Depositary receipts: A Level 1 playing field

Increasingly companies are looking to make their shares available to US investors through so-called Level 1 depositary receipt programmes.
One might think that the turmoil in US financial markets over the past few months would act as a deterrent for non-US companies to even think about having their shares trade there, but in reality the interest to come to the US is actually on the rise û much thanks to two rule changes by the Securities and Exchange Commission (SEC).

However, many of the companies pondering whether to make their shares available to US investors arenÆt actually looking to list on the New York Stock Exchange or the Nasdaq, but to set up a so-called Level 1 depositary receipt programme and trade over the counter (OTC).

Level 1 DRs allow companies that are listed outside the US to also have their shares trade in the US market û thus making them available to US investors, who are not allowed to, or prefer not to, buy stocks listed outside the US. The idea is that the access to a broader investor base will make the company more visible, increase the liquidity in the stock and improve valuations over time û something which is particularly important in a bear market when companies are literally competing for investors.

Foreign companies with Level 1s are not registered with the SEC and therefore not required to comply with Sarbanes-Oxley or to report earnings according to US GAAP, thus allowing them to avoid many of the costs associated with a ôproperö US listing. However, they do need to get an exemption from registering with the SEC under Rule 12g3-2(b) (essentially an exemption from US reporting). And this has now become a lot easier thanks to a rule change that was adopted by the SEC in August and took effect on October 10.

Previously, a company had to apply for this exemption and to get it had to prove that it was indeed a foreign issuer, one criteria of which was that it had no more than 300 US-based shareholders (something which isnÆt always that easy to prove).

Simplifying rules

Under the new rules, these criteria have been made a lot simpler and also, companies no longer have to apply for the exemption, but will automatically qualify provided that they meet a couple of easy requirements: at least 55% of their trading volume must be on exchanges outside the US; and they have to publish on their website û promptly and in English û any information that they are required to file with their home exchange or distribute to the holders of their common shares. However, they no longer have to send a copy of every press release, earnings announcement and annual report to the SEC, making their life yet a bit simpler.

Aside from making the process a lot easier, the automatic exemption should reduce the time it takes for an international company to start trading in the US.

ôOur understanding is that this is part of the SECÆs plan to be more accommodating to foreign private issuers accessing the US. It is easier to set up a Level 1 programme now and it makes quite a bit of sense to do so,ö says Gregory Roath head of North Asia ex-Japan within the DR division at the Bank of New York Mellon. With a Level 1 you are free to do whatever accounting you do in your home market, there is no need to reconcile to US GAAP, there is no Sarbanes-Oxley, corporate governance requirements are the same as you have in your home market, and yet you become available to US buyers.ö

In theory, there are a lot of companies worldwide that meet the new requirements and industry specialists believe the new rule will be a boost to the market for OTC-traded American Depositary Receipts (ADRs) on foreign companies.

ôWe do see increasing interest and inquiries to set up Level 1s, particularly in Japan, Hong Kong and Australia and the rule changes may also open the door for more unsponsored programmes,ö says Kenneth Tse, Asia-Pacific head of the depositary receipts group at J.P. Morgan. Unsponsored DRs refer to DR programmes that are set up by a depositary bank without the participation of the company itself on the belief that that there is sufficient interest among investors to trade the stock. More than one DR bank can set up an unsponsored programme in the same stock.

Since Level 1 DRs donÆt come with the issuance of new shares, they can be set up at any time, irrespective of how the market is performing û which is why the meltdown in US markets over the past month is having little impact on the interest in establishing new programmes. In fact, the current situation may even increase the demand among US investors for non-US stocks as they look for growth potential outside their severely damaged domestic market.

Meanwhile, a second rule change by the SEC, set to take effect in November, may prove to be just as important for the development of this market as it will put OTC-traded ADRs on a level footing both with other OTC-traded US stocks and with listed ADRs when it comes to real-time prices. Under the new rule, brokers will have to report all OTC trades within 90 seconds of execution and information about the last trade must be available on a real-time basis. Previously, OTC DR transactions only had to be reported by 1.30pm the following day.

In an explanatory note on the rule change, Bank of New York Mellon says the change will make the pricing more transparent, which should increase the liquidity and likely lead to tighter bid-ask spreads. It will also enable investors to value their portfolios on a real-time basis and allow OTC-traded DRs to be included in DR indices. At present they are not eligible because of the lack of real-time price information.

ôYou are going to have, virtually, most of the benefits of a full exchange listing without the costs and burdens of SEC registration or SOX compliance. So why would you go out and spend millions on a listing?ö says Andrew Kyzyk, director of business development for International OTCQX at PinkOTC Markets Inc. He notes that some companies which have recently delisted from NYSE or Nasdaq say they spent over $5 million on Sarbanes Oxley compliance and separate reporting every year û money which they can now use on investor relations instead.

æThese are all good developments,ö Tse at J.P. Morgan says of the rule changes. ôBut I wouldnÆt characterise them as transformational.ö Cost and trading efficiency are certainly important for companies seeking to have their shares trade in the US, he says, but there are other factors to consider, such as where their peers are trading û for many companies the answer to that question is invariably Nasdaq or the NYSE. Another issue is liquidity, which for a company without a well-known global brand is likely to be thinner in the OTC market.

The most obvious reason why a company would prefer to list on one of the US exchanges, however, is that they cannot raise new funds in the OTC market. That said, more and more companies are becoming interested in OTC-traded ADRs and this trend is reflected in the rapid growth of the electronic OTCQX platform since it was set up in March 2007. OTCQX is essentially a premier, or ôtrustedö tier within the US OTC market (also referred to as the Pink Sheets) that is open to high-quality companies (QX stands for quality and excellence) with Level 1 DRs. The idea is to help them stand out among the 5,000 or so companies that trade OTC in the US and thus attract more investors.

International players

Kyzyk notes that close to 50 international companies have taken advantage of an SEC offer for companies with less than 5% of their annual global trading volume in the US to deregister and delist from the NYSE or Nasdaq in the past year, choosing instead to trade OTC. And several of those have ended up on the OTCQX. As of the end of September, 33 international and six US companies have listed on the OTCQX and the combined market cap has grown to close to $400 billion. The members include national champions such as Roche, Adidas, Air France-KLM, Wolseley, Marks & Spencer, Benetton and Imperial Tobacco.

Singapore-listed First Ship Lease Trust became the first Asian company to list on OTCQX in late October, joining 10 Australian firms already there. And Hong Kong-listed Imagi International Holdings, a maker of computer graphics animated films, has also announced its intention to set up a Level 1 DR programme and start trading on the new platform.

Kyzyk, who is travelling the globe trying to solicit new companies to come to OTCQX, says he expects another five Hong Kong companies will take advantage of the new fast-track rules to set up Level 1 programmes and list on the OTCQX, including three before the end of this year.

This article first appeared in the October issue of FinanceAsia magazine.
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