This morning, Cochlear, the Australian maker of hearing-aid implants, became one of hundreds of new American Depositary Receipts created in the wake of a rule change last fall by the Securities and Exchange Commission. About 750 new ADRs have been created since the change, leading some to anticipate a trading boom.
Like Cochlear, all of the new ADRs are “unsponsored” programs. That means the issuers of the underlying shares were not involved in establishing the ADR programs. In a sponsored arrangement, the issuer selects the depositary bank and controls the terms and conditions of the ADR program. There are about 1,800 ADRs in the U.S., according to Bank of New York Mellon.
R. Cromwell Coulson, CEO of Pink OTC Markets, believes the SEC’s rule change will boost volume in ADRs. “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.”
Last year, almost $100 billion, or two-thirds of Pink OTC’s dollar volume traded, was in ADRs, Coulson said. About 500 ADRs trade on the Pinks, up from 425 before the SEC’s rule change took effect on Oct. 10. U.S. exchanges, which account for most ADR trading, transacted $3.7 trillion last year, according to a year-end BNY Mellon report.
Unsponsored ADRs and “Level 1” sponsored ADRs trade in the gray market and Pinks, although efforts are under way to move more trading to the Pinks. Those issuers are exempt from registering their securities with the SEC and have minimal disclosure requirements. Level 2 and 3 sponsored ADRs are SEC-registered securities whose issuers must meet higher disclosure standards and must reconcile their financial statements to U.S. GAAP. These ADRs are listed and traded on exchanges (Level 3 also allows an issuer to raise capital).
Bernardo Mariano, an analyst at Equity Research Desk, an investment advisory firm in Greenwich, Conn., doesn’t think the new unsponsored ADRs will build a lot of liquidity. “These are tailor-made ADRs for special needs,” Mariano said. “There will be more trading, but not significantly more trading.” He added that a limited number of investors buy securities traded on the Pinks or gray market.
The October rule change involves Rule 12g3-2(b) under the Securities Exchange Act of 1934. Before October, foreign firms wishing to create ADRs that would trade OTC had to formally apply for an exemption and submit periodic financial statements to the Commission. Many industry participants, including the Security Traders Association and the Securities and Financial Markets Association, lobbied to eliminate the paper filing process. The SEC responded obligingly but floated the idea that foreign companies would have to register if their U.S. average daily trading volume exceeded 20 percent of their worldwide volume.
The Commission’s final rule excluded the 20 percent provision. A number of industry respondents, including STA, opposed that provision. A study by the SEC’s Office of Economic Analysis, released in March 2008, found that 95 percent of ADRs quoted on the Pinks would qualify for the 12g3-2(b) exemption because they fell below the 20 percent threshold.
The upshot of the SEC’s amended rule is that foreign companies don’t have to fill out any forms. But the rule change is much more significant. Now, depositary banks can create unsponsored ADRs without asking the issuer to apply for the exemption. As long as the required disclosure materials are published in English on the issuer’s web site, the depositary bank can go ahead with a presumptive exemption in hand.
BNY Mellon, one of the largest depositary banks and a big ADR player, has issued more than 500 new unsponsored ADRs (including Cochlear) since the SEC’s amendment went into effect, according to Jason Paltrowitz, a vice president at the bank. About 150 of them have been duplicated by other banks. Unsponsored ADRs, Paltrowitz said, can be created on the same underlying stock, although all trading takes place with one ticker symbol and one CUSIP. The other big depositary banks in the ADR landscape are Deutsche Bank, Citibank and J.P. Morgan.
“From an unsponsored point of view and a depositary bank’s point of view, the supply window is open” as a result of the SEC’s amendment to the foreign exemption requirements, Paltrowitz said. “We can create unsponsored programs and offer them to the U.S. investor community.” BNY Mellon’s selection of ADRs, he added, was based on investor demand.
However, some say the SEC may have unwittingly opened a door it hadn’t intended to open along with that ADR exemption window. “The dramatic rise in unsponsored ADRs was somewhat unanticipated,” said Antonia Stolper, a New York-based partner at Shearman & Sterling, a law firm that represents companies sponsoring ADR programs. “It’s not clear whether the SEC foresaw this.” Her law firm opposed the SEC’s change to the exemption eligibility requirements.
Stolper noted that the ability of a depositary bank to decide whether an issuer qualifies for an exemption, regardless of a company’s wishes, puts companies in a precarious position. If the issuer winds up with over 300 U.S. investors, SEC registration is required. “An issuer could discover that it didn’t have 12g3-2(b) eligibility after all, despite what the depositary bank thought,” Stolper said. “That is a legal problem, and it’s an inchoate concern today.”
Until October, BNY Mellon’s Paltrowitz said, about 80 percent of the ADRs traded in the U.S. were sponsored by the issuers. The vast majority of ADR trading occurs in the registered securities listed on exchanges such as the New York Stock Exchange and Nasdaq.
According to Paltrowitz, there’s tremendous continuing demand for ADR programs, “notably in the separately managed accounts space.” Wrap managers, he said, use ADR-only programs to try to replicate institutional portfolios that can own ordinary shares. Mutual funds and other institutions may also use ADRs if they can’t trade foreign stocks directly or don’t have custody and settlement arrangements in place in particular countries. Retail investors trade exchange-listed ADRs and can trade OTC, although many big brokers don’t provide ready access to the latter.
Market makers are now gearing up for more trading. “There are many quality names that we did not have access to before,” said Joe Ricciardi, managing director of Knight Equity Markets. “These ADR programs are being fast-tracked and we’re preparing for more volume in them.” He added that Knight expects to see as many as 1,500 new ADRs as a result of the SEC’s rule change.
