Markets, "We expect that dollar volume to grow significantly." Coulson said. "I wouldn't be stunned if our dollar volume in ADRs is 10 times higher in three years." This is because unsponsored ADRs and "Level 1" sponsored ADRs trade in the gray market and Pinks. These are tailor-made ADRs for special needs, needs that unlikely match the needs of typical US retail and smaller institutional investors, such as "global standard" disclosure and reporting requirements.

Only a limited number of US investors buy securities traded on the Pinks or gray market. Consequently, the real beneficiaries of the unsponsored ADR explosion are expected to be the intermediaries, not the issuers or US retail and small insitutional investors, or the Japanese stock (foreign stock) specialist newsletters, investment advisors or brokers that are trying to reach these investors.

Comments

[Alan Young:]

Thanks for a much-needed step toward clarification of the ADR markets.

There are an immense number of enticing investment opportunities available overseas that are excessively difficult for US individuals to research and trade. It seems like there should be a very rich market niche here, if anyone can craft an improvement over the deadly illiquidity (and often opaque reporting) of the unsponsored ADRs that undercuts the cost of the foreign-trading desk at most brokerages.

Apr 25 05:57 PM

[AlexS:]

Yes, appreciate it as well. I've invested in ADRs and I confess that I don't know the ins and outs of their registration. I was even considering buying the pink sheeted version of a Japanese ADR, which is what brought me to this article. Can't imagine why the Japanese don't want to get mixed up with our roulette version of a tort-liability system (a bit of sarcasm there).

Apr 26 03:27 PM

[Chelsey Loshak:]

There are a couple of erroneous statements in your article related the SEC Rule 12g3-2(b).

The new amended 12g3-2(b) SEC exemption safeguards companies even if they attract more than 300 U.S. investors. It also clarifies that the SEC will require foreign securities to register if their average U.S. daily trading volume meets or exceeds 55% of their worldwide trading volume (not 20% as stated in your article.)

Lastly, the real-time trade dissemination rule change helps drive secondary market trading, which is a goal of the most companies, who view the U.S. market as a valuable source of liquidity.

Apr 30 06:11 PM