ADRs, Restricted Stock, and Corporate Actions

American Depositary Receipts

An American Depositary Receipt is a negotiable receipt issued by a US depositary bank representing shares of a foreign company that the bank — or its foreign custodian — actually holds. The ADR trades in the United States, in US dollars, settling like a domestic security, which is the entire point: it lets a US investor own foreign equity without a foreign brokerage account, foreign currency settlement or foreign custody.

One ADR may represent one foreign share, several, or a fraction, depending on the ratio the depositary sets to bring the price into a normal US trading range.

Dividends are declared by the foreign issuer in its own currency, converted by the depositary and paid to holders in dollars, net of the depositary's fee and any foreign withholding tax. That withholding is a real feature: the holder may be able to claim a foreign tax credit, but the cash arriving is reduced.

The risks the exam wants named are currency risk — because the underlying share's value is denominated in a foreign currency, a fall in that currency against the dollar reduces the ADR's dollar value even if the share price is flat — plus political and economic risk in the home country, and differences in the accounting and disclosure standards the foreign issuer follows.

ADR holders generally do not have the voting rights of a direct shareholder. The depositary bank is the registered holder, and voting arrangements vary by programme; in an unsponsored programme in particular the holder may have no practical vote at all. A sponsored ADR is established with the cooperation of the foreign issuer; an unsponsored one is created by a depositary without it.

Restricted and control securities

Two different problems that Rule 144 solves with one rule, and the exam wants the distinction crisp.

Restricted securities are unregistered securities acquired directly or indirectly from the issuer or an affiliate in a transaction not involving a public offering — a private placement, a Regulation D offering, an employee equity award. They are restricted because they never went through a registration statement, so reselling them publicly would be an unregistered distribution.

Control securities are securities held by an affiliate — an officer, a director, or a holder of a large enough block to exert control, together with immediate family in the same household. The shares themselves may be entirely ordinary registered stock bought in the open market. What is restricted is who is selling, because a large sale by an insider looks like a distribution by the issuer.

A holder can be caught by both at once: an executive holding stock from a private placement holds securities that are both restricted and control.

Rule 144 sets out the conditions under which a resale is deemed not to be a distribution. There are five, and which apply depends on who is selling.

Holding period. If the issuer is subject to Exchange Act reporting and has been for at least ninety days, a minimum of six months must elapse between the acquisition of restricted securities from the issuer or an affiliate and their resale. If the issuer is not a reporting company, the period is one year. A non-affiliate selling restricted securities of a reporting issuer may sell freely once one year has elapsed.

Current public information. Adequate current information about the issuer must be available.

Volume limitation. For an affiliate, the amount sold in any three-month period may not exceed the greatest of one percent of the shares of the class outstanding, or the average weekly reported trading volume during the four calendar weeks preceding the filing of the notice. Compute both and take the larger — that is the exam question nearly every time.

Manner of sale. The sale must be a broker's transaction, a transaction directly with a market maker, or a riskless principal transaction — not a special selling effort.

Notice. If the amount to be sold during any three-month period exceeds 5,000 shares or an aggregate sale price of $50,000, a notice on Form 144 must be filed electronically with the Commission. Below both thresholds, no filing is required.

Rule 145 is the neighbouring rule, covering securities received in a reclassification, merger, consolidation or transfer of assets.

Rule 144A and institutional resales

Rule 144A provides a safe harbour for the resale of restricted securities to qualified institutional buyers without registration. It is what makes a large private debt or equity market possible: an issuer places securities privately, and the institutional buyers can then trade among themselves in a liquid secondary market rather than being locked in.

A qualified institutional buyer is, broadly, an institution that in the aggregate owns and invests on a discretionary basis at least $100 million in securities of issuers not affiliated with it. Registered broker-dealers qualify at a lower threshold, $10 million. The critical point for a representative is that a QIB is an institution, never a natural person, however wealthy. That is the distinction from an accredited investor under Regulation D, which can be an individual meeting income or net worth tests — covered in Module 8.

Securities sold under 144A may not be offered to the general public, and a retail customer cannot buy them. When a question puts a 144A security in front of a retail customer, the answer is that it is unsuitable because it is unavailable.

Corporate actions

A corporate action changes the position, the basis, or both, and the firm must notify affected customers.

A forward split multiplies the share count and divides the price: a two-for-one split on 100 shares at $60 leaves 200 shares at $30. Total value and total cost basis are unchanged; basis per share halves. Not a taxable event. The holding period of the new shares tacks onto the original.

An uneven split — five-for-four, three-for-two — works the same way, and the exam likes it because the arithmetic is less automatic. A 5-for-4 split of 100 shares at $50 gives 125 shares at $40.

A reverse split reduces the share count and raises the price, most often to regain compliance with an exchange's minimum price listing standard. It creates no value; a customer who reads a higher price as good news has misread it.

A stock dividend distributes additional shares instead of cash. Like a split, it is not taxable and it spreads the same basis over more shares.

A spinoff distributes shares of a subsidiary to the parent's shareholders, and the original cost basis is allocated between parent and spinoff in proportion to their relative fair market values.

A tender offer invites holders to sell their shares to the offeror at a stated price, generally above market. Two rules attach. Rule 14e-4 prohibits short tendering — tendering more shares than you actually own net long — which is why the exam's answer to 'how many shares may this customer tender' is always the net long position, counting shares owned outright plus shares the customer has an unconditional right to acquire, such as through in-the-money long calls or convertible securities already submitted for conversion. Rule 14e-3 prohibits trading on material non-public information about a tender offer, and is deliberately broader than the general insider trading law: it does not require a breach of a duty, only knowledge that the information came from the offeror or the target.

Smaller shareholders often benefit from an odd-lot tender provision, which accepts holdings under 100 shares in full rather than pro-rating them.