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.

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