Corporate Finance: Asia's Hot Depositary Receipts

When Brazil’s Vale, the world’s largest iron ore company, listed depositary receipts (DRs) in Hong Kong in December, it marked a watershed of sorts for Asia’s CFOs. A new and liquid market has now joined traditional DR leaders New York and London for capital-raising and other purposes.

 
Also last year, India listed its first DR, a rupee-denominated instrument issued by Standard Chartered Bank. Brazil’s stock exchange launched its first DR last April. More is to come, says BNY Mellon, which acted as depositary bank for 62% of all sponsored DR programs last year.
 
J.P. Morgan, another major depositary bank, expects a surge in issuers from China and Singapore listing DRs on the Taiwan Stock Exchange, and global companies and Asian companies doing the same in Hong Kong and elsewhere.
 
“With the continued recovery of capital markets globally and in improvement in corporate earnings generally, we’re expecting 2011 to deliver another strong year of growth in the Asia Pacific depositary receipts space,” says Kenneth Tse, Asia Pacific Head of J.P. Morgan’s depositary receipts group.
 
For CFOs, the question is whether their company should tap the growing DR markets, particularly those in Asia. What are the gains and potential challenges? What role, if any, can DRs play in capital-raising, enhancement of investor profile, M&A strategies and other business aims? Is it the most cost-efficient and effective instrument to reach these goals?
 
What Is a DR?
First, a short review. As finance professionals know, a depositary receipt is not a stock. It is a tradeable security that represents ownership of an equity share (or debt instrument, preferred share or other asset that can be equitised). While they are different instruments, a DR and a stock confer on their holders the same rights and obligations, including voting rights and dividends.
 
One obvious use of DRs is to give companies access to capital outside of their home market. PetroChina’s shares, for example, are denominated in Hong Kong dollars and trade on the Hong Kong stock exchange. The company has also issued depositary receipts, which are denominated in US dollars and trade on the New York Stock Exchange. One PetroChina ADR (American Depositary Receipt) represents ownership of 100 ordinary shares.
 
By issuing ADRs, PetroChina has in effect done a dual listing, tapping capital in both Hong Kong and the U.S. using essentially the same set of documentation. That’s one beauty of a DR, says Gregory Roath, Managing Director of BNY Mellon Depositary Receipts.
 
“The DR and the documentation around it allows you to translate that share and create a U.S. form of equity, as opposed to trying to transport a Hong Kong share to the U.S.,” he explains. “And now we see here in Asia numerous exchanges across the region also adopting DR rules to facilitate cross listings to their exchanges as well.”
 
This means that a company listed on the Philippine Stock Exchange, for example, may issue a DR in Hong Kong, thereby enlarging its investor base outside of its home market. The company need not even be listed. Chinese search engine Baidu, for one, issued DRs in the U.S. without listing the underlying shares anywhere.
 
Unsponsored DRs
Baidu and PetroChina DRs are sponsored programmes, meaning that both companies were actively involved in their issuance. But it is also possible for DRs to be unsponsored, a situation in which the company that issued the underlying shares has nothing to do with the DR.
 
This happens if one or more of the depositary banks, among them BNY Mellon, JP Morgan Chase, Citi and Deutsche Bank, establish a DR programme for a company in response to demand from brokers and investors. Typically, a broker buys a large block of the shares on the open market and deposits them with the depositary bank, which makes money from issuing and cancelling the DRs.
 
Not all companies are eligible. In the U.S., an unsponsored DR can be issued against a foreign company only if that firm has a security listed on at least one foreign stock exchange and makes available on its website an English-language annual report that comply with the requirements of its country of incorporation, organization or domicile.
 
Unsponsored DRs can trade only on OTC Markets in the U.S. According to BNY Mellon, 101 new unsponsored DR programmes were established from 22 countries last year, bringing the total to 1,127 DRs from 42 nations.
 
Unsponsored DRs from the Asia Pacific made up 39% of that total (49% came from emerging Europe, Middle East and Africa, with the balance from Western Europe).
 
The most actively traded unsponsored DR from Asia Pacific last year was Japan’s Nintendo, whose trading volume reached US$1.9 billion. Other active DRs from the region include Seven & I Holdings, FANUC and FUJIFILM (also from Japan), China’s BYD and Tencent Holdings, and Cheung Kong and Hutchison Whampoa from Hong Kong.
 
The Japanese DRs did not do very well overall in terms of value (minus 34%), reports BNY Mellon, but the prices of other Asia Pacific DRs surged:
 
  • Philippines                1,128%
  • Indonesia                    375%
  • Australia                     174%
  • Singapore                   137%
  • China/Hong Kong         54%
  • New Zealand                  4%
 
Sponsored or Unsponsored?
For Nintendo and the other companies, the main benefit is enhanced visibility among U.S. investors and increased liquidity, valuation and overall market capitalization (although it can go the other way, too, if U.S. investors for whatever reason dump the unsponsored DR and thus spook stock investors in the home market).
 
For some CFOs, a sponsored programme may be preferable to having a depositary issue a DR without its participation. Japan’s Takeda Pharmaceutical, for example, converted its unsponsored DR programme into a sponsored one last May.
 
The company wanted to “enhance the appeal of their DRs,” according to BNY Mellon, and “extend rights to their DR holders in order to ensure better corporate governance practices.”
 
Unlike the unsponsored DR, which can be issued by more than one depositary bank, a sponsored programme is administered by one depositary bank engaged by the company. This gives the CFO control over the issuance, including the transparency and accuracy of information disseminated to DR holders.
 
The company can also decide on the terms and conditions of the programme, how many DRs to register for trading, and how and what to communicate to this class of investors. The company will also know who the DR holders are, which helps with investor relations.
 
But it also means custodian and other service fees, something that the company need not bother with if its DRs are unsponsored. Those costs are generally not exorbitant (the depositary will also be paid by DR investors and brokers as they trade) – certainly not as much as what the company will pay investment banks and other service providers in an IPO.
 
What CFOs Should Know
The decision of whether or not to tap the DR market and in what form “depends on the company’s goals,” says BNY Mellon’s Roath. “If there’s an intention or desire to actively use a DR program to engage a greater number of investors, to expand the universe of potential investors, then yes, having a sponsored program is the right way to go.”
 
If the company is content with simply raising its profile in a foreign market, an unsponsored DR may be sufficient, which is apparently fine with companies like Cheung Kong and Hutchison Whampoa.
 
Note, however, that unsponsored DRs are not permitted in Hong Kong, India, Taiwan and several other stock exchanges. For these jurisdictions, only sponsored depositary receipts can be issued.
 
If the intent is to do M&A, a sponsored DR structure can be useful. One example is French company Alcatel, which issued depositary receipts to shareholders of U.S.-listed Lucent, which it merged with in 2006.
 
The DR structure allowed Alcatel to deliver its shares listed in the Paris Stock Exchange to Lucent’s U.S. shareholders denominated in U.S. dollars, not the euro. In that way, the U.S. holders did not need to set up French brokerage accounts, trade the shares in France, own shares in a foreign currency and so on.
 
“We also see the use of sponsored DR programmes among companies that have substantial employee bases in other markets,” adds Roath. “Having a DR allows them to transport and deliver their equity to those other markets and have their shares available for their employees.”
 

Which market or markets should the DRs be registered and traded? Again, it depends on the company’s goals. If the aim is to complete an M&A transaction, the DR programme will be established in the market where the other company’s shareholders are.

 
If the aim is to raise the company’s profile among U.S. investors, the OTC Markets is an option. Both unsponsored and sponsored DRs can be established there. “It’s not for raising capital, but it’s a very efficient way to provide your equity in U.S. markets without having to follow Sarbanes-Oxley and U.S. GAAP,” says Roath – and without needing to register with the SEC.
 
Regulatory Hurdles
If the primary goal is to have a high profile among deep-pocketed institutional investors that trade on Nasdaq, NYSE and the American Exchange, a Level II DR is the most suitable option. (Level I DRs trade only on OTC.)
 
Compared with Level I, the hurdle for companies is higher for a Level II DR. The DRs should be registered with the SEC and the financial reporting must comply with U.S. GAAP. The underlying shares are existing shares (e.g., being sold by a major shareholder).
 
If the goal is to raise new capital in the U.S., a Level III DR is required (which is the DR structure of PetroChina and Baidu). Typically, the company will be doing an IPO in its home market, with a portion of the newly issued shares allocated to serve as the underlying shares of the Level III DR sold to U.S. investors.
 
The company may also opt not to list those new shares (i.e., not do an IPO), as Baidu has done. Whatever the case, it is required to file SEC Form F-1, which is similar to an IPO prospectus in content and format. Both Level II and Level III DRs must comply with U.S. listing rules or risk getting delisted.
 
The regulatory regimes for DRs in Hong Kong, India and Taiwan generally follow Level II and Level III strictures. In Hong Kong, DR issuers must comply with the same listing requirements as those that issue shares – the requirements for admission, listing process and continuing obligations are the same.
 
This means, among others, profits of at least HK$50 million (US$6.4 million) in the last three years, with profit in the most recent year at HK$20 million (in Taiwan, pre-tax profit of at least NT$250 million – US$8.6 million – in the past two years).
 
These are not really very onerous conditions for many companies in Asia, but as Roath says, any decisions that are made must be consistent with the goals and circumstances of each company.
 
It is clear that DRs are showing up on the corporate finance radar of Asia’s enterprises, including those in frontier markets. “We have mandates from a couple of Mongolian issuers that are working on establishing programmes [in Hong Kong],” says Roath. “A DR can be quite helpful where the market is still small and growing, but the companies there require greater access to capital than what the domestic market can provide.”
 
Additional impetus is being provided by the launch in Singapore last year of a trading platform for DRs known as GlobalQuote, which allows investors in Asia to trade in DRs listed overseas during the Singapore trading day. This early, 19 DRs by Chinese companies issued in the U.S. are already trading on the new platform.
 
About the Author
Cesar Bacani is Editor-in-Chief of CFO Innovation.
 
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