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Depository Receipts: Stealth Weaponry for the Commerce Wars

Another reason that foreign investment by Sovereign Wealth Funds in the United States can be so difficult to accurately measure is the indirect means by which many of these funds can acquire shares of US companies.  In addition to direct share purchases from traders or brokerage houses here in the US – purchases which are more easily monitored and measured through the booking process – Sovereign Wealth Funds may also purchase shares of US companies while remaining almost completely under the radar of both the target company and the United States government.  

One of the prime methods for such stealth equity purchasing by sovereign wealth funds is the use of depository receipts (“DRs”).  A depositary receipt is a type of representative negotiable financial security that is traded on a local stock exchange but represents a security – usually in the form of equity – that is issued by a foreign publicly listed company.  The DR, which is a physical certificate, allows investors to hold shares in equity of other countries.  

The DR is created when a foreign company wishes to list its already publicly traded shares or debt securities on a foreign stock exchange.  These depository receipts can be traded either publicly, or over-the-counter. Before it can be listed to a particular stock exchange however, the company in question will first have to meet certain requirements put forth by the exchange.   In the United States, for example, these requirements are governed by the SEC and are similar to the public company reporting requirements for US companies.  However, as is described after the following example, there are ways in which a foreign company can circumvent many of these reporting requirements and trade depository receipts without any regulatory oversight whatsoever.  As we will see, this distinction turns primarily on the level of “sponsorship” attached to the particular depository receipt being traded.    

For example, assume a toy company in China has fulfilled the requirements for depository receipt listing and now wants to list its publicly traded shares on the NYSE in the form of an American Depository Receipt (“ADR”).  Before the toy company’s shares can be freely traded on the exchange, a U.S. broker, through an international office or a local brokerage house in China, would purchase the domestic shares from the Chinese market and then have them delivered to the local (Chinese) custodian bank of the depository bank.  

The depository bank is the American financial institution that issues the ADRs in America, and the leading institution for depository receipts in the US is The Bank of New York Mellon (“BNY Mellon”).  Once BNY Mellon’s local custodian bank in China receives the shares, this custodian bank verifies the delivery of the shares by informing BNY Mellon that the shares can now be issued in the United States.  BNY Mellon then delivers the ADRs to the broker who initially purchased them.

Based on a determined ADR ratio, each ADR may be issued as representing one or more of the Chinese local shares, and the price of each ADR would be issued in U.S. dollars converted from the equivalent Chinese price of the shares being held by the depository bank. The ADRs now represent the local Chinese shares held by the depository, and can now be freely traded equity on the NYSE.

After the process whereby the new ADR of the Chinese toy company is issued, the ADR can be traded freely among investors and transferred from the buyer to the seller on the NYSE, through a procedure known as intra-market trading.  All ADR transactions of the Chinese toy company will now take place in U.S. dollars and are settled like any other U.S. transaction on the NYSE.  The ADR investor may now hold privileges like those granted to shareholders of ordinary shares – such as voting rights and cash dividends – depending upon the specific rights stated on the ADR certificate.

Most depository receipts are known as “sponsored” depository receipts and are issued pursuant to a formal agreement with the company.  These sponsored DRs can be issued in accordance with different “sponsorship levels” and be made available across various trading markets, but the key factor delineating a “sponsored” DR from an “unsponsored” DR is that a sponsored DR is only issued by a single depository appointed by the company via a Deposit Agreement or service contract.   This sponsorship allows the company to maintain a measure of control over their DRs while still taking advantage of both domestic and foreign capital markets.  

If a depository receipt is issued pursuant to the aforementioned sponsorship method, the sponsored depository receipt can be leveled on a scale of one (“I”) to three (“III”).   For US companies, A Sponsored Level I Depositary Receipt program is the simplest method for companies to access the U.S. and non-U.S. capital markets.  Level I Depositary Receipts are traded in the U.S. over-the-counter (OTC) market with prices published in the “Pink Sheets” and on some exchanges outside the United States.  Most notably, Level I Depository Receipts do not require full SEC registration and the company does not have to report its accounts under U.S. Generally Accepted Accounting Principles (GAAP) or provide full Securities and Exchange Commission (SEC) disclosure.  A Sponsored Level I Depositary Receipt program effectively allows companies to enjoy the benefits of a publicly traded security without changing its current reporting process.

For these reasons, the Sponsored Level I Depositary Receipt market is the fastest-growing segment of the Depositary Receipt business and the majority of sponsored programs are Level I facilities.   However, if a company wishes to list its Depository Receipt on a US exchange – such as the NYSE – a Level II or Level III Sponsored Depository Receipt program will be required.  Unlike Level I programs, these programs require adherence to US GAAP requirements and registration with the SEC.  

In light of the above, it is therefore apparent that the Depository Receipt regime provides various opportunities for equity interests to be stealthily consumed by foreign entities such as Sovereign Wealth Funds.