It may have been a quiet eight months in terms of new equity issuance, but US investors have had no shortage of new American depositary receipts to buy in recent months, following a rule change that has made it easier for DR banks to set up unsponsored DR programmes.
The data is quite fluid with new programmes being both created and withdrawn, but since early October when the rule change took effect, more than 1,300 unsponsored programmes have been set up by the four DR banks. Since many issuers have been targeted by more than one bank, not all of these have resulted in new choices for investors, but according to data compiled by Bank of New York Mellon, 766 new companies from 47 countries had become available for investors to trade by the end of April. Of the new programmes, 366 are for companies based in Asia-Pacific, primarily Japan and Australia, but Hong Kong/China and Singapore have also got their fair share.
Previously, a foreign company had to apply in writing for an exemption from registering with the US Securities and Exchange Commission under Rule 12g3-2(b) (essentially an exemption from US reporting and from complying with Sarbanes Oxley) before an unlisted ADR programme (also referred to as a Level 1 DR) could be set up, whether it was sponsored or unsponsored. But the rule change in October means that companies are now automatically exempt as long as they meet three basic criteria: They have to be listed on another stock exchange and comply with its reporting requirements; at least 55% of their trading volume must be on exchanges outside the US; and they have to publish on their website -- promptly and in English -- any information that they are required to file with their home exchange.
This has meant that the DR banks can now determine whether an issuer qualifies simply by checking the company's website. No contact with the management is necessary and when it comes to unsponsored ADRs, which are set up by a DR bank without the participation of the company itself, the company doesn't even need to know about it.
Since many foreign companies that previously didn't have a 12g3-2(b) exemption now qualify automatically, the SEC has in one swift move enabled the creation of hundreds of new products for US investors -- which was indeed the main idea behind the rule change in the first place.
"Seeing the activity since October, there was clearly a lot of pent-up demand for some of these issuers, such as blue-chip or household names in Japan and China, and that demand is now being satisfied," said Tom Murphy, transaction manager for depositary receipts at Deutsche Bank in London.
Christopher Kearns, head of depositary receipts for Asia-Pacific at BNY Mellon, noted that it would have been hard to pick a worse time than October last year to launch a lot of new products, but in spite of the market turmoil and the credit crunch he said the bank is pleased with the level of activity in the new programmes.
"We estimate, based on our own numbers, that more than $1 billion of new investment have gone into the equity of companies around the world through new unsponsored ADRs [since October] and that is money that I think you can fairly safely say wouldn't have existed or come in but for these new programmes. Clearly, at a time like this, that is a fantastic story," he said.
BNY Mellon has been the most active DR bank with regard to this new trend, having set up a total of 668 unsponsored DR programmes, of which 291 are in Asia. Kearns said the bank initially focused on the 200 most wanted companies globally (as per a group of selected US investors) that didn't already have a US listing. It then targeted companies that are part of key indices around the world to enable fund managers to replicate these indices in DR form.
Citi and Deutsche Bank have also been busy tapping into this opportunity. Deutsche has created more than 400 new programmes so far, including more than 250 for Asian issuers, while Citi has set up about 220 new programmes, of which 140 are in Asia. J.P. Morgan has been less active with 30 new unsponsored programmes since October. All four banks say their starting point was to ask US investors and brokers which companies they would like to have access to in DR form and then worked backwards from there to see whether these companies qualified.
Many US funds have mandates that don't allow them to buy stocks listed outside the US, while others simply choose not to because of foreign exchange risks or expensive custody costs. This has created a steady demand for ADRs, which enable US investors to make these investments through a dollar-denominated instrument that trades in the US -- either on an exchange or over the counter.
Mass creation causes concern
Some companies are not all that happy about the latest developments though, and have taken action to stop the DR banks from offering their shares in the form of unsponsored DRs, which in turn has caused concern among some industry participants that this may not be in the best interest of the DR industry in general. One of them is Kenneth Tse, Asia-Pacific head of the depositary receipts group at J.P. Morgan, who noted that "some Level 1 programmes are already giving a bad reputation to ADRs because of a lack of liquidity" and widespread discontent related to unsponsored programmes could do a disservice to the market.
In his view, all DR programmes should be beneficial to the company as well as to the investors -- and the DR bank of course -- and to achieve that he believes new programmes shouldn't be set up without the consent of the company, even though this isn't required for unsponsored DRs. Among the other banks, Citi and Deutsche say they have a similar approach in terms of seeking consent or consulting each company, while BNY Mellon said it does inform all companies before setting up an unsponsored programme.
One key area of discontent is the fact that companies have limited control over the services delivered by the DR bank when it comes to an unsponsored programme. For instance, the DR bank is not required to pass on annual reports, press releases or company updates to the DR holders or to inform them about upcoming shareholders' meetings. And it may not exercise voting rights on behalf of DR holders. This could leave the company exposed to certain reputational risk. It is also possible for more than one bank to set up an unsponsored DR programme based on any one company, which can create some confusion among investors as the level of services may differ between the banks. The DR banks may use different exchange rates with regard to dividend payouts and the fees they charge the DR holders may vary.
Over the past few months, some companies in Japan and Europe have voiced their objection to the unsponsored programmes by putting up a disclaimer on their website saying that they do not intend to provide the required information in English. Others have simply asked the DR bank, or banks, to cancel the programmes. Disgruntled companies also have the option of teaming up with one specific DR bank to create a sponsored programme, in which case all unsponsored programmes will have to be cancelled. Or they could of course go all the way and list their ADRs on a US exchange, which would also allow them to raise new capital by selling new shares to US investors (something you cannot do under a Level 1 programme).
Despite his concerns, Tse at J.P. Morgan said he is confident that the market will eventually sort out this issue. For instance, programmes that generate less trading volumes than expected may end up being withdrawn.
Some of the earlier protests also appear to have calmed down as company managements have learnt more about the product.
According to Kearns, BNY Mellon has seen "very little discontent" among the companies for which it has set up unsponsored programmes and noted that the bank has withdrawn fewer than 10 programmes in Asia because of objections from companies. He said the bank wrote to all companies before it set up an unsponsored programme based on their shares, giving them the opportunity to voice any objections. Only a "very small number" of companies replied saying they didn't want the bank to go ahead.
Meanwhile, Deutsche bank has over the past few months teamed up with law firms and arranged telephone conferences and seminars to address the concerns among companies about the new development and to explain the benefits of having a DR programme. For one, a DR programme, whether sponsored or not, does tend to increase the liquidity and value of the company's common shares in its home market too.
DR bankers generally agree that a sponsored programme is preferable for issuers as it gives them more control and a clearer line of communication with the investors, but Kearns noted that an unsponsored one is better than no programme and can act as a step on the way towards either a sponsored DR or a full-fledged ADR listing.
An unsponsored programme is a good way for issuers to test how much demand there is for their shares in the US market, agreed Siu-chan Kwan, Asia-Pacific sales head for depositary receipt services at Citi.
"If they agree to an unsponsored programme now, they can come back in 12 months and ask us and our competitors how much activity there is and if it is at a good level, then they can consider upgrading to a sponsored facility and do a bit more promotion. I would expect that in one to two years' time some of these issuers will convert their facilities into sponsored ones," he said.
This article was first published in the May issue of FinanceAsia magazine.
