An Overview of Depositary Receipts

Equity investment by foreign investors into a country can occur in one or more of three ways. Foreign investors can directly purchase shares in the stock market of the country e.g. investment by Foreign Institutional Investors (FIIs) in the Indian stock market. Or, companies from that country can issue shares (or depositary receipts) in the stock markets of other countries. Finally, indirect purchases can be made through a mutual fund which may be a specific country fund or a multi-country regional fund.

The Depositary Receipts Mechanism

The volume of new equity issues in the international markets increased dramatically between 1983 and 1987 and again after 1989. The 90’s saw a growing interest in the emerging markets. From the side of the issuers, the driving force was the desire to tap low-cost sources of financing, broaden the shareholder base, acquire a spring board for international activities such as acquisitions and generally improve access to long-term funding. From the point of view of investors, the primary motive has been diversification. Some of these markets may not be readily accessible except to very high quality issuers. When the issue size is large the issuer may consider a simultaneous offering in two or more markets. Such issues are known as Euroequities.

Issue costs are an important consideration. In addition to the underwriting fees (which may be in the 3 – 5% range), there are substantial costs involved in preparing for an equity issue particularly for developing country issuers unknown to developed country investors. Generally speaking, issue costs tend to be lower in large domestic markets such as the US and Japan.

ADRs, EDRs, and GDRs

During the late 80’s, a number of European and Japanese companies have got themselves listed on foreign stock exchanges such as New York and London. Shares of many firms are traded indirectly in the form of depositary receipts. In this mechanism, the shares issued by a firm are held by a depositary, usually a large international bank, which receives dividends, reports etc. and issues claims against these shares. These claims are called “depositary receipts” with each receipt being a claim on a specified number of shares. The depositary receipts are denominated in a convertible currency, usually US dollars. The depositary receipts may be listed and traded on major stock exchanges or may trade in the OTC market. The issuer firm pays dividends in its home currency. This is converted into dollars by the depositary and distributed to the holders of depositary receipts. This way the issuing firm avoids listing fees and onerous disclosure and reporting requirements which would be obligatory if it were to be directly listed on the stock exchange. This mechanism originated in the US, the so-called American Depositary Receipts or ADRs. Recent years have seen the emergence of European Depositary Receipts (EDRs) and Global Depositary Receipts (GDRs) which can be used to tap multiple markets with a single instrument. Transactions in depositary receipts are settled by means of computerized book transfers in international clearing systems such as Euroclear and Cedel.

In 1992 following the experience of the first ever GDR issue by an Indian corporate, a fairly large number of Indian companies took advantage of the improved market outlook to raise equity capital in international markets. During the period April 1992 to 1994, almost 30 companies are estimated to have raised a total of nearly US$3 billion through GDR issues.

From the point of view of the issuer, GDRs represent non-voting stock with a distinct identity which do not exhibit in its books. There is no exchange risk since dividends are paid by the issuer in its home currency. The device allows the issuer to broaden its capital base by tapping large foreign equity markets. The risk is that the price of GDRs may drop sharply after issue due to problems in the local markets and damage the issuer’s reputation which may harm future issues. From the investors’ point of view, they achieve portfolio diversification while acquiring an instrument which is denominated in a convertible currency and is traded on developed stock markets. The investors bear exchange risk and all the other risks borne by an equity holder. There are also taxes such as withholding taxes on dividends and taxes on capital gains.

A major problem and concern with international equity issues is that of flowback, i.e. the investors will sell the shares back in the home stock market of issuing firm. Authorities of some countries have imposed a minimum lock-in period during which foreign investors cannot unload the shares in the domestic market. Withholding taxes on dividends paid to non-residents reduces the attractiveness of the asset to foreign shareholders and consequently raises the cost to the issuer.

During 1993-94, GDR issues were a very popular device for many large Indian companies. Yields in developing country markets were rather low and many Indian issues offered attractive returns along with diversification benefits. The economic liberalization policy of the government made Indian issues an attractive investment vehicle for foreign investors. In subsequent years, a variety of problems with the workings of the Indian capital markets – lack of adequate custodial and depositary services, long settlement periods, delivery and payment delays, suspicions of price rigging etc. – led to the wearing off of investor enthusiasm.