A Lesson in ADR and SOX

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A Lesson in ADR and SOX

• Comparative Intl. Labor Relations
• By S. Carpenter, A. Caccamo, and K. OBrien

2
What is an ADR?

• American Depositary Receipt (ADR)
• A stock that trades in the U.S. but represents a
  specific number of shares in a foreign
  corporation
• Bought and sold on American markets
• Issued/sponsored in the U.S. by a domestic bank
  or brokerage

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History of ADR

• Introduced to the financial markets in 1927
• Result of (1) complexities in buying shares in
  foreign countries and (2) difficulties with
  trading at different currency values
• U.S. banks purchase bulks of shares from the
  foreign company, bundle the shares into groups,
  and reissue on the NYSE, AMEX or the Nasdaq
• In return, foreign company must provide detailed
  financial information to the sponsor bank
• The depositary bank sets the ratio of U.S. ADRs
  per home-country share this ratio can be
  anything less than or greater than 1
• Majority of ADRs range between 10 and 100 per
  share

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Pricing Example

• Russian Vodka Inc. wants to list shares on the
  NYSE to gain exposure to the U.S. market and to
  tap into the growing demand for vodka
• Russian Vodka already trades on the Russian Stock
  Exchange at 127 Russian roubles (equivalent to
  US4.58)

• A U.S. bank purchases 30 million shares from
  Russian Vodka Inc. and issues them in the U.S. at
  a ratio of 101. This means each ADR share you
  purchase is worth 10 shares on the Russian Stock
  Exchange
• The new ADR should have an issue price of around
  US45.80 each (10 times 4.58)

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Three Types of ADRs

• Level 1 Foreign companies either don't qualify
  or don't wish to have their ADR listed on an
  exchange
• over-the-counter market
• loosest requirements from the SEC
• Level 2 Listed on an exchange or quoted on
  Nasdaq
• slightly more requirements from the SEC
• higher visibility trading volume
• Level 3 Issuer floats a public offering on U.S.
  exchange
• able to raise capital and gain substantial
  visibility in the U.S. financial markets

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Benefits of ADRs?

• For individuals, ADRs are an easy, cost-effective
  way to buy shares in a foreign company
• Foreign entities like ADRs because they get more
  U.S. exposure, allowing them to tap into the
  wealthy North American equities markets

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Risks of ADRs

• Political Risk
• Is the government of the ADRs home country
  stable?
• Exchange Rate Risk
• Is the currency of the home country stable?
• Inflationary Risk
• Extension of exchange rate risk

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What is SOX?

• Sarbanes-Oxley Act of 2002 (also Public Company
  Accounting Reform and Investor Protection Act of
  2002)
• US Federal law enacted in response to a number of
  major corporate and accounting scandals

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Background on SOX

• Applies new standards for all U.S. public company
  boards, management and public accounting firms
• Does not apply to privately held companies
• Act contains 11 Titles and requires the SEC to
  implement rulings on requirements to comply with
  the new law

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11 Titles in SOX

• Public Company Accounting Oversight Board (PCAOB)
• Auditor Independence
• Corporate Responsibility
• Enhanced Financial Disclosures
• Analyst Conflicts of Interest
• Commission Resources and Authority
• Studies and Reports
• Corporate and Criminal Fraud Accountability
• White Collar Crime Penalty Enhancement
• Corporate Tax Returns
• Corporate Fraud Accountability

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Effect on Non-US Companies

• Depends if country is developed/well-regulated or
  less developed
• i.e. poorly regulated countries benefit from
  better credit ratings by complying to
  regulations developed countries incur costs
• Displaces business from NY to London
• Alternative Investment Market claims that its
  growth in listings almost entirely coincided with
  SOX legislation

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Praise of SOX

• Improved investor confidence and more accurate,
  reliable financial statements
• "Sarbanes-Oxley helped restore trust in U.S.
  markets by increasing accountability, speeding up
  reporting, and making audits more independent.
  SEC Chairman Christopher Cox, 2007
• Auditor conflicts of interest have been addressed
  - prohibits auditors from having lucrative
  consulting agreements with the firms they audit
• Improved investor confidence in financial
  reporting improvements in board, audit
  committee, and senior management engagement in
  financial reporting improvements in financial
  controls

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Criticisms of SOX

• Reduced America's international competitive edge
  against foreign financial service providers, by
  introducing a complex and regulatory environment
  into U.S. financial markets
• Following the act's passage, smaller
  international companies were more likely to list
  in stock exchanges in the U.K. rather than U.S.
  stock exchanges (Journal of Accounting Research,
  2008)
• Overall reluctance of small businesses and
  foreign firms to register on US stock exchange
• These regulations are damaging American capital
  markets by providing an incentive for small US
  firms and foreign firms to deregister from US
  stock exchanges Ron Paul

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How SOX Regulates ADRs

• Level 1 ADRs do not have to have to comply with
  SOX
• Not registered with the SEC
• Level 2 and Level 3 ADRs must comply with SOX
• Can be costly for a company beginning a U.S. ADR
  Program
• Costs include a significant intangible cost
  diversion of senior management time

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Compliance with SOX

• Establish a full-time investor, or investor
  relations team, based in the U.S.
• Senior executives must visit institutional
  investors and securities analysts at least twice
  a year, if not more

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The Future of SOX and ADRs

• Currently, interest by foreign companies to have
  shares traded in the U.S. is on rise because of
  two new SEC rules
• Japan, Hong Kong, and Australia
• Companies are not looking to list on NYSE or
  Nasdaq
• Want to set up Level 1 ADRs and trade over the
  counter (OTC)
• Two Rules
• Automatic exemption from listing on SEC
• Brokers must report trades within 90 seconds and
  information on each trade must be available in
  real time
• Will make pricing more transparent

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The End

• Questions, comments?