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INTRODUCTION

It is estimated that in 2003 U.S. investors allocated eleven to
twelve percent of their total equity portfolio to non-U.S. equities. Institutional
investors purchases of foreign equities in 2003 amounted to $1,300 billion
according to the U.S. Federal Reserves Flow of Funds. Institutional investors
are also responsible for the large interest in the trading of American Depositary
Receipts (ADRs). ADR programs are set up by U.S. depositary banks and are
claims against the ordinary shares that trade in the home market as discussed in
detail later in this paper. In 2003, the combined dollar trading value of listed
depositary receipts on the New York Stock Exchange, the American Stock
Exchange and Nasdaq totaled $630 billion.
1
Mutual funds such as Fidelity
Management and Putnam Investment are among the largest U.S. investors in
depositary receipts.
U.S. investors interested in investing in a foreign firm (one based outside
the U.S.) can do so by purchasing ADRs in the U.S., or by purchasing the
underlying stock in the home market of the firm, or by doing both. This paper
examines the factors that affect an institutional investors choice of investment
security, i.e. investing in the ADR versus investing in the underlying shares of
an emerging market firm. Thus, we are interested in the question of how a fund
manager, once she has decided to invest in a company cross-listed in the U.S.,
chooses to divide that investment amount between the ADR share and the non-
ADR shares (primarily the underlying domestic share that trades on the home
stock exchange of the issuer) of that company. The factors that affect fund
managers choice of a particular firm
1
See Depositary Receipt Market Review 2003, Bank of New York website.

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have been addressed by Aggarwal, Klapper and Wyscocki (2004), our focus is
the determinants of security choice (the ADR versus the underlying).
We investigate the country and firm-level attributes associated with the
decision to hold ADRs versus underlying (domestic) shares, or a combination of
both. Coffee (1999) suggests that U.S. securities law provides additional
protection to investors if the firm is listed in the U.S. and argues that firms from
countries with weak shareholder protection laws can effectively bond
themselves to the more stringent U.S. laws. This implies that on the margin,
ADR holders have better legal standing compared to holders of the underlying
security as the ADRs are purchased in the U.S. This line of argument implies
that fund managers should prefer ADRs of firms from countries with weak legal
protection for shareholders. A recent example of such SEC enforcement is the
case SEC brought against TV Azteca, a Mexican firm, in January 2005 alleging
self dealing and insider trading by Companys officers and Directors. Yet
another example is the ability of US security holders of Bre-X, a Canadian
mining company, to sue in a US court while the Canadian security holders did
not get that privilege.
However, Siegel (2004a, 2004b) using a sample of Mexican firms, finds
that cross-listing is associated with higher probability of asset stealing by
controlling shareholders (thus causing significant wealth loss for minority
shareholders). Furthermore, he reports that the SEC rarely prosecutes
transgressions of U.S. listed foreign firms.
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Siegels findings suggest that
investors should not expect significant benefits from investing in ADRs of cross-
listed firms as the enhanced legal protection is not significant. This debate
provides conflicting predictions about the effect of a countrys legal system (in
particular its investor

2
Although Coffee (2002a, 2002b) argues that while the SEC may not be a very effective enforcer, private law
suits can still be brought against U.S. listed foreign firms, Siegel (2004a,2004b) in turn argues that the dollar
amount of settlements in such cases is relatively small.

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protection/corporate governance laws) and a U.S. investors choice of investing
security (ADR versus underlying) for cross-listed firms from that country. The
effect of local laws may be hard to identify, since the development of a
countrys stock exchange (reflected in transaction costs and liquidity of that
exchange) may in turn be related to the legal origins of that country. La Porta et
al. (1997) report that, on average, countries with English common law origin
have more developed financial markets. Thus, to the extent that legal origin is a
proxy for the quality of a countrys stock exchange, it may exert an additional
effect (independent of the better investor protection effect) on the investment
allocation pattern of U.S. investors.

In addition to legal considerations, there are also operational issues that
can be significantly influence a fund mangers choice between holding the ADR
or the underlying stock for a particular firm. Financial institutions that offer
depositary services such as Bank of New York, Citicorp, and JP Morgan,
frequently stress the advantages of an ADR program
for potential investors on measures such as liquidity, transparency and ease of
trading.
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Industry participants also point to the lower costs of executing trades as a major
factor in their preference for an ADR over the domestic security, for issuers
from countries with stock exchanges with high transaction costs. However, we
are not aware of any empirical work that provides evidence to confirm or dispute
these assertions. This paper seeks to address this gap in our understanding of
how professional fund managers allocate their investment between ADR
securities and non-ADR securities.

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For example Bank of New York describes the potential benefits to US investors as While most investors
recognize the benefits of global diversification, they also understand the challenges presented when investing
directly in local trading markets. These obstacles can include inefficient trade settlements, uncertain custody
services and costly currency conversions. Depositary Receipts overcome many of the inherent operational and
custodial hurdles of international investing. Source: http://www.adrbny.com/dr_edu_basics_and_benefits.jsp

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Our paper also contributes to the debate on the impact of cross listing on
the liquidity of the issuers shares, both in the domestic market and ADR
market. A number of studies report that issuers who cross-list in the U.S. enjoy
an increase in liquidity as measured by higher trading volumes or lower bid-ask
spreads.
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However other studies find that the ADR issuance impacts
development of the local market and is associated with a reduction in the size,
liquidity, and growth of the issuing firms domestic market (Karolyi 2004,
Levine and Schmukler 2004, Claessens, Klingbiel and Schmukler 2002).
Although we do not study liquidity, per se, we investigate the conditions under
which trading is more likely to stay on local exchanges. In this regard, we find
important differences between ADR investment in Latin America and Asia.
Several earlier papers have examined ADRs from the issuers perspective
focusing on the advantages of U.S. listing for the issuer. Reese and Weisbach
(2002) classify this theoretical and empirical body of work in three broad
categories. The first category consists of theoretical models of market
segmentation/investor recognition which imply that when capital flow across
countries is costly, cross-listing leads to a lowering of the cost of capital (thus
higher equilibrium price) for the issuer (Stapleton and Subrahmanyam, 1977 and
Errunza and Losq, 1985). Another related set of studies reports evidence
supporting Mertons (1987) investor recognition hypothesis which implies
that as a firm gains recognition (e.g. by cross-listing abroad), the pool of
potential investors also increases, resulting in the
lowering of its cost of capital.
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See, for example, Bekaert, Harvey and Lundblad, (2003), Errunza, Hogan and Hung, (2000), and Errunza and
Miller, (2000).

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Miller (1999) and Errunza and Miller (2000) find empirical support for the market segmentation hypothesis.
Support for investor recognition hypothesis is provided by Miller (1999) (larger abnormal returns exchange
listed ADRs compared to those that listed on the OTC market) and Baker et al. (2002) and Lang, Lins and Miller
(2004) who report higher analyst coverage (a proxy for higher recognition) for ADR issuers.


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The second category of research papers focus on the impact of cross listing on
the liquidity of the issuers shares (both in the domestic market and the
ADR market).
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Chowdhary and Nanda (1991) model trading of the same
security on multiple exchanges. A key result of their model is that when several
markets compete for order flow of the same security, the exchange offering the
lowest transaction costs attracts liquidity traders which in turn induces informed
traders to also move to that exchange (in order to camouflage their private
information). Thus, one exchange emerges as the dominant exchange in which
the bulk of trading is concentrated.
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at least for U.S. investors. This suggests that
if a country has high trading costs (implying a relatively less liquid stock
market), U.S. investors are likely to have a relatively larger fraction of their
investment in the form of ADRs for firms from that country. Conversely, if the
home market is deep and liquid (implying low trading costs), across-listing in
the U.S. would not lower the attraction of holding the underlying.
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The third category of recent studies has examined the benefits of listing an
ADR in terms of better shareholder protection. La Porta et al. (1997, 1998,
2000) show that different legal systems provide different levels of protection to
minority shareholders with English common law being the most protective and
French civil law being the least protective. An ADR listing on a U.S. exchange
may provide the ADR investor with rights that are

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Studies that report positive association between a firms U.S. cross-listing and the liquidity of its underlying
include Bekaert, Harvey and Lundblad (2003), Errunza, Hogan and Hung (2000), and Errunza and Miller (2000).
However, Karolyi (2004) and Claessens, Klingbiel and Schmukler (2002) report contrary evidence.

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Lukoil, a Russian energy company, is an example of such extreme concentration in which a large proportion of
trading takes place in the ADR.

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Halling et al. (2004) report that European firms cross-listed on exchanges outside their home country (U.S. as
well as non-U.S.), foreign trading decline rapidly in the post-listing period. Migration of trading back to home
exchange (flow back) is strongest for firms from deep and liquid home markets that cross-list on a high cost,
less liquid foreign exchange. Thus, they argue that unless there are compelling economies in trading costs
(among other factors), trading tends to revert back to the home market.


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comparable to those provided by a U.S. firm. An issuer from a weak shareholder
protection legal system can therefore effectively bond itself to provide higher
protection by listing on a U.S. exchange. This bonding hypothesis is discussed in
Coffee (1999), and a number of recent studies have found some support for this
argument. For example, Doidge, Karolyi and Stulz (2004) find that foreign firms
that list in the U.S. particularly those from countries with poor investor rights,
have a significantly higher valuation than firms from the same country that are
not cross-listed. Reese and Weisbach (2002) also report a higher level of equity
issuance (thus signifying better bonding) in the post-ADR issue period.
Our paper differs from the studies described above on one critical
dimension. While these studies have largely focused on the benefits to the ADR
issuers, we focus on the motivation of investors when they choose to invest in
the ADR rather than the underlying security. Many of the benefits of a U.S.
listing that have been attributed to issuers (better investor recognition, higher
liquidity and conformity with a more stringent legal framework) are equally
relevant to investors.
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For example, if holding a U.S. listed security provides
additional legal protection, then a U.S. based-fund is more likely to hold the
ADR rather than the underlying share for issuers based in a country with poor
investor protection laws. Similarly, if the transaction costs/liquidity of a firms
home stock are unattractive compared to those of a U.S. exchange, investors are
likely to hold a larger proportion of their investment in the form of that firms
ADR. The overall decision of whether or not to invest in a particular foreign
firm has been the focus of some recent studies.
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However, once a decision to
invest

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For example, Ammer et al. (2004) report that a foreign firm can significantly increase the proportion of its stock held by U.S. based
investors by cross-listing in the U.S. Bradshaw, Bushee and Miller (2003) find that U.S. institutions invest more in non-U.S. firms that follow
U.S. GAAP and that this relationship is significantly stronger in the subsample of firms that issue ADRs.


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These papers show that both country-wide factors (such as size of the economy, shareholder rights and legal structure) and individual
firm-specific characteristics (such as firm-size, liquidity, extent and quality of information disclosure) are important determinants of
investment decisions for U.S. based fund managers. For



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in a particular firm is made, not much is known about how a fund manager
chooses to split that investment between the ADR security and the domestic
security.
The main results of our paper are the following: At the country-level, the
legal origin of a firms home country is significantly related to the U.S.
investors choice of investment security for that firm. On average, funds hold a
significantly larger fraction of their investment in the form of ADRs for firms
from countries of French legal origin and for firms from transition countries
(e.g. Russia, Hungary, etc.). These results are consistent with the better legal
protection argument which implies that for issuer from weak legal systems,
investors prefer to hold a U.S. issued and traded ADR rather than the underlying
stock. However, these results can also occur due to another well documented
finding in recent studies that report that the level of a countrys stock market
development (e.g. size as well as liquidity) is positively associated with the
degree of investor protection its legal system offers. To isolate the effect of a
countrys legal framework from that countrys stock market characteristics we
include some direct measures of the level of stock market development along
with legal origin variables. On average, fund holdings of ADRs are higher for
firms based in a country with a low level of stock market development (i.e. low
stock market capitalization to GDP ratio or low trading volume). These results
support the ease of transaction argument which implies that investors prefer to
hold securities that trade on deep and liquid exchanges. However, the legal
framework continues to be a significant determinant of funds choice of
investment security even after controlling for these more specific measures of a
particular countrys level of stock market development. Finally, if we control for
individual firm-specific characteristics, we find that for an issuer whose ADR
security is

more details see Aggarwal, Klapper and Wyscocki (2004), Ammer et al. (2004), and Bradshaw, Bushee and Miller (2003).

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characterized by high trading volume relative to its underlying stock, the
average fund holding is relatively higher in the ADR. As discussed earlier,
industry participants highlight the ease of trading as the primary benefit of
holding ADRs. Our results provide empirical support for this argument as the
benefits of ease of trading and increased liquidity appear to be significant factors
in an investors choice between the ADR and the underlying security of a firm.
These findings are also consistent with the theoretical predictions of Chowdhry
and Nanda (1991) that if the same security trades in multiple markets, trading
aggregates on the exchange with the lower trading costs.

The remainder of the paper is organized as follows. We provide a brief
description of ADRs and their fee structure in Section 2. Section 3 describes our
main hypotheses. A discussion of the data and the variables follows in Section 4.
The methodology and the major results are reported in Section 5. We conclude
in Section 6.

2. American Depositary Receipts (ADRs)
ADRs were first introduced in 1927 and are negotiable U.S. securities
representing ownership of publicly traded shares in non-U.S. corporations.
ADRs are quoted and traded in U.S. dollars on a U.S. exchange. The dividends,
if any, are also paid to ADR holders in U.S. dollars. ADRs were specifically
designed to facilitate the purchase, holding and sale of securities on non-U.S.
based firms by U.S. investors. The structure of ADRs typically involves a
depositary bank that acquires the domestic shares in the local market (either
directly from the company or in the local stock market) and deposits these with a
custodian bank. Against these immobilized local shares, the depositary bank
issues depositary certificates for sale in the U.S. The ADRs are then traded just
like any exchange listed U.S. security. All ADRs are structured with a specific
bundling ratio that denotes the number of

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underlying shares represented by each ADR. For Example Taiwan
Semiconductor ADR has a bundling ratio of 1:5 which implies that each ADR
represents 5 underlying shares.
There are generally no costs for ADR to ADR trading with the depository
trust company, which accounts for most trading of highly liquid ADRs. The
depositary bank also handles the cross-selling of ADRs, which is the
simultaneous buying of one security (the ADR, for example) and selling of the
other (underlying) to exploit arbitrage opportunity. As described in Gagnon and
Karolyi (2004) there can be significant pricing differences between the ADR and
the underlying security although there are non-trivial trading costs that need to
be borne to exploit these arbitrage opportunities.
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An investor wishing to
convert his ADRs into its underlying shares (or vice versa) incurs some
additional costs such as conversion fee and foreign exchange transaction costs.
The conversion fee for ADRs is specified in the Deposit Agreement filed with
the SEC for sponsored ADR programs. These standard cross-border fees are
paid to the depositary bank, and can be as high as up to $5.00 per 100 ADRs
converted. However this fee is often negotiated by brokers for shares that trade
at less than $5.00 per 100. Dividend fees are prohibited on NYSE ADR
programs, but Level I or 144A programs charge a standard fee of $0.02 per
share.
ADRs can be issued at four different levels. Level I ADRs do not involve
capital raising, are not offered to the public at large, and are not listed on an
exchange but instead trade over the counter. Level IV ADRs are issued under
Rule 144A/Reg. S and are a hybrid of a public offering and a private placement.
Initially these issues can trade only among Qualified Institutional Buyers (QIBs)
that have a net worth of $100 million and have registered broker-dealer
accounts. They trade on the PORTAL system. These securities

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Gagnon and Karolyi (2004) report that for most ADR issuers the price differences between the ADR and the underlying domestic security
tends to be within 20 to 85 basis points although it can be as high as 66% premium to as low as 87% discount for the ADR relative to the
domestic share.

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allow foreign issuers to include a U.S. tranche without all the disclosure
requirements. Both Level I and Level IV ADRs require minimal SEC
registration and no additional disclosure other than what is required by the home
country regulators. Level II ADRs involve a public offering though there is no
capital raising. They trade on an exchange such as the NYSE, AMEX or Nasdaq
and the issuer is subject to U.S. disclosure requirements. Level III ADRs are
issued in a public offering and new capital is raised. The issuer must register
with the SEC and is also subject to disclosure requirements. Both Level II and
III ADRs require subsequent annual filings (20-F) with the SEC and also require
partial (Level II) or full reconciliation (Level III) with U.S. Generally Accepted
Accounting Principles (GAAP). Furthermore, the listing exchange typically
imposes listing requirements in terms of annual turnover, breadth of shareholder
base etc. which also must be met. Figure 1 maps the key disclosure requirements
for different level ADRs against the ease of trading for these securities.
3. Main Hypotheses
Our first hypothesis examines the impact of the legal environment in a
firms home-country on the relative allocation of U.S. funds investment
between the ADR security and the domestic security of that firm. We assume
that a fund manager first decides whether to invest in a particular firm. Once the
decision to invest in the firm has been made, the manager decides how to
allocate the investment between the ADR and the domestic security. The second
decision can depend on both country and firm-level factors. Specifically, the
legal protection offered by a country may affect the attractiveness of holding the
underlying security of a firm from that country. As previously discussed, there is
a dispute in the literature: Coffee (1999, 2002a, 2002b) argues that a U.S. listing
provides significant



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protection to minority investors, since an ADR listing makes a firm subject to
rule 10b-5, which gives shareholders the right to sue for losses ensued because
of fraudulent statements made by a company whose shares they own.
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On the
contrary, Siegel (2004a) reports that in the case of Mexican firms, cross-listing
in the U.S. is associated with higher probability of asset stealing by the insiders.
He interprets these findings as evidence against the legal bonding hypothesis
proposed in the literature. These conflicting views motivate our first hypothesis:
Hypothesis 1 (H1): If a firm is based in a country that has poor investor
protection laws, fund managers allocate a larger fraction of their investment in
the ADR security of that company relative to the underlying domestic security.
Our second hypothesis examines the effect of market development on
ADR trading. As discussed earlier, countries with deep and efficient stock
exchanges are better positioned to retain the trading volume of their cross-listed
firms. For issuers from such countries the ease of trading benefits arising from
holding an ADR rather than the underlying stock are likely to be small. On the
other hand, if an issuer is based in a country that lacks a well-developed stock
market, the cost of trading the underlying stock is likely to be significantly
higher compared to trading its ADR on a U.S. exchange. This suggests the
following testable hypothesis:

Hypothesis 2 (H2): If a firm is based in a country that has a less developed
stock market, fund managers allocate a larger fraction of their investment in the
ADR security of that company relative to the underlying domestic security.



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Irvine (2000) describes the case of Bre-X (also discussed by Reese and Weisbach, 2002), a Canadian mining company that claimed (fraudulently) it
had found large gold deposits causing a huge increase in its market value. These claims were later found to be untrue and the shareholders sued the
company as the share price collapsed. Bre-X was cross-listed on NASDAQ and Toronto stock exchanges. The shareholders who bought the shares on
NASDAQ were able to sue under American law but shareholders who bought in Toronto stock exchange could only sue under Canadian law.

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We employ a number of proxies to capture country-level measures of stock
market development, such as size of the stock market relative to the economy,
liquidity (estimated as average turnover), settlement proficiency, and transaction
costs that reflect direct costs of executing a trade (e.g. stamp duty, capital gains
tax, broker commission, etc.). For example, if higher transaction costs in the
domestic security are found to be associated with funds devoting a larger fraction
of their investment in a particular firm to that firms ADR security, it can be
interpreted as support for H2. Our third hypothesis considers firm-level
characteristics. While factors related to an issuers home country stock exchange
may have an impact on the fraction of total investment in that firm held as ADR,
there are arguably factors that are unique to an issuer that can also affect the
investors allocation decision. Specifically, while a countrys market may not be
well-developed and may not have sufficient liquidity, an individual firm from
that country may have fairly good liquidity for its underlying (domestic) security
and large local investor base, making its underlying security easy to trade. For
such firms, investors should hold relatively higher proportion of their investment
in the form of underlying security. In addition, relatively higher liquidity (e.g.
trading volumes) of an issuers ADR compared to the liquidity of its underlying
stock may make holding the ADR more attractive. This suggests the following
hypotheses:

Hypothesis 3 (H3): For an ADR issuer, if the level of domestic liquidity is low,
a fund manager is likely to allocate a larger fraction of its investment to the
ADR security of that firm. Additionally, for firms with listed ADRs, if the relative
liquidity of the ADR security compared to the liquidity of the underlying stock is
high, a fund manager is likely to allocate a larger fraction of her investment in
the ADR security of that firm.



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4. Data and Variables
To test these hypotheses, we create a unique database using a number of
data sources. Our primary data source is the February 2002 edition of the
Morningstar database for each U.S. mutual fund with a stated objective of
investing primarily in emerging market equities.
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All of the sample funds are primarily equity funds with more than 90 percent of
their investment in equities. We include three classifications of U.S. mutual
funds: Diversified Emerging Markets, Pacific/Asia excluding Japan, and Latin
America. We exclude Diversified Pacific/Asia mutual funds because the
majority of their investments are in countries that are not considered emerging
markets, such as, Japan, Hong Kong and Singapore. Similarly, we exclude
European funds because of their emphasis on developed Western European
markets. In the Pacific/Asia excluding Japan sample of funds, we exclude 11
funds that invest 90 percent or more of their assets in 3 or less countries. We
also exclude multiple classes of the same emerging market mutual fund. Certain
funds have multiple classes that have identical portfolio holdings but different
fee structures. For example, one fund may have an exit fee but the other does
not. Finally, since our analysis focuses on active portfolio allocation decisions of
U.S. mutual funds, we also exclude exchange-traded funds and funds that
explicitly follow passive indexing strategies. Our final sample consisted of 111
funds consisting of the three categories; Diversified Emerging (73 funds), Latin
America (14 funds), and Asia (24 funds). The country level data is taken from
various sources including Datastream, IMF and La Porta et al. The data for
individual firms is obtained from Worldscope, Datastream, Bloomberg and hand
collected data from 20-F filings.

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Consistent with the MSCI Emerging Markets Free Index, we define the following 30 countries as emerging markets: Argentina, Brazil,
Chile, China, Colombia, Czech Republic, Egypt, Ghana, Greece, Hungary, India, Israel, Jordan, Malaysia, Mexico, Morocco, Pakistan, Peru,
Philippines, Poland, Russia, Slovakia, South Africa, South Korea, Sri Lanka, Taiwan, Thailand, Turkey, Venezuela and Zimbabwe.

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Appendix A provides a detailed description of all the variables. Appendix
B provides key country-level statistics. Shareholder Rights are generally highest
for English legal origin countries such as India, Pakistan and South Africa and
lowest for French legal origins countries that include Mexico and Venezuela.
Market development as measured by market capitalization/GDP is highest for
South Africa, Malaysia, Taiwan and Chile. Korea and Taiwan are some of the
largest and most liquid markets. There is not much variation in settlement
proficiency with most countries receiving the highest possible score of three.
However, there is considerable variation in transactions cost efficiency with only
four countries receiving the highest score of three. Appendix C provides
correlation measures of various firm-level characteristics. In the following
section we describe how our principal dependent variables are constructed.

4.1 Dependent Variables - Measurement of Allocation Choice
One of the primary goals of this research is to examine factors that
determine how the total investment in a firm is divided between that firms ADR
and its underlying security. Thus we need to construct meaningful measures of
what constitutes this relative over or under weight in the ADR relative to the
underlying. Our primary measure for this allocation choice is ADR
Differential. This is constructed using the Morningstar database described
above. For each firm i, we first identify all funds that hold an investment in that
firm. This investment can be either in ADRs, in the underlying domestic security
or in both. For illustration let us assume that there are k funds that hold an
investment in firm i. To estimate the relative weighting of investments in ADR
versus the domestic security for this firm we follow a two step process. In the
first step, for each fund k we calculate the total dollar amount of investment
(sum of investment in ADR and underlying) in firm i, that a fund holds. We


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then calculate the fraction of that investment in the ADR and the fraction in the
underlying for that fund. Next, we take the difference between the fraction of
investment in the ADR versus the domestic stock. This difference reflects the
relative over or underweighting in ADR for that fund. We repeat this process for
all of the k funds, thus generating the relative over or under allocation of
investment in ADRs for each fund. In the second step, we take a simple average
of these k values to get the aggregate measure of over/underweighting across all

funds that invest in the firm i and denote it by (ADR
Differential).
This process can
be
described by the following equation:
k
( ADR _ Differential)
k





( ADR _
Differential) =
n
1
i
(1)



k

i
Where ( ADR _
Differential )
k

denotes fund k's over or underinvestment in firm i 's
ADR and is estimated as
i
( ADR _
Differential)
k

= (Fraction of investment held in ADR ) - (Fraction
of held in undelying)
i





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We also create an alternative measure of over or under weight in the
ADR denoted by ADR_RATIO. For a particular issuer i, the ADR_RATIO is
also calculated in two steps. First, the total value of (U.S. dollar amount) of
investment by all funds in that firm is calculated. This calculation includes all
securities issued by issuer i (for most issuers it is the ADR and the underlying
security of that issuer). The second step involves calculating the total investment
by all funds in the ADR security of firm i. ADR_RATIO is calculated by taking
the ratio of investment in ADR security of firm i by all funds to the investment
in all

securities of firm i by all funds. Equation 2 describes the calculation of
ADR_RATIO below:

k
(Total $ amount invested in ADR
security of firm i )
k






n
1
i
( ADR _
RATIO)
i
=

(2)

k


(Total $ amount invested in ADR security and
domestic security of firm i )
k


n
1
i





16

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We use the example of Telefonos de Mexico (Telmex), a Mexican
telecommunications firm to illustrate how the ADR_Differential and the
ADR_RATIO are calculated for this firm. Telemex is held by 79 funds and the
total investment in this firm is $363 million. Of this $363 million, $344 million is
held as ADRs and $19 million is held as the underlying security. Thus,
(ADR_RATIO)
Telmex
equals 0.94 ($344/$363). For calculating
(ADR Differential)
Telmex
we need to calculate the difference in the fraction of
investment held

in ADR and the fraction of investment held in the underlying for each fund. Of
the 79 funds, 70 hold only the ADR. Thus the ADR differential for each of these
funds is 1 (fraction held in ADR fraction held in underlying). 7 funds hold only
the underlying which implies that ADR differential for each of these funds is -1.
Remaining two funds hold both ADR and underlying of Telmex, with ADR
differential of -0.94 and 0.15. The calculation of (ADR
Differential)
Telmex
is as follows:

( ADR _
Differential) =
(70 7 0.15
0.94)
=
0.787


Telm
ex 79


The example of Telmex also illustrates that a predominant fraction of
funds (70 out of 79) invest in Telmex through its ADR. In other firms the
opposite is true, i.e. most funds hold only the underlying security rather than the

18

ADR. For example, consider the case of Advanced Semiconductor, a Taiwan-
based semiconductor fabricator. There are 16 funds that hold a total of $8.2
million in this firm and of which only $0.1 million is held in the form of the
ADR. Of the 16 funds, 14 hold only the underlying and one fund holds only the
ADR while one fund holds both. For Advanced Semiconductor the
ADR_Differential and

ADR_RATIO are -0.83 and 0.01 respectively. These examples highlight an
interesting feature of ADR holding patterns observed in our sample. For a typical
issuer, any single fund typically either holds only the ADR or holds only the
underlying. Figues 2 and 3 illustrate this propensity of funds to favor either the
ADR or the underlying. Figure 2 provides a frequency distribution of the 111
funds holding ADR holdings pattern. Of the 136 listed ADR issuers, in 38 cases
every fund that invests in these firms invests only in the underlying shares of
these firms. For 22 firms all the funds that invest in these firms hold only the
ADR. Thus for nearly half of the sample of ADR issuers the fund holding is
exclusively in either the underlying or the ADR. Figure 3 plots the number of
firms against the aggregate dollar amount invested by funds in the ADR of these
firms. Again, we observe the same concentration of investment in either the
ADR or the underlying. At the individual issuer level this pattern of strong
preference of either the ADR or the underlying is clearly evident, however we
find that at the fund level there are no clear preferences for holding ADRs or the
underlying local shares. We do not, for example, find funds that specifically
invest only in ADRs. Most funds hold both underlying and ADR securities. The
average and median percent holdings of ADRs across funds is 29%, with a
standard deviation of 10%. These summary statistics suggest that a funds
decision to hold ADRs versus underlying shares is influenced by country and
firm level characteristics.


19

Our finding that most funds hold primarily the ADRs or underlying shares
of specific firms motivated us to construct an alternative measure of a funds
preference for a firms ADR versus its underlying security. This is a binary
variable (ADR_OverWeight)
i
which

equals one if at least 50% of all funds that invest in firm i invest only in its ADR
(and zero otherwise). Hence, (ADR_OverWeight)
i
captures the aggregate fund
choice of investment

security for firm i. Thus for Telmex, ADR_OverWeight equals 1 while for
Advanced Semiconductor the value is zero.

4.2 Sample Descriptive Statistics

Panel A of Table 1 shows that the portfolio holdings of Asian and Latin
American

firms show different patterns. Funds invest in 31 percent of non-ADR firms in
Asia as compared to only 19 percent in Latin America. Of all the Asian firms
with an ADR program, 65 percent are held by at least one fund. For Latin
America the corresponding number is 73 percent. Panel B of Table 1 reports the
same pattern when the market value of firms is used instead of number of firms.
It shows that of the Latin American firms covered by Worldscope, those that
have an ADR represent 66 percent of that regions market capitalization.
However, Asian firms with ADRs represent only 43 percent of that regions
market capitalization.

Several conclusions can be drawn from this analysis. For the universe of
firms covered by Worldscope: 1) A larger proportion of Latin American firms

20

issue ADRs than Asian firms; 2) Funds are more likely to hold positions in firms
that have ADRs; and 3) Funds are more likely to invest in non-ADR firms from
Asia than non-ADR firms from Latin America (this may reflect the fact that
Latin American firms are almost two times more likely to have ADRs than are
Asian firms).

5. Empirical Results

This section describes the methodology employed to test the hypotheses
discussed in section 3 and reports our major findings.

5.1 Differences between Latin America and Asia
Most emerging markets have some ADRs listed in the U.S. The fraction
of ADR

listings is particularly high for Latin America as seen in Table 2. For example, 20
percent of all Mexican firms (covered by Worldscope) have a listed ADR. The
corresponding numbers are 14.29 percent, 7.55 percent and 10.92 percent for
Argentina, Brazil and Chile, respectively.

Often, it is the largest firms in a country that issue ADRs. These firms represent a
large proportion of the market capitalization of each countrys stock exchange. In
the case of Argentina and Brazil, firms with ADRs make up more than 50
percent of the countrys market capitalization. For most Asian countries the
proportion of firms with listed ADRs is small and varies between one to three
percent. Even though the fraction of Asian firms that have an ADR program is
small, these few firms account for a fairly large proportion of total market
capitalization. For example, the fraction of market capitalization of ADR firms is
42 percent for China, 41 percent for Korea and 34 percent for India.

21


Table 3 provides some descriptive statistics on the average holdings of the
111 mutual funds studied. The 73 diversified firms are on average larger with an
average portfolio market value of $124 million. These are followed by the 14
Latin American funds at $65.6 million, with Asian funds being the smallest at
$42.7 million. On average, a fund invests 25 percent of its assets in ADRs (both
listed and unlisted), with the remaining 75 percent being in domestic stocks. The
proportion of holdings in unlisted ADRs is small, on average ranging from 0.1
percent of a funds assets for Asian funds to 6.6 percent for Diversified
Emerging Market funds.

Latin American funds have a far greater fraction of their investment in
ADR securities compared to Asian funds. Latin American funds invest more than
45 percent of their assets in ADRs and the remaining 55 percent in domestic
stocks. U.S.-based emerging market mutual funds invest in a total of 1,361 firms:
136 firms have listed ADRs, 251 have unlisted ADRs and 974 firms do not have
an ADR as shown in Table 4. The 136 firms with listed ADRs are, on average,
larger as measured by market capitalization and book value of total assets, and
have a higher market to book ratio than firms with unlisted ADRs or no ADRs.
Firms with unlisted ADRs are, in turn, larger and have higher market to book
ratio than firms with no ADRs.
5.2 Legal Environment and ADR Investment
Our first objective is to determine the impact of country-level attributes on
the funds choice of investment security for ADR issuers from that country
(see H1). As we discussed earlier, if U.S.-based investors feel that holding
an ADR confers additional legal protection to them (Coffee 1999, 2002a,
2002b), they would prefer holding the ADRs to the underlying (especially
for firms from countries with poor investor protections laws). In H1 we are
interested in measuring the relationship between the investor

22

protection/corporate governance laws of an issuers home country and the
investment allocation decision of a U.S. investor. A number of recent
studies show that the legal origin of a country and the quality and
enforcement of investor protection laws are closely related.
14

Common law (English)


14
Denis and McConnell (2002) define corporate governance as the set of mechanisms designed to induce managers to make decisions that
maximize shareholders' wealth and to deter managers from expropriating shareholder wealth. La Porta et al. (1997, 1998, 2000) discuss the
role of strong investor protection laws and enforcement in fostering corporate governance that protects and attracts outside investors. Their
empirical results show that better investor protection laws and law enforcement institutions are associated with more developed capital
markets. The quality of information provided to outside investors is also higher in countries with strong investor protection (see, for example,
Leuz, Nanda, and Wysocki, 2003).

23

countries offer the strongest investor protection while civil law (French)
countries offer the weakest investor protection. The investor protection offered
by a countrys laws may have an impact on an investors portfolio allocation
decision across firms from countries with different legal systems. However,
once a fund manager has chosen to invest in a particular firm, the legal
environment or shareholder protection laws of the country in which that firm is
based should not influence how much of that investment is in the form of that
companys ADR versus its underlying domestic security, if both the ADR holder
and the holder of the domestic security have similar rights. For example, an
investor holding an ADR of a Brazilian firm typically does not have any voting
rights. However, the underlying security (typically a preferred share) also lacks
these voting rights. While this may make investment in a Taiwanese firm more
attractive, there would be no compelling argument as to why an investor would
prefer the ADR over the domestic security (or vice versa) in either country if the
ADR and the underlying offered exactly the same benefits. In such a case we
should expect to see no relationship between a countrys legal origins and
relative fraction of investment in ADRs of firms from that country. However, as
we discussed earlier, if U.S. based investors perceive that holding an ADR
confers additional legal protection to them (Coffee 1999, 2002a, 2002b), they
would prefer holding the ADRs to the underlying (especially for firms from
countries with poor investor protections laws).

To test these arguments we estimate the following model:

ADR Differential
0

1
(GDP Per Capita )
2
( French )
3

(German)
+
4
(Transition )
5
( Shareholder Rights ) (3)


24


The variables for equation 3 are discussed below:

ADR Differential: An aggregate measure of over or under investment in the
ADR security of firm i as described in equation 1 and as discussed in Section
4.1.
Legal Origin Dummy Variables: A dummy variable that identifies the legal
code of the country as common law (English), civil law (French), or
Germanic (German) as described by La Porta et al. (1998). We also include
an additional dummy for the formerly Soviet Union block countries
(Transition).

Shareholder Rights: This variable measures the anti-director rights index
originally developed by La Porta et al. (1998) and was subsequently updated
by Pistor (2000) to include transition emerging markets. It is the sum of
dummies identifying one-share/one vote, proxy by mail, unblocked shares,
cumulative vote/proportional representation, preemptive rights, oppressed
minority, and percent of shares needed to call a shareholders meeting.

GDP per Capita: This serves as a control variable for the level of economic
development of the economy.

By construction ADR Differential is restricted to lie between -1 (when all firms
invest only in the domestic security) and +1 (when all firms invest in the ADR).
Thus our dependent variable is truncated in both the left and the right tail. We
report the results for an OLS model as well as for a Tobit specification where the
dependent variable is constrained to lie between
-1 and +1.
15


25


The analysis covers the 387 firms that are held in at least one funds
portfolio and that have an ADR issued (listed or unlisted) at the beginning of
2001. A fund manager thus has the option to invest in only the ADR, only the
underlying domestic stock, or a combination of the ADR and the domestic stock
for these firms. Each model is first estimated for all firms that have issued an
ADR (listed or unlisted). To better isolate the effects of a liquid and easily
traded ADR, we also estimate each model for the subset of firms that have a
listed ADR. The

15
We also estimated the same model using ADR_RATIO and ADR_OverWeight as the dependent variable. ADR_RATIO is calculated by
dividing the total dollar amount of investment (across all funds) in the ADR security of a company i by the total dollar investment (across all
funds) in all securities (ADR and non-ADR) of company i. ADR_OverWeight is a binary variable that equals 1 if at least 50% of all funds
that invest in a company only invest in its ADR. The results for these alternative proxies for choice investment security are very similar to
those reported for ADR_Differential and are available on request from the authors.



26

First model includes GDP per Capita and legal origin as the
explanatory variables as reported in Table 5. We include dummies that identify
the legal code of the country; the common law (English) dummy is left out and
serves as the benchmark. In the second model, Legal Origin is replaced by
Shareholder Rights.

Table 5 reports the results of the country-level estimations. Panel A
reports the results for the OLS regression while Panel B reports the results for
the Tobit regression. The results are essentially similar in both specifications.
We find that Legal Origin-French is positive and significant in both models and
Legal Origin-Transition is positive and significant for listed ADR sub-sample.
Our results suggest that in non-English legal systems fund managers invest more
in the ADR than the domestic stock. Shareholder Rights is not significant in any
of the models. If for a firm its ADR holders and underlying security holders
have exactly the same rights it would imply that legal origin and shareholder
rights by themselves should not matter. However, as discussed earlier in the
introduction section, US investors may perceive that ADRs offer better legal
protection compared to holding the underlying especially if the issuer is based in
a country with weak investor protection/corporate governance laws. It is also
possible that legal origin is a proxy for market development that could be
important in determining the allocation between the ADR and the domestic
security.
5.3 Stock Market Development and ADR Investment
Next, we attempt to examine the role of market development in explaining
a fund managers decision to invest in the ADR versus the domestic stock (See
H2). However, legal origin and investor protection laws are also associated with
degree of development of financial markets. Beck, Demirguc-Kunt and Levine
(2002) conclude that well-functioning legal systems that defend the rights of
individual investors are important for stock market

27


transactions. LLSV (1998) find that a countrys legal origin is important in
explaining the countrys laws on creditor rights, shareholder rights, and private
property rights and also a countrys level of market development. They argue
that legal origin matters for financial development because some legal traditions
are able to adapt more efficiently to evolving economic conditions. To the extent
that legal origin might serve as a proxy for capital market development it would
also affect a fund managers decision to invest in the ADR versus the domestic
stock. Therefore, we use more direct measures of market development and
transaction costs in addition to legal origin as explanatory variables. Specifically,
we estimate the following model:

ADR Differential
0

1
(GDP
Per Capita )
2
(MarketCap
GDP )
3
(Turnover
Country)
+
4
(Transaction
Efficiency )
5
(Settlement
Efficiency)

6
(FX
Volatility)

7
(French )
8

(German )+
9
(Transition) (4)


Equation 4 is an expanded version of equation 3. We use direct measures
of market development and transaction costs in addition to legal origin as
explanatory variables. We include the ratio of market capitalization to GDP
(Market Cap/GDP) as a measure of the overall size of the equity market relative
to the size of the economy. Liquidity of an exchange is critical for institutional

28

investors and we estimate the average daily turnover (Turnover Country) for the
domestic stock exchange and include it as an explanatory variable. We also
include a direct measure of transaction costs (Transaction Efficiency). The score
on this variable ranges from one to three and is obtained from Wilshire
Consulting Groups report for California Public Employees' Retirement System
(CALPERS). A higher score implies lower transaction costs and therefore higher
efficiency. Transaction costs are associated with trading in a particular market
and include items such as stamp taxes and duties, amount of dividends and
income taxed, and capital gains taxes. Countries such as Brazil and Mexico have
the highest transaction efficiency (lowest costs) with a score of three. The
countries with the lowest score on transaction efficiency include Chile, China,
Colombia and Indonesia. Similarly, we also include a settlement proficiency
variable (Settlement Proficiency) from the same report for CALPERS. This
variable captures whether or not a countrys trading and settlement is automated
and measures the success of the market in settling transactions in a timely
manner. A score of one to three is assigned for each country - a higher score
indicates a more efficient settlement system. Most emerging market countries
with large market capitalization have a score of three. The exceptions are India,
Russia and South Africa, which have 3- to 5-day settlement windows.

We also include FX Volatility, to control for the likelihood of exchange
rate depreciation. ADR share prices carry the same foreign currency risk as
underlying shares and most ADRs trade in line with the underlying security. The
spread is generally very small, reflecting the cost of foreign exchange conversion
and other execution costs. If the currency of the underlying stock rises against
the US dollar, the ADR price is expected to rise (and vice versa). Dividends are
converted and paid in US dollars.



29


Our results are reported in Table 6: Panel A reports the results of an OLS
regression while Panel B reports the estimates of the Tobit regression. Again the
results are broadly similar across the two specifications. In the first model we
only include Market Cap/GDP and

Turnover Country in addition to GDP per Capita. The model is estimated for all
ADRs and for only listed ADRs. The coefficient on Market Cap/GDP is
significant and negative for the entire sample and for the sub sample of listed
firms it is negative but not significant. The results suggest that fund mangers
allocate a relatively smaller proportion of their investment in particular firms
ADR security if that firms domestic market is well developed (as measured by
Market Cap/GDP). The coefficient on Turnover Country is negative and
significant in both models. Thus if a firm is based in a country with domestic
markets that are deep and liquid, the fund holdings of ADRs of such a firm is
relatively low. This provides empirical evidence support for market
microstructure models of multiple exchanges (Chowdhary and Nanda (1991))
that predict that informed traders (assuming the active mutual fund investors of
our sample can be considered informed traders) choose to trade in markets

that have the highest liquidity.
16
These results suggest that countries with high
turnover appear to retain the order flow of their ADR issuers in the home
market. Conversely, the results imply that professional investors are more likely
to invest in the ADR relative to the domestic stock if the issuers home countrys
stock market is not well developed and has low liquidity.

Earlier we discussed the results of previous studies that have documented
the association between market development and legal origin. It is possible that
our earlier results, showing significant association between a countrys legal

30

origin and fund managers ADR vs. domestic security allocation decision were
likely being driven by market development as the legal origin dummy variable
was capturing the effect of how developed the countrys stock market is. To test
this alternative explanation, in the second set of models in Table 6 , we include
market development variables (Market Cap/GDP and Turnover Country), FX
Volatility, and Legal Origin dummies. We also include Settlement
Proficiency and Transaction Efficiency to capture the cost of trading in the
domestic market. We find that the market development attributes are no longer
significant. However, Transaction Efficiency is negative and significant in two of
the three models at the 1 percent level. The results imply

16
The informed traders are drawn to the most liquid markets as they can conceal their (informed) trade better
in a market where trading activity is high.


31


that if the cost of executing transactions is high in the domestic market, funds
are more likely to invest in the ADRs of firms from that country. The French
Legal Origin continues to be positive and significant in the model both with all
ADRs and with only listed ADRs.

Transition Legal Origin is also significant for listed ADRs. Therefore, the
results suggest that the legal system captures more than just market
development. It is also interesting to note that the R
2
increases from 0.09 to 0.17
for all ADRs and from 0.04 to 0.20 for listed ADRs from the reduced model
with only market development variables to the full model that also includes legal
origin and transaction efficiency.

To summarize, funds are likely to allocate more funds to the ADR than
the domestic stock in countries that have non-English legal origin, particularly in
ADRs of firms from French legal origin and from former communist block
(Transition). It is possible that legal origin might simply be capturing market
development. We do find that funds are more likely to allocate more funds to the
ADR than the domestic stock in countries that have less developed stock
markets, low liquidity and high costs of trading. These results are consistent
with the commonly cited explanation by industry professionals which argues
that transaction-related factors play an important role in the choice of a firms
ADR security over the domestic security for an investor. However, legal origin
continues to be important even after controlling for these factors. Investors
allocate more funds to the ADR of a firm if that firm is based in a country with
French legal origins or if it was a former communist bloc country.




32



5.4 Firm-Level Attributes and ADR Investment

We next extend our analysis to firm-level attributes. If the liquidity of an
underlying security is high in the domestic market of the issuer, the investors
incentive to hold the firms ADR should be lower (see H2). Also for firms with
ADRs, if the liquidity of the underlying security is low compared to the liquidity
of its ADR, funds are expected to hold a higher fraction of their investment in
that firm in the form of ADRs (see H3). To examine the impact of these liquidity
measures on the funds investment allocation between the ADR and the
domestic security we estimate a model of the following form:

ADR Differential
0

1
(Log
Market Cap )
2
(Number of
Analysts )
3
( Accounting Quality)

4
(Liquidity
Underlying )
5
(Liquidity -
Relative )
6
(GDP Per
Capita ) +
7
(MarketCap
GDP)

8
(Turnover Country )+
9

(Transaction Efficiency )
1
0
(Settlement
Efficiency)

11
(FX Volatility )
12
(French )
13
(German )+
14
(Transition) (5)





33



Equation 5 is based on the specification used to measure the impact
of country level factors on the ADR_Differential (equation 4). In addition to
the country characteristics we now include the following variables:

Liquidity-Underlying: This is the ratio of the daily average volume of
underlying traded (for 2001) to average number of underlying
outstanding (simple average of 2000 and 2001 reported numbers). The
data is obtained from Datastream.

Liquidity-Relative: This is calculated by dividing the average daily
trading volume of ADRs (converted into the equivalent underlying by
using the ADR to underlying ratio) to the average trading volume of the
underlying. Thus a high value for Liquidity-Relative implies that the
ADR security is more liquid than the underlying. The trading volume
data is obtained from Bloomberg.

While intuitively straightforward, data collection on each of these
liquidity variables posed some special challenges. The underlying security
is not always the common stock. Issuers from Brazil and Mexico almost
always have multiple classes of shares. For example, Brazilian firms issue
ADRs that have preferred shares as the underlying security. The preferred
share is the main security for domestic investors, while the common stock
is held mostly by a small group of insiders.
17
To identify the class of
security that is underlying the ADR, we read through 20-F filings, which
are mandatory SEC filings of listed ADRs. Also, while the ADR Ratio is
usually reported by major databases (e.g. Datastream, Compustat and

34

BONY website), it requires adjustment for some of the issuers that have
ADR ratios greater than 1,000. In such cases the underlying securitys
trading volume is reported in units of thousands and to convert the ADR
trading into equivalent underlying trading volume this convention needs to
be accounted for.

The liquidity estimation process is illustrated by using the example of Videsh
Sanchar Nigam Limited (VSNL), an Indian firm. For the year 2000-01, the
average number of shares outstanding for VSNL was 28,500,000. On the
Bombay Stock Exchange, the average daily trading volume (in 2001) of VSNLs
underlying shares was 352,500 shares. Thus the Liquidity-Underlying for VSNL
is 0.0124 (352,500/28,500,000). Furthermore VSNL has issued an ADR that is
listed on the NYSE. One VSNL ADR provides the holder a right to own two
underlying shares. The daily ADR trading volume on the NYSE for VSNL is
183,090 ADRs. This is equivalent to 366,180 underlying shares. The Liquidity-
Relative for VSNL is thus 1.0388 (366,180/352,500).

We also include a number of other firm-specific characteristics.
18



17
Voting rights (and dividend rights) for holders of preferred shares are severely limited. Similarly, Mexican firms have many different
classes of stocks and typically have a complex underlying security (usually referred to as a CPO or a unit) that is a bundle of different classes
of stock (e.g. Grupo Televista has an ADR on an underlying CPO that represents 1 A Share, 1 L Share and 1 D Share). Also some firms have
multiple ADRs based on multiple underlying stocks in Mexico (e.g., Telefonos de Mexico, America Movil, Transport Maritima Mex) and
Chile (e.g. Sociedad Quimica, Embotelladora Andina). All Chinese ADRs are based on H class shares (different from domestic class shares
which can only be held by Chinese investors) which trade on the Hong Kong stock exchange.


18
Previous literature has shown a positive relationship between better firm-level attributes and financial and equity performance in
developed and emerging markets (see, for example, Gompers, Ishi and Metrick, 2003, and Klapper and Love, 2003).


35

Log Market Cap: Natural log of market capitalization of the issuer in US
dollars as reported by Worldscope.
Number of analysts: As reported by I/B/E/S.
Accounting Quality: We create an index of firm-level accounting quality
(Accounting Quality) which equals the sum of the four separate accounting
quality variables: Use of an international Big-5 accounting firm,
consolidation of financial reports, receipt of a clean audit opinion, and
reconciliation with either U.S. GAAPor International Accounting Standards.
19

Table 7 reports the estimated models for 1) All ADRs, and 2) Listed ADRs both
for the OLS regression (Panel A) and for the Tobit regression (Panel B). Two
models are estimated. The first includes only the firm-level attributes discussed
above and the second includes both firm-level and country-level attributes. We
find that, holding all else constant, higher liquidity of a firms underlying stock
is negatively associated with the fraction of investment held in the ADR of that
firm. This is consistent with the ease of trading arguments and theoretical
models that predict that informed traders would tend to concentrate in the most
liquid markets. This finding is strongly supported when we run the regression
for the sub-sample of firms that have listed ADRs. Here we can use a more
direct measure of liquidity differences between a firms ADR and its underlying
security by including the Liquidity- Relative variable.
20
The coefficient on this
variable is positive and significant at the one percent level across all
specifications. Thus, the mere act of listing an ADR need not move the trading
volume from
19
Mitton (2002) finds that higher firm-level disclosure quality had a strong impact on firm performance during the East Asian financial
crisis. Related studies also find that firms with ADRs appear in better information environments that are then associated with higher market
valuations and significantly larger market reactions to earnings announcements (for example see, Foerster and Karolyi, 1999, Lang, Lins and
Miller, 2003, and Bailey, Karolyi, and Salva, 2002, Doidge et al., 2004). See Karolyi (1998) for an excellent review of the ADR literature.


20
We also used an alternative proxy for relative liquidity denoted by ADR Fraction which is the fraction of the underlying security that is in
form of ADR. The results very similar to those for Relative Liquidity and are not reported. These results are available from authors on
request.


36


domestic market to the U.S. market if the domestic markets are deep and liquid..
For example, Kookmin Bank, a large South Korean bank has a listed ADR (each
ADR represents 1 underlying share) and is held by 67 funds. The average daily
volume for the underlying stock is 2.7 million while for the ADR it is only 0.14
million shares. Transaction costs at the country-level continue to be an important
factor in deciding whether to invest in the ADR or the domestic stock. Settlement
efficiency, however, is no longer a significant factor in funds allocation between
ADR and domestic security for the sub-sample of listed ADRs. Finally legal
origin continues to be significant for issuers from French legal system countries.
The positive and significant coefficient implies strong funds preference for
holding ADR securities of issuers from French legal system countries.

6. Summary and Conclusions
In this paper we review the firm, country, and market characteristics that
are related to a fund managers choice to hold an ADR security versus the
domestic security of emerging market firms. We specifically examine this
allocation decision for firms that have both an ADR and a domestic security
trading, therefore providing a fund manager the choice of whether to invest in
the firm by investing in the ADR or the underlying domestic stock. We find that
country-level institutional factors, such as legal origin, are significant in
explaining the fund managers choice, but shareholder rights are not significant.
In previous literature, legal origin has been shown to be related to market
development. Therefore, in addition to legal origin we introduce direct measures
of capital market development. Fund managers are found to allocate more funds
to ADRs in countries that have small equity markets relative to the size of the
economy, have lower market liquidity, and have higher transaction costs.



37


However, even after controlling for direct measures of market development,
legal origin continues to be significant.

At the firm-level, we find that mutual fund managers are more likely to
invest in an ADR relative to the domestic stock if the liquidity of the domestic
security is low. In particular, if the ADR liquidity is higher than the domestic
security liquidity, fund holdings are more concentrated in the ADR rather than
the (low liquidity) domestic security. These results are consistent with the ease
of trading argument that is frequently offered by industry participants as the
primary reason for investors to hold ADRs. These results also provide support
for theoretical models which predict that if a security trades in multiple
exchanges, the trading in such a security would tend to aggregate in the
exchange with lowest transaction costs.

Our findings suggest that ADRs can be an effective mechanism for firms
in emerging markets to access institutional investment. Even after controlling for
firm-level factors, country-level transactions costs and legal origin continue to
be significant. To summarize, we find that ADRs are the preferred mode of
holdings if the local market of the issuer has weak investor protection, low
liquidity and high transaction costs, and if the firm is small and has limited
analyst following. Our results also suggest that ADR listings of local firms
might not negatively impact local markets if the investment climate is good.

38

Chapter 1- Dematerialization
What is Dematerialization?
Dematerialization or "Demat" is process whereby your securities like shares,
debentures etc, are converted into electronic data and stored in computers by a
Depository. Securities registered in your name are surrendered to depository
participant (DP) and these are sent to the respective companies who will cancel
them after "Dematerialization" and credit your depository account with the DP.
The securities on Dematerialization appear as balances in your depository
account. These balances are transferable like physical shares. If at a later date,
you wish to have these "Demat" securities converted back into paper
certificates, the Depository helps you to do this.
Indian investor community has undergone sea changes in the past few years.
India now has a very large investor population and even increasing volumes of
trades. However, this continuous growth in activities has also increased
problems associated with stock trading. Most of these problems arise due to the
intrinsic nature of paper based trading and settlement, like theft or loss of share
certificates. This system requires handling of huge volumes of paper leading to
increased costs and inefficiencies. Risk exposure of the investor also increases
due tothis trading in paper.
Some of these risks are :
Delay in transfer of shares.
Possibility of forgery on various documents leading to bad deliveries,
legal disputes etc.
Possibility of theft of share certificates.
Prevalence of fake certificates in the market.
Mutilation or loss of share certificates in transit.

39

The physical form of holding and trading in securities also acts as a
bottleneck for broking community in capital market operations.
The introduction of NSE and BOLT has increase the reach of capital market
manifolds. The increase in number of investors participating in the capital
market has increased the possibility of being hit by a bad delivery. The cost and
time spent by the brokers for rectification of these bad deliveries tends to be
higher with the geographical spread of the clients. The increase in trade volumes
lead to exponential rise in the back office operations thus limiting the growth
potential of the broking members. The inconvenience faced by investors (in
areas that are far flung and away from the main metros) in settlement of trade
also limits the opportunity for such investors, especially in participating in
auction trading. This has made the investors as well as broker wary of Indian
capital market. In this scenario dematerialized trading is certainly a welcome.
Benefits of demat
Transacting the depository way has several advantages over the traditional
system of transacting using share certificates. Some of the benefits are:
Trading in demat segment completely eliminates the risk of bad
deliveries, which in turn eliminates all cost and wastage of time
associated with follow up for rectification. Thto reduction in brokerage to
the extent of 0.5% by quite a few brokerage firms.
In case of transfer of electronic shares, you save 0.5% in stamp duty.
You also avoid the cost of courier/ notarization/ the need for further
follow-up with your broker for shares returned for company objection.
In case the certificates are lost in transit or when the share certificates be
come mutilated or misplaced, to obtain duplicate certificates, you may
have to spend at least Rs. 500 for indemnity bonds, newspaper
advertisement etc. which can be completely eliminated in the demat form.

40

You can also receive your bonuses and rights into your depository
account as a direct credit, thus eliminating risk of loss in transit.
You can also expect a lower interest charge for loans take against demat
shares as compared to the interest for loan against physical shares. This
could result in a saving of about 0.25% to 1.5%. Some banks have
already announced this.
RBI has increased the limit of loans against dematerialized securities as
collateral to Rs2mn per borrower as against Rs. 1mn per borrower in case
of loans against physical securities.
RBI has also reduced the minimum margin to 25% for loans against
dematerialized securities as against 50% for loans against physical
securities.
1

How to Dematerialize your Shares
Fill up a dematerialization request form, which is available with
your DP;
Submit your share certificates along with the form; (white
"surrendered for demat" on the face of the certificate before
submitting it for demat)
Receive credit for the dematerialized shares into your account in 15
days.
Dematerialized shares do not have any distinctive or certificate numbers. These
shares are fungible - which means that 100 shares of a security are the same as
any other 100 shares of that security.
The investor can dematerialize only those certificates that are already registered
in his name and belong to the list of securities admitted for Dematerialization at
NSDL. Shares held in street name (market deliveries cannot be dematerialized.

1
http://www.mbaknol.com/investment-management/what-is-dematerialization, accessed on 18 Jan. 12, at
11:20 pm.

41

If the share certificates that investor wants to dematerialize do not belong to the
list of securities eligible for Dematerialization specified by NSDL, he can
approach the company and request them to sign up with NSDL to make their
securities available for Dematerialization. Odd lot share certificates can also be
dematerialized.
No transfer deed is required for dematerializing certificates, the certificates have
to be accompanied by a demat request form (DRF) which can be obtained form
DPs. It is compulsory to mention the ISIN number of the company while filling
up the Demat Request form. This to a certain extent, ensures that the security
mentioned in the Demat Request Form is the same as the one the investor
intends to dematerialize. However, the investor need not remember cryptic
numbers and can take the help of his DP in filling these forms.
Dematerialization is not compulsory. According to the Depositories Act, 1996,
an investor has the option to hold shares either in physical or in dematerialized
form. An investor can hold part of his holdings in demat form and part of his
holdings in the form of share certificates for the same security.
Although the depository would be a registered owner of securities in the
depository, a transaction involving dematerialized securities would not be
considered as benami transactions, the Benami Transactions (Prohibition) Act,
1988 have been suitably modified to exclude the securities held by a:
Depository as a registered owner.
DP as an agent of the depository.
Securities bearing the same distinctive numbers as demat securities can still
float in the market. It is a case of forged certificates and normal procedures that
are being followed in the physical market will be used to weed them out. The

42

concerned stock exchanges where the securities are listed are informed of the
details of securities dematerialized and rematerialized.
An investor can dematerialize shares that are pledged with a bank, which is a
DP as move.
The Concept of Dematerialization of Securities
Origin of Demat in India
The concept of demat was introduced in Indian capital market in 1996 with the
setting up of NSDL. A depository holds securities in dematerialized form. It
maintains ownership records of securities in a book entry form and also effects
transfer of ownership through book entry. SEBI has introduced some degree of
compulsion in trading and settlement of securities in demat form while the
investors have a right to hold securities in either physical or demat form, SEBI
has mandated compulsory trading and settlement of securities to select
securities in dematerialized form. This was initially introduced for institutional
investors and was later extended to all investors. Starting with 12 script on 15th
Jan. 1988, all investors are required to mandatory trade in dematerialized form
in respect of 2335 securities as at end-June 2001. By NBow, 2001, 3811
companies were under demit mode and the rest of the companies were brought
under compulsory demat mode by 2nd Jan. 2002.
2
The securities of companies
which fail to establish connectivity with both the depositories on the scheduled
date as announced by SEBI are traded on the "trade for trade" settlement
window of the exchanges. However in order to mitigate the difficulties of small
investors the stock exchanges provide additional windows for sales up to 500
shares in the physical form.
Favourable Points of demat

2
http://www.mbaknol.com/investment-management/how-to-dematerialize-your-shares, accessed on 18
Jan,12 at 9:48 pm.

43

Elimination of bad deliveries
Elimination of all risks associated with physical certification.
No stamp duty.
Immediate transfer and registration of securities.
Faster settlement cycle.
Faster disbursement of rights, bonus etc.
Reduction in brokerage by many brokers for trading in dematerialized
securities.
Reduction in handling of huge volumes of paper and postal delays.
Dematerialization
Dematerialization ("Demat" in short form) signifies conversion of a share
certificate form its physical form to electronic form for the same number of
holding which is credited to your demant account which you open whth a
Depository Participant (DP) Depository. A Depository (NSDL & CDSL) is an
organization like a Central Bank where the securities of a shareholder are held
in the electronic form at the request of the shareholder through the medium of a
Depository Participant If an investor wants to utilize the services offered by a
Depository, the investor has to open an account with the Depository through a
Depository Participant. The Depository can legally transfer beneficial
ownership which a custodian cannot. The main objective of a Depository is to
minimize the paper work involved with the ownership, trading and transfer of
securities.
Advantages of dematerialization
There is no risk due to loss on account of fire, theft or mutilation.
There is no chance of bad delivery at the time of selling shares as there is
no signature mismatch.

44

Transaction costs are usually lower than that in the physical segment.
The bonus/ rights shares allotted to the investor will be immediately
credited into his account. Share transactions like sale or purchase and
transfer/ transmission etc. can be effected in a much simpler and faster
way.
Problems of Dematerialization
Prior to dematerialization there was almost a gap of three months between
application date and listing of shares. Dematerialisation has reduced this gap to
a great extent. But quick money brings with itself a host of problems. Current
regulations prohibit multiple bids or applications by a single person. But the
investors open multiple demat accounts and make multiple applications to
subscribe to IPO's in the hope of getting vallotment. The recent IPO allotment
scam proves that even a highly automated system is not the solution to prevent
malpractices, if there is laxity. The scam of Yes bank and IDFC reveal that the
investor banker has failed to weed out multiple applications either direct or
benami. Not only the investor banker the DP and the depository failed to detect
the large number of demat accounts opened names. Lack of coordination
between banks, DP's broker's depositories, registrars and investment bankers
and clarity of their roles has given rise to such problems.
Remedial measures
To Prevent the sprouting of fictitious demat accounts at DP's the
allotment of shares should be checked thoroughly.
The concerned DP should strictly enforce the Know your client (KYC)
norms rather than relying on bank documents and verification of brokers.
DP's should be asked to give monthly figure of accounts opened for the
public.

45

Coordination and Clear definition of roles is important to weed out
manipulations.
3

Dematerialization and Rematerialization in Commodity Markets
The Indian commodity futures market has grown exponentially in the recent
times. With the increase in trade volume at the Commodity Exchanges; the need
to have ca vibrant and efficient settlement system was felt. This led to the
concept of dematerialization of warehouse receipts. Demat of warehouse receipt
eliminates the difficulties arising out of the use of physical warehouse receipts.
Dematerialization refers to the process of conversion of the physical paper (i.e.
share certificates, warehouse receipts, etc.) into the electronic balances. In this
demat account owner of the physical document. The concept of demat has been
in vogue in the securities market from the year 1996 with the setting up of the
first depository i.e. National Securities Depository Limited (NSDL) to remove
the difficulties arising out of the use of physical (paper) certificates for
settlement of trades on stock exchanges and for improving settlement efficiency.
What is a Warehouse Receipt?
Warehouse receipts are title documents issued by the warehouse to the
depositors against commodities deposited in warehouses. These receipts are
transferable by endorsement and delivery. Either the original depositor or the
holder in due course (transferee) can claim the commodities from the
warehouse. According to Sec.32 of the Bombay Warehouse Act, 1959, a receipt
issued by a warehouseman shall, unless otherwise specified on the receipt, e
transferable by endorsement, and shall entitle its lawful holder to receive the
goods specified in it on the same terms and conditions on which the person who
originally deposited the goods would have been entitles to receive them. The

3
http:www.mbaknol.com/investment-management/how-to-do-dematerialize-your-shares, accessed on 18
Jan.12, at 9:48 pm.

46

physical warehouse receipt suffers from the following deficiencies being the
paper form of title documents.
Need for splitting the warehouse receipt in case the depositor has an
obligations to transfer only a part of the commodities. A single
warehouse receipt is generally issued to the depositor for the goods
deposited by him at one time hence he faces this difficulty in case of
part transfer.
Need to physically move the warehouse receipt from one place to
another with the risk of theft, mutilation, loss in transit etc. if the
transferor and the transferee are at two different locations.
Risk of fake / forged warehouse receipt with the introduction of
dematerialization of warehouse receipt the above deficiencies are taken
care of.


Entities involved in the demat process
Issuer: The issuer is an entity, which floats the physical paper document.
It would be a company in case of the share certificate or warehouse in
case of warehouse receipt.
The Registrar and Transfer Agents: It acts on behalf of the issuer as an
interface between the issuer and the depository for converting the
physical warehouse receipt in the demat form.
The Depository: The Depository maintains the records of the beneficial
owner in its books. Presently there are two depositories in India i.e.
National Securities Depository Limited (NSDL) and Central Depository
Services Limited (CDSL)

47


Types of Demat Account
Beneficiary Owner Account is used to hold and transact in commodity
balances. The depositor is required to quote this account number at the
time of depositing commodity in the warehouse. The commodity balances
are credited in this type of account. All the investors trading in the
commodity markets are required to separately open beneficiary owner
account for commodity. The existing demat account for securities cannot
be used for the purpose of holding and transacting in the commodity.
Unlike the securities demat account, the investors need to open the
commodity demat account with both the depositories i.e. NSDL and
CDSL. The basic reason behind opening the account in both the
depositories is that the Depositories have not yet started Inter-Depository
transfer in case of commodities.
Clearing Member Pool Account is used for the purpose of settlement of
delivery obligations. The account is used by the member for giving or
receiving delivery of commodity to or from the Clearing House of the
Exchange. In short the pay-in and pay-out of the exchange is settled
through this account. All the members of the exchange are required to
open the CM Pool Account with both the depositories. This cannot be
used for holding the commodity.

Process of Demat Commodity
The depositor at the time of deposit of commodity contacts the Exchange
approved Quality Certifying Agency (QCA) to get the quality of goods assayed
in order to ascertain whether the goods confirms to the quality specification

48

norms of the Exchange. After receipt of the quality certificate from the QCA the
depositor is required to fill Commodity Deposit Form (CDF) which contains the
details of the quality, quantity validity dates of both for a commodity, demat
account number of the depositor, etc. The depositor is required to ensure that all
these details are properly filled in the form to avoid any kind of delays or errors.
The depositor submits the CDF, quality certificate and warehouse receipt to the
warehouse and receives acknowledgement of the same. The warehouse
management then initiates the process of demat credit vin co-ordination with the
Exchange, Registrar and Transfer Agent and the Depository. The Depositor is
required to check the holding statement (which can be obtained from his
depository participant) after a day or two to see whether the commodity
deposited has been credited to his account under proper Commodities Identifier
ICIN.
Concept of International Commodity Identification Number (ICIN)
ICIN refers to International Commodity Identification Number. Commodities
that have been dematerialized are identified by its unique code (i.e. (ICIN)
allotted by depository. ICIN is generated on the uniqueness of the following 4
parameters:
1. Commodity.
2. Warehouse Location
3. Grade/ Fineness of the commodity.
4. Validity date of the commodity.
Change in any of the above parameters will result in the generation of new
ICIN. For example, suppose there are four designated Vaults for Gold delivery

49

and 2 qualities of gold are tendered for delivery then a total of 8 ICINs will be
generated for Gold. The ICIN description provides the name of the commodity,
grade of goods, the unit if measurements and the validity date of the ICIN.
Process of Demat Delivery
If the futures contract on its expiry results into delivery, then the member
having delivery obligation is required to give delivery of the commodity to the
exchange on or before the respective pay-in date. This is done by transferring
commodity from the Clearing Member Pool Account to the Clearing House
Account of the Exchange; the member is required to give the delivery
instruction to his Depository Participant before the pay-in deadline. On Payout,
the exchange credits the commodity to the Buying Member Pool Account.
Rematerialization / Withdrawal / Revalidation of Commodities
The depositor approaches the DP and makes request for withdrawal of
commodity in the prescribed from called Remat Request Form (RRF). The
acknowledgement copy of RRF is given to the depositor. The depositor will
approach the vault/ warehouse along with the following documents for
withdrawal of commodity.
1. Original copy of acknowledgement issued by DP on which RRN is
written
2. Authority letter from the depositor (in case agent)
3. Proof of identification of the agent person.
All agricultural commodities have a shelf life and cannot be stored indefinitely.
The "final expiry" of commodity refers to the maximum time period for which
the particular commodity has shelf-life. "Validity /Revalidity Duration" refers to
the number of times and the corresponding duration for which the quality
certification is valid. After the validity date, ICIN is considered to have expired
and the same would not be acceptable as good delivery at the exchange.

50

The depositor has two options after the validity date:
1. The depositor can withdraw the goods from the warehouse.
2. The depositor can go for re-validation of the commodity.
Thus in case of revalidation of commodity, the depositor needs to submit the
fresh quality certificate as revalidation form. The relevant quantity will be
credited on the new ICIN.

















51

Chapter 2 Indian Depository Receipt
An Indian Depository Receipt
4
is an instrument denominated in Indian Rupees
in the form of a depository receipt created by a Domestic Depository (custodian
of securities registered with the Securities and Exchange Board of India) against
the underlying equity of issuing company to enable foreign companies to raise
funds from the Indian securities markets.
5

The foreign company IDRs will deposit shares to an Indian depository. The
depository would issue receipts to investors in India against these shares. The
benefit of the underlying shares (like bonus, dividends) would accrue to the
depository receipt holders in India.
The Ministry of Corporate Affairs of the Government of India, in exercise of
powers available with it under section 642 read with section 605A had
prescribed the Companies (Issue of Indian Depository Receipts) Rules, 2004
(IDR Rules) vide notification number GSR 131(E) dated February 23, 2004.
Standard Chartered PLC become the first global company to file for an issue of
Indian depository receipts in India.
6

The rules provide inter alia for (aP Eligibility for issue of IDRs (b) Procedure
for making an issue of IDRs (c) Other conditions for the issue of IDRs (d)
Registration of documents (e) Conditions for the issue of prospectus and
application (f) Listing of Indian Depository Receipts (g) Procedure for transfer
and redemption (h) Continuous Disclosure Requirements (i) Distribution of
corporate benefits.

4
http://en.wikipedia.org/org.wiki/Indian Depository Receipt, accessed on 22 Jan.12, at 3:30pm.
5
Issues by foreign companies in India (Indian Depository Receipts)(IDRs) Securities and Exchange Board of
India(SEBI)
6
Issue of Indian Depository Receipts Reserve Bank of India, July22, 2009

52

These rules (principal rules) were operationalised by the Securities and
Exchange Board of India (SEBI) the Indian markets regulator in 2006.
Operation instructions under the Foreign Exchange Management Act were
Issued by the Reserve Bank of India on July 22, 2009.
7
The SEBI has been
notifying amendments to these guidelines from time to time.
Depository System
A depository is an organization which holds securities (like shares, debentures,
bonds, government securities, mutual funds units etc.) of investors in electronic
form at the request of the investors through a registered Depository Participant.
It also provides services related to transactions in securities. At present two
Depositories viz. National Securities Depository Limited (NSDL) and Central
Depository Services (India Limited (CDSL) are registered with SEBI. The
minimum net worth stipulated by SEBI for a depository in Rs. 100 crore.
A depository Participant (DP is an agent of the depository through which it
interfaces with the investor and provides depository services. Public financial
institutions, scheduled commercial banks, foreign banks operating in India with
the approval of the Reserve Bank of India, state financial corporations,
custodians, stock-brokers, clearing corporations/ clearing houses, NBFCs and
Registrar to an Issue or Share Transfer Agent complying with the requirements
prescribed by SEBI can be registered as DP. Banking services can be availed
through a branch whereas depository services can be availed through a DP.
As per the available statistics at BSE and NSE, 99.9 per cent transactions take
place in dematerialized mode only. Therefore, in view of the convenience of
trading in dematerialized mode, it is advisable to have a beneficial owner (BO)
account for trading at the exchanges.

7
Securities and Exchange Board of India (Issue of capital and disclosure requirements) regulations, 2009
Securities and Exchange Board of India (SEBI), August 26, 2009

53

However to facilitate trading by small investors (Maximum 500 shares,
irrespective of their value) in physical mode the stock exchanges provide an
additional trading window, which gives one time facility for small investors to
sell physical shares which are in compulsory demat list. The buyer of these
shares has to demat such shares before further selling.
8

First an investor has to approach a DP and fill up an account opening form. The
account opening form must be supported by copies of any one of the approved
documents which serve as proof of identity (POI) and proof of address (POA)
as specified by SEBI. Apart form these PAN card has to be shown in original at
the time of account opening.
9

Depository
Depository functions like a securities bank, where the dematerialized physical
securities are traded and held in custody. This facilities faster, risk free and low
cost settlement. Depository is much like a bank and performs many activities
that are similar to a bank.
NSDL and CDS
At present there are two depositories in India, National Securities Depository
Limited (NSDL) and Central Depository Services (CDS). NSDL is the first
Indian depository, it was inaugurated in November 1996. NSDL was set up with
an initial capital of US$28mn, promoted by Industrial Development Bank of
India (IDBI), Unit Trust of India (UTI)and National Stock Exchange of India
Ltd. (NSEIL). Later, State Bank of India (SBI) also became a shareholder.
The other depository is Central Depository Services (CDS). It is still in the
process of linking with the stock exchanges. It has registered around 20 DPs and

8
http://www.indianexpress.com/depository-system/761907/1, accessed on 18 Jan, 12, at 5:50pm.
9
www.sebi.gov.in

54

has signed up with 40 companies. It had received a certificate of
commencement of business from Sebi on February 8, 1999.
These Depositories have appointed different Depository Participants (DP) for
them. An investor can open an account with any of the depositories DP. But
transfers arising out of trades on the stock exchanges can take place only
amongst account-holders with NSDLs DPs. This is because only NSDL is
linked to the stock exchanges (nine of them including the main ones-National
Stock Exchange).
In order to facilitate transfers between investors having accounts in the two
existing depositories in the country the Securities and Exchange Board of India
has asked all stock exchanges to link up with the depositories. Sebi has also
directed the companies registrar and transfer agents to effect change of
registered ownership in its books within two hours of receiving a transfer
request from the depositories. Once connected to both the depositories the stock
exchanges have also to ensure that inter-depository transfers take place
smoothly. It also involves the two depositories connecting with each other. The
NSDL and CDS have signed an agreement for inter-depository connectivity.
Depository Participant
Similar to the brokers who trade on your behalf in and outside the Stock
Exchange; a Depository Participant (DP) is your representative (agent) in the
depository system providing the link between the Company and you through the
Depository. Your Depository Participant will maintain your securities account
balances and intimate to youre the status of your holding form time to time.
According to SEBI guidelines, Financial Institutions like banks, custodians,
stockbrokers etc. can become participants in the depository. A DP is one with
whom you need to open an account to deal in electronic form. While the

55

Depository can be compared to a Bank, DP is like branch cof your bank with
which you can have an account.
How does the Depository System operate?
The Depository System functions very much like the banking system. A bank
holds funds in accounts whereas a Depository holds securities in accounts for its
clients. A Bank transfers funds between accounts whereas a Depository
transfers securities between accounts. In both systems, the transfer of funds or
securities happens without the actual handling of funds or securities. Both the
Banks and the Depository are accountable for the safe keeping of funds and
securities respectively.
Safety to the investor
Securities Exchange Board of India (SEBI) has laid down certain rules
and regulations for getting registered as depository participant. With the
recommendation of the Depository and SEBIs own independent
evaluation a DP will be registered under SEBI.
The investors account will be credited/ debited by the DP only on the
basis of valid instruction from the client.
The system driven mandatory reconciliation is done between the DP and
NSDL.
Periodic inspections of both DP and R&T agent are conducted by NSDL.
The date interchange between NSDL and its business partners is
protected by standard protection measures such as encryption.
No direct communication links exist between two business partners and
all communications are routed through NSDL.
A statement of account is received periodically by the investors. NSDL
sends statement of account to a random sample of investors as a counter
check.

56

The investor has the right to approach NSDL if the grievances of the
investors are not resolved by the concerned DP.
Eligibility of companies to issue IDRs
The regulations relating to the issue of IDRs is contained in Securities and
Exchange Board of India (Issue of capital and disclosure requirements)
Regulations, 2009 as revised from time to time.
10

According to Clause 26 in Chapter III (provisions as to public issue), the
following are required of any company intending to make a public issue in
India:
It has net tangible assets of at least Indian Rupee three crore in each of
the preceding three full years (of twelve months each), of which not more
than fifty per cent are held in monetary assets: Provided that if more than
fifty per cent of the net tangible assets are held in monetary assets, the
issuer has made firm commitments to utilize such excess monetary assets
in its business or project;
It has a track record of distributable profits in terms of section 205 of the
Companies Act, 1956, for at least three out of the immediately preceding
five years: Provided that extraordinary items shall not be considered for
calculating distributable profits;
It has a net worth of at least INR one crore in each of the preceding three
full years (of twelve months each);
The aggregate of the proposed issue and all previous issues made in the
same financial year in terms of issue size does not exceed five times its
pre-issue net worth as per the audited balance sheet of the preceding
financial year;

10
IDR listing to enhance Stan Charts commitment to India: CEO Business Standard, Mumbai November 12,
2009 17:37 IST

57

If it has changed its name within the last one year, at least fifty per cent of
the revenue for the preceding one full year has been earned by it form the
activity indicated by the new name.
Further, Clause 97 in Chapter X stipulates additional requirements from a
foreign company intending to make an issue of IDRs: An issuing company
making an issue of IDR shall also satisfy the following:
The issuing company is listed in its hole country;
The issuing company is not prohibited ti issue securities by any
regulatory body;
The issuing company has track record of compliance with securities
market regulations in its home country.
StanChart IDR Issue
Standard Chartered plc is the first foreign company to have publicly elicited
interest in making an IDR issue in India. The company is already listed on the
London and Hong Kong stock Exchanges. Standard Chartered CEO Peter Sands
is quoted in the Indian media as saying the IDR listing (is) to enhance
StanCharts commitment to India.
11

1. Recent news reports suggest Standard Chartered PLC may be inching
closer to an issue. We have already got advisors and we will file for the
IDR issue after our (india) results are published by March-end, said
Neeraj Swaroop, Regional Chief Executive, India and South Asia of
Standard Chartered. Patrick Hosking, financial editor of the Times reports
that Standard Chartered (may) offer up to $750 million of new shares to
Indians. Standard Chartered to be listed in Mumbai The Times, March 4,

11
IDR listing to enhance StanCharts commitment to India: CEO Business Standard, Mumbai November 12,
2009, 17:37 IST

58

2010
12
but Indias top financial portal reported top officials as suggesting
the amount could be anywhere between $500 million and $750 million.
13

Follow up to earlier reports cited, Standard Chartered Plc files DRHP to issue
IDRs in India with SEBI on March 30, 2010.
14
Standard Chartered Bank is set
to become the first foreign company to list in India through an Indian depository
receipts (IDR) issue. StanChart expects to raise around $500-750 million (Rs
2,250-3375 crore) to grow its businesses globally.[
15
] [
16
]
Standard Chartered opened its IDR offering to Indian investors on May 25
2010, as reported by BBC News. The price band for the offering is 100 (1.47;
$2.10) to 115 rupees per IDR. The bank, which makes most of its profits in
Asia, will issue 240 million IDRs through the offer. [
17
][
18
]
In an interview with NDTV India, Neeraj Swaroop, CEO South Asia at
Standard Chartered Bank, said that the decision to list in India through an Indian
depository receipts (IDR) issue, was not about raising capital but it is about a
message of commitment to India.
19

Standard Chartered fixed its issue price for Indian Depository Receipts at Rs.
104 per unit.
20
At this issue price, the bank will raise Rs. 2,490 crore ($530
million) by selling 24 crore IDRs.
21
Every 10 IDRs represents one share of the
bank.

12
IDR listing to enhance StanCharts commitment to India: CEO Business Standard, Mumbai November 12]
2009, 17:37 IST
13
Standard Chartered to be listed in Mumbai The Times, March 4, 2010
14
StanChart plans India listing in June quarter Money Control, Mar 4, 2010
15
Standard Chartered Plc pdf SEBI, March 30, 2010
16
Standard Chartered set to make IDR history at Rs. 105-115 DNA, May 14, 2010
17
Standard Chartered Allocates 36 Million Indian Depository Receipts To Anchor Investors Morning Star, May
25, 2010
18
Standard Chartereds Indian share offering opens BBC, 25 May, 2010
19
StanChart gets bids from 6 anchor investors Hindu Business Line, 25 May, 2010
20
IDR not about capital: StanChart Video NDTV
21
StanChart IDR Priced at Rs. 104. Times of India. 31 May, 2010. http:timesofindia.indiatimes.com/Biz/India-
Business/StanChart-IDR-Priced at-Rs-104/articleshow/5992626.cms.

59

The IDRs opened at the Bombay Stock Exchange and National Stock Exchange
on June 11.
22
Standard Chartered PLCs Indian Depository Receipt, listed at Rs.
106, exceeded expectations by Rs. 2 or 1.92 per cent of the National Stock
Exchange.
23

IDR issue Process
According to SEBI guidelines, IDRs will be issued to Indian residents in the
same way as domestic shares are issued. The issuer company will make a public
offer in India, and residents can bid in exactly the same format and method as
they bid for Indian shares. The issue process is exactly the same: the company
will file a draft red herring prospectus (DRHP), which will be examined by
SEBI. The general body of investors wil get a chance to read and review the
DRHP as it is a public document, available on the websites of SEBI and the
book running lead managers. After SEBI gives its clearance, the company sets
the issue dates and files the document with the Registrar of Companies. In the
next step after getting the Registrars registration ticket, the company can go
ahead with marketing the issue. The issue will be kept open for a fixed number
of days, and investors can submit their application forms at the bidding centers.
The investors will bid within the price band and the final price will be decided
post the closure of the Issue. The receipts will be allotted to the investors in
their demat account as is done for equity shares in any public issue. On 256
th

October 2010, SEBI notified the framework for rights issue of Indian
Depository Receipts (IDRs), Disclosure requirement IDR rights would more or

22
Standard Chartered Raises $540 Million From Share Sale in India. Business Week. 30 May, 2010.
http://www.businessweek.com/news/2010-05-30/standard-chartered-raises 540 -million-from-share-sale-in-
india.html.
23
The IDR opened at the Bombay Stock Exchange and National Stock Exchange on June 11.Smart Investor. 11
June,2010. http://smartinvestor.in/market/story-31398 -storydet-Standard-Chartered39s-IDRs-debuts-at-Rs-
105.htm.

60

less be in line with the reduced requirement applicable for domestic rights
issue.
24

IDR Fungibility
The Indian depository Receipts shall not be automatically fungible into
underlying equity shares of issuing company. IDR Holders can convert IDRs
into underlying equity shares only with the prior approval of the Reserve Bank
of India (RBI). Upon such exchange, individual persons resident in India are
allowed to hold the underlying shares only for the purpose of sale within a
period of 30 days from the date of conversion of the IDRs into underlying
shares. Current regulations do not provide for exchange of equity shares into
IDRs after the initial issuance i.e. reverse fungibility is not allowed.

Eligibility for investors
According to Sebi guidelines, the minimum bid amount in an IDR issue is Rs.
20,000 per applicant. Like in any public issue in India, resident Indian retail
(individual) investors can apply up to an amount of INR 2,00,000 and Non-
institutional investors (also called high net worth individuals) can apply above
INR 1,00,000 but up to applicable limits.
Reservations in IDR issues (clause 98, Chapter X)
According to current regulations, at least 50% of the Issue is to be allocated to
qualified Institutional Buyers (QIBs), 30% of the issue to the retail individual
investors and balance 20% of the issue to non institutional investors and
employees. The ratio of non-institutional investors and employees is at the

24
Standard Chartered IDR lists at Rs. 106 on NSE. Economic Times. 11 June, 2010.
http://economictimes.indiatimes.com/IPOs/articleshow/6035719.cms.

61

discretion of the company to decide. The issue will fail if the company does not
get QIB investors to the extent of 50% of the issue size.
Taxation
Corporate lawyer Cyril Shroff of law firm Amarchand & Mangaldas & Suresh
A. Shroff & Co. explain the tax implications.
25

IDRs would also help improve the Sharpes ratio of domestic portfolios by
reducing home bias, that is either rooted in mistakes on the part of fund
managers or in capital controls, says Professor Ajay Shah of the Indira Gandhi
Institute of Developmental Research.
26


Depositories in India
At present there are two depositories in India, National Securities Depository
Limited (NSDL) and Central Depository Services (CDS). NSDL is the first
Indian depositor, it was inaugurated in November 1996. NSDL was set up with
an initial capital of US$28mn, promoted by Industrial Development Bank of
India (IDBI), Unit Trust of India (UTI) and National Stock Exchange of India
Ltd. (NSE). Later, State Bank of India (SBI) also became a shareholder.
The other depository is Central Depository Services (CDS). It is still in the
process of linking with the stock exchanges. It has registered around 20.DPs and
has signed up with 40 companies. It had received a certificate of
commencement of business from Sebi on February 8, 1999.
These depositories have appointed different Depository Participants (DP) for
them. An investor can open an account with any of the depositories DP. But

25
Sebi doubles retail limit, tightens IPO norms. Business.rediff.com.
http://business.rediff.com/report/2010/oct/26/sebi-tightens-ipo-norms.htm. Retrieved 27Oct.2010.

26
Standard Chartered might do an Indian Depository Receipt

62

transfers arising out of trades on the stock exchanges can take place only
amongst account-holders with NSDLs DPs. This is because only NSDL is
linked to the stock exchanges (nine of them including the main ones- National
Stock Exchange and Bombay Stock Exchange).
In order to facilitate transfers between investors having accounts in the two
existing depositories in the country the Securities and Exchange Board of India
has asked all stock exchanges to link up with the depositories. Sebi has also
directed the companies registrar and transfer agents to effect change of
registered ownership in its books within two hours of receiving a transfer
request from the depositories. Once connected to both the depositories the stock
exchanges have also to ensure that inter-depository transfers take place
smoothly. It also involves the two depositories connecting with each other. The
NSDL and CDS have signed an agreement for inter-depository connectivity.
Depository Participant
NSDL carries out its activities through various functionaries called business
partners who include Depository Participants (DPs), Issuing corporate and their
Registrars and Transfer Agents, Clearing corporations/Clearing Houses etc.
NSDL is electronically linked to each of these business partners via a satellite
link through Very Small Aperture Terminals (VSATs). The entire integrated
system (including the VSAT linkups and the software at the software at NSDL
and each business partners end) has been named as the NEST [National
Electronic Settlement & Transfer] system.
Just as one opens a bank account in order to avail of the services of a bank, an
investor opens a depository account with a depository participant in order to
avail of depository facilities.
27


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Chapter 3 The Depositories Act, 1996
The Depositories Act, 1996 was enacted to provide for regulation of
depositories in securities and for matters connected therewith or incidental
thereto. It came into force from 20
th
September, 1995.
The terms used in The Depositories Act, 1996 are defined as under:
(1) Beneficial owner means a person whose name is recorded as such with a
depository.
(2) Depository means a company, formed and registered under the Companies
Act, 1956 and which has been granted a certificate of registration under sub-
section (1A) of section 12 of the SEBI Act, 1992.
(3) Issuer means any person making an issue of securities.
(4) Participant means a person registered as such under sub-section (1A) of
section 12 of the SEBI Act, 1992.
(5) Registered owner means a depository whose name is entered as such in
the register of the issuer.
Agreement between depository and participant
A depository shall enter into an agreement in the specified format with one or
more participants as its agent.
Services of depository
Any person, through a participant, may enter into an agreement, in such form as
may be specified by the bye-laws, with any depository for availing its services.


64


Surrender of certificate of Security
Any person who has entered into an agreement with a depository shall surrender
the certificate of security, for which he seeks to avail the services of a
depository, to the issuer in such manner as may be specified by the regulations.
The issuer, on receipt of certificate of security, shall cancel the certificate of
security and substitute in its records the name of the depository as a registered
owner in respect of that security and inform the depository accordingly. A
depository shall, on receipt of information enter the name of the person in its
records, as the beneficial owner.
Registration of transfer of securities with depository
Every depository shall, on receipt of intimation from a participant, register the
transfer of security in the name of the transferee. If a beneficial owner or a
transferee of any security seeks to have custody of such security, the depository
shall inform that issuer accordingly.
Options to receive security certificate or hold securities with depository
Every person subscribing to securities offered by an issuer shall have the option
either to receive the security certificates or hold securities with a depository.
Where a person opts to hold a security with a depository, the issuer shall
intimate such depository the details of allotment of the security, and on receipt
of such information the depository shall enter in its records the name of the
allottee as the beneficial owner of that security.
Securities in depositories to be in fungible form
All securities held by a depository shall be dematerialized and shall be in a
fungible form.

65


Rights of depositories and beneficial owner
A depository shall be deemed to be the registered owner for the purposes of
effecting transfer of ownership of security on behalf of a beneficial owner. The
depository as a registered owner shall not have any voting rights or any other
rights in respect of securities held be it. The beneficial owner shall be entitled to
all the rights and benefits and be subjected to all the4 liabilities in respect of his
securities held by a depository.
Pledge or hypothecation of securities held in a depository
A beneficial owner may with the previous approval of the depository create a
pledge or hypothecation in respect of a security owned by him through a
depository. Every beneficial owner shall give intimation of such pledge or
hypothecation to the depository and such depository shall thereupon make
entries in its records accordingly. Any entry in the records of a depository under
Section 12 (2) shall be evidence of a pledge or hypothecation.
Furnishing of information and records by depository and issuer
Every depository shall furnish to the issuer information about the transfer of
securities in the name of beneficial owners at such intervals and in such manner
as may be specified by the bye-laws. Every issuer shall make available to the
depository copies of the relevant records in respect of securities held by such
depository.
Option to opt out in respect of any security
If a beneficial owner seeks to opt out of a depository in respect of any security
he shall inform the depository accordingly. The depository shall on receipt of
intimation make appropriate entries in its records and shall inform the issuer.

66

Every issuer shall, within thirty days of the receipt of intimation from the
depository and on fulfillment of such conditions and on payment of such fees as
may be specified by the regulations, issue the certificate of securities to the
beneficial owner or the transferee, as the case may be.
Depository to indemnify loss in certain cases
Any loss caused to the beneficial owner due to the negligence of the depository
or the participant, the depository shall indemnify such beneficial owner. Where
the loss due to the negligence of the participant is indemnified by the
depository, the depository shall have the right to recover the same from such
participant.
Securities not liable to stamp duty
As per the Section 8-A of Indian Stamp Act, 1899:
a) An issuer, by the issue of securities to one or more depositories shall, in
respect of such issue, be chargeable with duty on the total amount of
security issued by it and such securities need not be stamped;
b) Where an issuer issues certificate of security under sub-section (3) of
Section 14 of the Depositories Act, 1996, on such certificate duty shall be
payable as is payable on the issue of duplicate certificate under the Indian
Stamp Act, 1899;
c) Transfer of registered ownership of securities from a person to a
depository or from depository to a beneficial owner shall not be liable to
any stamp duty;
d) Transfer of beneficial ownership of shares, such securities dealt with by a
depository shall not be liable to duty under Article 62 of Schedule 1 of
the Indian Stamp Act, 1899;

67

e) Transfer of beneficial ownership of units, such units being units of mutual
fund including units of the Unit Trust of India, dealt with by a depository
shall not be liable to duty under Article 62 of Schedule 1 of the Indian
Stamp Act, 1899.
Advantages and disadvantages of the Depository System
The advantages of dematerialization of securities are as follows:
Share certificates, on dematerialization, are cancelled and the same will
not be sent back to the investor. The shares, represented by
dematerialized share certificates are fungible and, therefore, certificate
numbers and distinctive numbers are cancelled and become non-
operative.
It enables processing of shares trading and transfers electronically
without involving share certificates and transfer deeds, thus eliminating
the paper work involved in scrip-based trading and share transfer system.
Transfer of dematerialization securities is immediate and unlike in the
case of physical transfer where the change of ownership has to be
informed to the company in order to be registered as such, in case of
transfer in dematerialized form, beneficial ownership will be transferred
as soon as the shares are transferred from one account to another.
The investor is also relieved of problems like bad delivery, fake
certificates, shares under litigation, signature difference of transferor and
the like.
There is no need to fill a transfer form for transfer of shares and affix
share transfer stamps.
There is saving in time and cost on account of elimination of posting of
certificates.

68

The threat of loss of certificates or fraudulent interception of certificates
in transit that causes anxiety to the investors, are eliminated.
Disadvantages/Problems of the Depository System
Some disadvantages were about the depository system were known beforehand.
But since the advantages outweighed the shortcomings of dematerialization, the
depository system was given the go-ahead.
Lack of control: Trading in securities may become uncontrolled in case
of dematerialized securities.
Need for greater supervision: It is incumbent upon the capital market
regulator to keep a close watch on the trading in dematerialized securities
and see to it that trading does not act as a detriment to investors. The role
of key market players in case of dematerialized securities, such as stock
brokers, need to be supervised as they have the capability of manipulating
the market.
Complexity of the system: Multiple regulatory frameworks have to be
confirmed to, including the Depositories Act. Regulations and the various
Bye Laws of various depositories. Additionally, agreements are entered at
various levels in the process of dematerialization. These may cause
anxiety to the investor desirous of simplicity in terms of transaction in
dematerialized securities.
Besides the above mentioned disadvantages, some other problems with the
system have been discovered subsequently. With new regulations people are
finding more and more loopholes in the system. Some examples of the
malpractices and fraudulent activities that take place are:
Current regulations prohibit multiple bids or applications by a single
person. But investors open multiple demat accounts and make multiple

69

applications to subscribe to IPOs in the hope of getting allotment of
shares.
Some listed companies had obtained duplicate shares after the originals
were pledged with banks and then sold the duplicates in the secondary
market to make a profit.
Promoters of some companies dematerialized shares in excess of the
companys issued capital.
Certain investors pledged shares with banks and got the same shares
reissued as duplicates.
There is an undue delay in the settlement of complaints by investors
against depository participants. This is because there is no single body
that is in charge of ensuring full compliance by these companies.
28












28
http://www.mbaknol.com/investment-management/advantages-and-disadvantages-of-the-depository-
system, accessed on 22 Jan, 12, at 2:08 pm.

70



Chapter 4 American Depositary Receipt
(ADR)
American depositary receipt (ADR) was introduced in 1927 as a more
convenient way for investors to buy and sell shares of foreign
corporations. Put simply, ADRs represent a specific number (or fractions)
of a share in a company that doesnt
An American Depository Receipt, or ADR, is a security issued by a U.S.
depository bank to domestic buyers as substitute for direct ownership of stock in
foreign companies. An ADR can represent one or more shares, or a fraction of a
share, of a non-U.S. company. Individual shares of a foreign corporation
represented by an ADR are called American Depositary Shares (ADSs).
An ADR is a convenient way for companies whose stock is listed on a foreign
exchange to cross-list their stock in the United States and make their stock
available for purchase by U.S. investors, as these receipts can be traded on U.S.
exchanges.
Some ADRs are traded on major stock exchanges such as the Nasdaq Stock
Market (NDAQ) and the New York Stock Exchange, which require these
foreign companies to conform to many of the same reporting and accounting
standards as U.S. companies. Other ADRs are traded on over-the-counter
exchanges that impose fewer listing requirements.
Stock dividends and similar adjustments to the underlying shares are paid in
cash or ADR dividends by the bank.

71



History and Reasons for using ADRs
Depositary receipts (DRs) were created in 1927, primarily to circumvent the
difficulties associated with different currencies in the foreign market. Investors
attempting to enter the emerging markets or other foreign stock exchanges have
to go through expensive commissions and currency exchange before
successfully investing in a foreign market. With ADRs, however, investors can
take advantage of foreign markets while trading in U.S. Stock markets. The
bank choosing to issue the ADR controls the number of foreign shares each
ADR represents. Each ADR could represent multiple shares of the foreign
company, or vice versa.
Since each ADR represents a share or shares of the foreign company, the price
of the ADR changes in tandem with the price of the foreign stock. Therefore,
any change in price in the foreign companys stock applies to the change in
price of the ADR. In this way, investors can benefit from price changes without
worrying about currency conversion.
ADRs take into account currency fluctuations and foreign inflation. Should
there be rampant inflation in the nation of the foreign company, its ADR would
rapidly decrease in real value. Investors do have to worry about inflation and
currency changes in the foreign nation despite not having to convert currency to
buy foreign shares.
Different type of ADR issues
Level 1 These are found on Over the counter market and have the
loosest requirements from Securities and Exchange Commission.

72

Level 2 These are listed on an exchange or Nasdaq. They have slightly
more requirements from the SEC, but they have greater visibility and
trading volume.
Level 3 The issuer floats a public offering of ADRs on a U.S.
exchange.
29

American depositary receipt
An American depositary receipt (ADR) is ca negotiable security that
represents the underlying securities of a non-US company that trades in the US
financial markets. Individual shares of the securities of the foreign company
represented by an ADR are called American depositary shares (ADSs)
The stock of many non-US companies trades on US stock exchanges through
the use of ADRs. ADRs are denominated, and pay dividends, in US dollars, and
may be traded like shares of stock of US-domiciled companies.
The first ADR was introduced by J.P. Morgan in 1927 for the British retailer
Selfridges. There are currently four major commercial banks that provide
depositary bank services: BNY Mellon, J.P. organ, Citi, and Deutsche Bank.
Depositary receipts
More generally, depositary receipts (DRs) are negotiable securities that
represent the underlying securities if foreign companies that trade in a domestic
market. DRs enable domestic investors to buy the securities of a foreign
company without the accompanying risks or inconveniences of cross-borders
and corss-currency transactions.
Each DR is issued by a domestic depositary bank when the underlying shares
are deposited in a foreign custodian bank, usually by a broker who has
purchased the shares in the open market local to the foreign company. A DR can

29
http://www.wikinvest.com/iki/American_Depositary_Receipt_%28ADR%29

73

represent a fraction of a share, a single or multiple shares of a foreign security.
The holders of a DR has the right to obtain the underlying foreign security that
the DR represents, but investors usually find it more convenient to own the DR.
The price of a Dr generally tracks the price of the foreign security in its home
market, adjusted for the ratio of DRs to foreign company shares. In the case of
companies in the United Kingdom, creation of ADRs attracts a 1.5% stamp duty
reserve tax (SDRT) charge by the UK government. Depositary banks have
various responsibilities to DR holders and to the issuing foreign company the
DR represents.
ADR Programs (facilities)
When a company establishes an ADR program, it must decide what exactly it
wants out of the program, and how much time, effort, and other resources they
are willing to commit. For this reason, there are different types of programs, or
facilities, that a company can choose.
Unsponsored ADRs
Unsponsored shares trade on the over-the-counter (OTC) market. These shares
are issued in accordance with market demand, and the foreign company has no
formal agreement with a depositary bank. Unsponsored ADRs are often issued
by more than one depositary bank. Each depositary services only the ADRs it
has issued.
Due to recent SEC rule change making it easier to issue Level I depositary
receipts, both sponsored and unsponsored, hundreds of new ADRs have been
issued since the rule came into effect in October 2008. The majority of these
were unsponsored Level 1 ADRs, and now approximately half of all ADR
programs in existence are unsponsored.
Sponsored Level 1 ADRs (OTC facility)

74

Level 1 depositary receipts are the lowest level of sponsored ADRs that can be
issued. When a company issues sponsored ADRs, it has one designated
depositary who also acts as its transfer agent.
A majority of American depositary receipt programs currently trading are issued
through a Level 1 program. This is the most convenient way for a foreign
company to have its equity traded in the United States.
Level 1 shares can only be trade4d on the OTC market and the company has
minimal reporting requirements with the U.S. Securities and Exchange
Commission (SEC). The company is not required to issue quarterly or annual
reports in compliance with U.S. GAAP. However, the company must have a
security listed on one or more stock exchange in a foreign jurisdiction and must
publish in English on its website its annual report in the form required by the
laws of the country of incorporation, organization or domicile.
Companies with shares trading under a Level 1 program may decide to upgrade
their program to a Level 2 or Level 3 program for better exposure in the United
States markets.
Sponsored Level II ADRs (Listing facility)
Level 2 depositary receipt programs are more complicated for a foreign
company. When a foreign company wants to set up a Level 2 program, it must
file a registration statement with the U.S. SEC and is under SEC regulation. In
addition, the company is required to file a Form 20-F annually. Form 20F is the
basic equivalent of an annual report (Form 10-K) for a U.S. company. In their
filings, the company is required to follow U.S. GAAP standards of IFRS as
published by the IASB.
The advantage that the company has by upgrading their program to Level 2 is
that the shares can be listed on a U.S. stock exchange. These exchanges include

75

the New York Stock Exchange (NYSE), NASDAQ, and the American Stock
Exchange (AMEX).
While listed on these exchanges, the company must meet the exchanges listing
requirements. If it fails to do so, it may be delisted and forced to downgrade its
ADR Program.
Sponsored Level III ADRs (offering facility)
A Level 3 American Depositary Receipt program is the highest level a foreign
company can sponsor. Because of this distinction, the company is required to
adhere to stricter rules that are similar to those followed by U.S. companies.
Setting up a Level 3 program means that the foreign company is not only taking
steps to permit shares from its home market to be deposited into an ADR
program and traded in the U.S.; it is actually issuing shares to raise capital. In
accordance with this offering, the company is required to file a Form F-1, which
is the format for an offering Prospectus for the shares. They also must file a
Form 20-F annually and must adhere to U.S. GAAP standards or IFRS as
published by the IASB. In addition, any material information given to
shareholders in the home market, must be filed with the SEC through Form 6K.
Foreign companies with Level 3 programs will often issue materials that are
more informative and are more accommodating to their U.S. shareholders
because they rely on them for capital. Overall, foreign companies with a Level 3
program set up are the easiest on which to find information. Examples include
the British telecommunications company Vodafone (VOD), the Brazilian oil
company Petro bras (PBR), and the Chinese technology company China
information Technology, Inc. (CNIT)



76

Restricted Programs
Foreign companies that want their stock to be limited to being traded by only
certain individuals may set up a restricted program. There are two SEC rules
that allow this type of issuance of shares in the U.S.: Rule 144-A and
Regulation S. ADR programs operating under one of these 2 rules make up
approximately 30% of all issued ADRs.
Privately placed (SEC Rule 144A) ADRs
Some foreign companies will set up an ADR program under SEC Rule 144(a).
This provision makes the issuance of shares a private placement. Shares of
companies registered under Rule 144-A are restricted stock and may only be
issued to or traded by Qualified Institutional Buyers (QIBs).
US public shareholders are generally not permitted to invest in these ADR
programs, and most are held exclusively through the Depository Trust &
Clearing Corporation, so there is often very little information on these
companies.
Offshore (SEC Regulation S) ADRs
The other way to restrict the trading of depositary shares to US public investors
is to issue them under the terms of SEC Regulation S. This regulation means
that the shares are not, and will not be registered with any United States
securities regulation authority.
Regulation S shares cannot be held or traded by any U.S. person as defined by
SEC Regulation S rules. The shares are registered and issued to offshore, non-
US residents.
Regulation S ADRs can be merged into a Level 1 program after the restriction
period has expired, and the foreign issuer elects to do this.

77

Sourcing ADRs
One can either source New ADRs by depositing the corresponding domestic
shares of the company with the depositary bank that administers the ADR
program or, instead, one can obtain existing ADRs in the secondary market.
The latter can be achieved either by purchasing the ADRs on a US stock
exchange or via purchasing the underlying domestic shares of the company on
their primary exchange and then swapping them for ADRs; these swaps are
called crossbook swaps and on many occasions account for the bulk of ADR
secondary trading. This is especially true in the case of trading in ADRs of UK
companies where creation of new ADRs attracts a 1.5% stamp duty reserve tax
(SDRT) charge by the UK government; sourcing existing ADRs in the
secondary market (either via crossbook swaps or an exchange) instead is not
subject to SDRT.
ADR termination
Most ADR programs are subject of possible termination. Termination of the
ADR agreement will result in cancellation of all the depositary receipts, and a
subsequent delisting from all exchanges where they trade. The termination can
be at the discretion of the foreign issuer or the depositary bank, but is typically
at the request of the issuer. There may be a number of reasons why ADRs
terminate, but in most cases the foreign issuer is undergoing some type of
reorganization or merger.
Owners of ADRs are typically notified in writing at least thirty days prior to a
termination. Once notified, an owner can surrender their ADRs and take
delivery of the foreign securities represented by the Receipt, or do nothing. If an
ADR holder elects to the possession of the underlying foreign shares, there is no
guarantee the shares will trade on any US exchange. The holder of the foreign
shares would have to find a broker who has trading authority in the foreign

78

market where those shares trade. If the owner continues to hold the ADR past
the effective date of termination, the depositary bank will continue to hold the
foreign deposited securities and collect dividends, but will cease distributions to
ADR owners.
Usually up to one year after the effective date of the termination, the depositary
bank will liquidate and allocate the proceeds to those respective clients. Many
US brokerages can continue to hold foreign stock, but may lack the ability to
trade it overseas.
30

DEPOSITARY RECEIPTS: THE INDIAN PERSPECTIVE
In an era of rapid globalization, investors are looking beyond the boundaries of
their countries for investment opportunities. This has given rise to opportunities
for companies looking to expand into new markets, tap new customers, get hold
of a new investor base and raise more capital. There was a great demand for
foreign capital in some of the lesser developed countries. At the same time,
supply of capital was in excess in the countries like U.S.A. and England. There
was a need to bridge this gap and make a channel to enable the flow of funds
from these countries to the ones that required the funds. Investing without such
a channel was a challenge not just financially but also administratively. The
transactions were complicated and settlement of the transactions in was very
difficult owing to currency values. In an effort to bridge this gap, JP Morgan
introduced a system of depositary receipts in 1927. JP Morgan intended to
provide a channel that allows for easier flow of funds from U.S.A. to other
counties by offering hem investment options abroad. Hence, the depositary
receipts program was intended as both an investment vehicle as well as an
investment option. Currently, there are two major depositary receipt programs
the American Depositary Receipts and the Global Depositary Receipts

30
http://en.wikipedia.org/wiki/American_depositary_receipt.accessed on 22 Jan.12, at 3:15 pm.

79

American Depositary Receipts (ADRs) enable companies to tap into the world's
largest and most active capital market - the American market. Global
Depositary Receipts (GDRs) give the companies access to European markets
besides the American market.
ADR Overview
An American Depositary Receipt is a U.S. Dollar - denominated security that
trades on the American market. An ADR is offered by financial institutions in
the U.S. on behalf of the foreign company. The financial institution, usually
banks, buys shares of companies wishing to issue equity in the U.S. Then, it
bundles these shares into groups of shares and sells these "groups" of shares.
The "groups" are known as American Depositary Receipts. Therefore, one
American Depositary Receipt represents a fixed number of shares in the parent
company. The companies wishing to issue ADRs have to sign a contract with
the financial institution. The financial institution which issues the ADRs on
behalf of the company is also known as sponsor bank / brokerage or depositary
bank. The contract which is signed by both parties is a comprehensive one. The
provisions of the contract include the number of home - country shares that are
on offer, the ratio of the shares - per - ADR, the voting rights of the U.S.
investors and the tax obligations, among many others. The voting rights, if any,
lie with the depositary bank. The holders of the ADRs indicate to the depositary
bank which way they want to vote. In the absence of any concrete arrangement,
and if it doesn't violate any U.S. law, the depositary bank votes as a proxy of the
ADR - holder. This contract is known as the Deposit Agreement. This
agreement is the first step forwards raising finance from the United States.
DEPOSITARY RECEIPTS: THE INDIAN PERSPECTIVE
In an era of rapid globalization, investors are looking beyond the boundaries of
their countries for investment opportunities. This has given rise to opportunities

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for companies looking to expand into new markets, tap new customers, get hold
of a new investor base and raise more capital. There was a great demand for
foreign capital in some of the lesser developed countries. At the same time,
supply of capital was in excess inv the countries like U.S.A. and England. There
was a need to bridge this gap and make a channel to enable the flow of funds
from these countries to the ones that required the funds. Investing without such
a channel was a challenge not just financially but also administratively. The
transactions were complicated and settlement of the transactions in was very
difficult owing to currency values. In an effort to bridge this gap, JP Morgan
introduced a system of depositary receipts in 1927. JP Morgan intended to
provide a channel that allows for easier flow of funds from U.S.A. to other
countries by offering them investment options abroad. Hence, the depositary
receipts program was intended as both an investment vehicle as well as an
investment option. Currently, there are two major depositary receipt programs
the American Depositary Receipts and the Global Depositary Receipts.
American Depositary Receipts (ADRs) enable companies to tap into the world's
largest and most active capital market - the American market. Global
Depositary Receipts (GDRs) give the companies access to European markets
besides the American market.
ADR Overview
An American Depositary Receipt is a U.S. Dollar - denominated security that
trades on the American market. An ADR is offered by financial institutions in
the U.S. on behalf of the foreign company. The financial institution, usually
banks, buys shares of companies wishing to issue equity in the U.S. Then, it
bundles these shares into groups of shares and sells these "groups" of shares.
These "groups" are known as American Depositary Receipts. Therefore, one
American Depositary Receipt represents a fixed number of shares in the parent
company. The companies wishing to issue ADRs have to sign a contract with

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the financial institution. The financial institution which issues the ADRs on
behalf of the company is also known as sponsor bank/ brokerage or depositary
bank. The contract which is signed by both parties is a comprehensive one. The
provisions of the contract include the number of home - country shares that are
on offer, the ratio of the shares - per - ADR, the voting rights of the U.S.
investors and the tax obligations, among many others. The voting rights, if any,
lie with the depositary bank. The holders of the ADRs indicate to the depositary
bank which way they want to vote. In the absence of any concrete arrangement,
and if it doesn't violate any U.S. law, the depositary bank votes as a proxy of the
ADR - holder. This contract is known as the Deposit Agreement. This
agreement is the first step towards raising finance from the United States.
Working of ADR
These ADRs can be bought and sold just like any other American security. For
this purpose, ADRs can even be listed on the New York Stock Exchange
(NYSE), the American Stock Exchange (AMEX) or the NASDAQ. These
ADRs are issued on any of these exchanges by the sponsor bank/ brokerage.
Hence, the company is required to disclose all financial information to the
sponsor bank / brokerage. The sponsor bank/ brokerage sets a ratio of ADRs to
number of shares purchased. This ratio should be either greater than or less
than.
1. This is done by the sponsor bank / brokerage so that the ADR is high enough
to show substantial value yet be low enough to attract investors. For instance,
Let us assume that Reliance, an Indian company, is currently trading at Rs. 300
on the Bombay Stock Exchange. One ADR of Reliance, representing one share
of Reliance, would trade at $ 7.50 on the American market. Investors in the U.S.
would fall back from investing in such penny stocks. But if, one ADR of
Reliance represented 10 shares, it would be trading at $75 per ADR, which falls

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in the substantial - yet - attractive category that was spoken about a little earlier.
As a result, majority of the ADRs trade at prices between $10 and $100 per
ADR. So, for companies whose shares trade at relatively lesser values in the
home country has an ADR that comprise of relatively greater number of shares?
For instance, if a company trading at Rs. 40 on the BSR may have an ADR that
comprises of 40 shares, i.e. at a price of $40 per ADR.
Price Determination
ADRs are just like any other security. The initial price or listing price, in case
the ADR is being listed, is determined by using the predetermined ratio as we
have just seen. Once listed, ADRs are traded just like other stock in the market.
This means that the price of the ADR will be determined by the market
mechanism of demand and supply. Let us recollect our earlier illustration
wherein Reliance is going to the U.S. market to raise capital. Let us assume that
Reliance wishes to list on the NYSE through JP Morgan. JP Morgan fixes a
ratio of 10:1, i.e. 1 ADR for every 10 shares of Reliance. Reliance is currently
trading at Rs. 300 per share on the BSE. This equates to $75 per ADR at the
fixed ratio. This means that the investor pay $45 for 10 shares in Reliance. So,
after initial listing, the Reliance ADR will be bought and sold at price
determined by the market. If the price of the ADR increases from $75 to $85 per
ADR, it implies that 10 shares in Reliance are now worth $85. This translates
to Rs. 340 per share as against the Rs. 300 that Reliance is trading at on the
BSE. Two important factors in the price determination of ADRs are the shares -
ADR ratio and the exchange rate of the home currency. While changes in the
ratio are predetermined, the exchange rate can prove to be extremely volatile.
Hence, there arises an opportunity for arbitrage. With the availability of real -
time news from all across the globe and modern technology that enables on line
transactions, ADR prices of companies have come to follow the trend of the
share prices in the home country.

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Structure
The structure of the American Depositary Receipt is one that offers investment
options to different kinds of investors. Investors can purchase ADRs through
stock exchanges or even over - the - counter (OTC). The structure offers the
interested companies the option of tapping retail investors as well as
institutional investors. The ADR structure offers four types of programs to the
investors:
Level 1 Depositary Receipts
Rule 144A Depositary Receipts
Level I1 Depositary Receipts
Level II1 Depositary Receipts
Unlisted programs (Level I and Rule 144A DRs) A Level 1 ADR program is
not listed on a stock exchange, but is available for retails investors to purchase
and trade in the over-the-counter market via NASDAQ's Pink Sheets. A Level
program does not create new capital in the US; rather, it gives the company an
opportunity to develop or expand its shareholder base by establishing a foothold
in the US market. The highlights of this program are given below:
The issuing company has to maintain home - market accounting and
disclosure standards. They needn't conform to the regulations laid down
by Securities Exchange Commission as regards accounting disclosure.
The issuing company makes use existing shares to raise funds from the
American market. This implies that the company tries to meet investor's
demand and their own need for liquidity without issuing new shares for
the American market. However, they can issue new ADRs. They can do
so by first issuing the shares in the home market and then cancelling it.
These shares are then made available to be bundled and issued.

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The issuing company is exempt from U.S. reporting requirements. There
porting requirements include compliance with Rule 12g3-2(b).
The issuing company has to register itself with the United State Securities
Exchange Commission through form F-6.
The bid prices of the ADRs are electronically updated at the end of the
trading day through the Pink Sheets LLC information Services. Vendors
like OTC quote, com even post real - time and intra - day quotes posted in
the market. Such services, however, are available to the issuing company
only through subscription.2.2.4.2 Rule 144A Depositary Receipts A Rule
144A DR is the quickest, easiest, and most cost-effective way to raise
capital in the United States. Under this program. New restricted shares
care created and then privately placed with institutional investors. Rule
144A facilitates the resale of privately placed with institutional investors.
Rule 144A facilitates the resale of privately placed securities to Qualified
Institutional Buyers in the US. These institutions manage at least $100
million in securities, or are registered broker-dealers that own or invest,
on a discretionary basis, $10 million insecurities of non-affiliates.

The highlights of this program:
Companies issuing Rule 144A DRs are not subject to U.S.
reporting requirements. In fact they aren't even registered with the
U.S. Securities and Exchange Commission.
These DRs may not be advertised for or actively promoted by the
issuer. This is because the sale of such DRs takes place through
private placement.
Under Rules 144A of the Securities Act, 1933 such trades are to
take place electronically on a system developed and managed by
the National association of Securities Dealers. The system is called
PORTAL.

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These DRs can be traded only to Qualified Institutional Buyers
(QIBs). This underlies the essence of such DRs - that they are
privately placed DRs type. However, for such a conversion to take
place, at least two years from the last deposit of shares under this
program have got to lapse. It is only after these two years that the
Rule 144A type ADR is eligible to be converted.
Level II and Level III Depository Receipts Listing your ADR means it will be
traded on one of the three major US exchanges the New York Stock Exchange
(NYSE), The American Stock Exchange (Amex), or the (NASDAQ). ADRs
that are listed on the NYSE or Amex, or quoted on NASDAQ, have higher
visibility in the US market, are more actively traded, and have increased
potential liquidity. In order to list your companys securities, you must meet the
listing requirements of your chosen exchange or market. Your company must
also comply with the registration provision and continued reporting
requirements of the Securities Exchange Act of 1934, as amended (The
Exchange Act), as well as certain registration provisions of the Securities Act,
which generally entail the following; Form F-6 registration statement, to
register the ADRs to be issued. Form 20-F registration statement, to register the
ADRs under the Exchange Act. This requires detailed financial disclosure from
the issuer, including financial statements and reconciliation of those
statements to US GAAP (Generally Accepted Accounting Principles). Annual
reports (on Form 20-F) have to be filed on a regular, timely basis with the US
Securities and Exchange Commission (SEC). Interim financial statements and
current developments, furnished on a timely basis to the SEC on Form 6-K, to
the extent such information is made public or filed with an exchange in the
home country or distributed to shareholders. A Level II ADR uses existing
shares to satisfy investor demand and liquidity. New ADRs are created from
deposits of ordinary shares in the issuers home market. Because these securities

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are listed or quoted on a major US exchange, Level II ADRs reach a broader
universe of potential shareholders and gain increased visibility through
reporting in the financial media. Listed securities can be promoted and
advertised, and may be covered by analysts and the media. In addition, listed
securities can be used to structure incentives for an issuers US employees, or
could be used to facilitate US mergers and acquisitions. Level III ADRs are a
public offering of new shares into the US markets. These capital raisings have a
high profile; They are followed closely by the financial press and other media,
often generating significant visibility for the issuer. In addition to the
requirements noted above, an issuing company establishing a Level III ADR
program is required to file Form F-1.This registers the securities underlying the
ADRs that will be offered publicly in the US, including a prospectus informing
potential investors about the issuer and any risks inherent in its business, the
offering price of the securities, and the issuers plan for distributing the ADRs.
In certain circumstances, an abbreviated registration statement (Form F-3) may
be acceptable. The company may substitute Form 8-A for Form 20-F
registration to register under the Exchange Act. However, Form 20-F annual
reports must be filed thereafter. This annual filing contains detailed financial
disclosure from the issuer, financial statements and a full reconciliation of those
statements to US Generally Accepted Accounting Principles (GAAP). Level III
ADRs can be actively promoted and advertised to increase investor awareness
and market liquidity. As with Level II ADRs, the securities can be used to
structure incentives for an issuers US employees, and may be used to facilitate
US mergers and acquisitions.
Legal Framework: United States
The Securities and Exchange Commission (SEC) was set up in 1929, just before
the Great Depression. It was formed to regulate the American capital market. It
is the SEC that regulates the ADRs in the U.S. In order to have its securities

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listed and traded in the U.S. through an ADR, the non U.S. company must
comply with these laws and regulations.
Federal Securities Acts
There are two federal securities laws that govern the cretion of ADRs: the
Securities Act, 1933 and The Securities Exchange Act, 1934 (amended as The
Exchange Act). The Securities Act, 1933 The Securities Act, 1933, governs the
offer and sale of securities. The Act requires full and fair disclosure of all
information that the investors should be aware of in order to make a well
informed decision as regards the securities on offer. It also contains
requirements for the registration of these securities to be offered. The Securities
Exchange Act, 1934. The Securities Exchange Act. 1934, regulates the
secondary markets for listed or unquoted securities. The Act requires on going
reporting from the issuers of these securities. In short, the Securities Act
governs The offer, sale and registration of securities while the Securities
Exchange Act regulates and secondary markets through mandatory on going
reporting and disclosure by the issuers.
Key SEC Rulings The regulatory and disclosure requirements imposed upon the
sponsor bank/ brokerage depends on the kind of program that it has opted for.
Rule 12g3-2(b)Under this rule, the ADR issuer is exempt from periodic
disclosure and reporting norms if it plans to make its Level I ADRs available to
the investors over the counter (OTC). This enables the ADR issuer to
make available to the SEC those details that its has already make public. Hence,
it is freed from the burden of exte4nsive reporting and other related
requirements. Form F-6; Registration of Level I, II and III ADRs with SEC. The
do so by filing form F-6 along with a copy of the Depository Agreement.
Besides the Depository Agreement, sponsor banks/ brokerages must also file the
legal opinion of their counsel. This legal opinion states the rights that the

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holders of these ADRs will have access to Once the SEC received the Form F-6
along with copy of the Depositary Agreement. Besides the Depositary
Agreement, sponsor banks/ brokerages must also file the legal opinion of their
counsel. This legal opinion states the rights that the holders of these ADRs will
have access to. Once the SEC receives the Form F-6 along with the other
documents and has no further comments, the sponsor bank / brokerage will file
an Acceleration Request with effectiveness on a particular date, on which the
ADRs can be issued. To put it simply, the Acceleration Request filed by the
sponsor bank brokerage is more like an information slip notifying the SEC
about when it plans to issue the proposed ADRs. This date on which they will
issue the ADRs, is the effectiveness date. Form 20F: Annual Disclosure &
Registration Document for Level II and III This form is used as both a form
for registration as well as for annual report filing. This form can be used for
registration only by Level II and Level III ADR issuers. For sponsor banks /
brokerages that have already registered, they have to use this form to file the
annual reports. Depending on the use of this form, certain exe4mptions are
made available.
The following are some of the disclosures required to be made:
Identity of directors and other senior management
Historical financial information.
Description of the Properties.
Financial prospects.
Major stakeholders and related party transactions
Offer and listing plans
Company documents
Quantitative and qualitative disclosure of market risks.

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Code of ethics EDGAR Filings the SEC has put in place a system for
electronic filing of disclosure documents. This system is known as
EDGAR System, short for Electronic Data Gathering and Retrieval
system. The major purpose of putting such a system in place is to enable
the investor to analyse all the documents filed by the company before
making any investment. Under the EDGAR System the following forms
need to be filed electronically.
Form F-6(For registrations of ADRs)
Form 6-K (For informational reports)
Form 20-F (For Annual report / registration)
Forms F-1, F-2, F-3, F-4 (For public offerings) The regulations regarding
filling of these forms are relaxed a little but for sponsor bank/ brokerage
issuing Level I ADRs. However, such relaxation of regulation does not
extend to the filing of Form F-6.
Legal Framework: India
In India, there wasnt any specific regulation regarding the issue of ADRs for
along time. It was only in 2000 that the Reserve Bank of India (RBI) issued a
notification permitting the issue of ADRs through the Foreign Exchange
Regulation Act (FERA). Notification No. F.E.R.A. 214/2000-RB The Reserve
Bank of India issued this notification on 20 the January, 2000. Putting it quite
simply, this notification permits the issue of ADRs by India companies. The
following points highlight the essence of this notification:
All companies governed by the Indian Companies Act, 1956, are permitted
to raise funds through the issue of ADRs.
The permission, however, shall stand to be cancelled if the company raising
funds violates any norms or exceeds any limits laid down by the Foreign

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Investment Promotion Board (FIPB) or the Secretariat for Industrial
Assistance (SIA).
The company has to get approval from the Ministry of Finance, Government
of India, to make such an issue.
The company is permitted to enter into any agreement/ sign any contract
with foreign agencies provided that such a contract is essential for the issue
of ADRs.
The companies are allowed to make payments to the relevant authorities and
the sponsor bank / brokerage towards their fees.
The companies are permitted to make any payments to U.S. government
towards any tax liability incurred as a result of issue of ADRs.
The companies are allowed to maintain bank accounts in the U.S. to deposit
the money collected.
The companies are also permitted to maintain a register of foreign members
if the company feels it necessary. This notification cleared a lot of
ambiguities that existed in the Foreign Exchange Regulation Act in the
absence of any concrete provision regards ADRs.
An American depositary receipt (ADR) is a negotiable security that represents
the underlying securities of a non- US company that trades in the US financial
markets. Individual shares of the securities of the foreign company represented
by an ADR are called American depositary shares (ADRs).
The stock of many non-US companies trades on US stock exchanges through
the use of ADRs. ADRs are denominated, and pay dividends, in US dollars, and
may be traded like shares of stock of US-domiciled companies.
The first ADR was introduced by J.P. Morgan in 1927 for the British retailer
Selfridges. There are currently four major commercial banks that provide
depositary bank services: BNY Mellon, J.P. Morgan, Citi, and Deutsche Bank.

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Depositary receipts
More generally, depositary receipts (DRs) are negotiable securities that
represent the underlying securities of foreign companies that trade in a domestic
market. DRs enable domestic investors to buy the securities of a foreign
company without the accompanying risks or inconveniences of cross-border and
cross-currency transactions.
Each DR is issued by a domestic depositary bank when the underlying shares
are deposited in a foreign custodian bank, usually by a broker who has
purchased the shares in the open market local to the foreign company. A DR can
represent a fraction of a share, a single share, or multiple shares of a foreign
security. The holder of a DR has the right to obtain the underlying foreign
security that the DR represents, but investors usually find it more convenient to
own the DR. The price of a DR generally tracks the price of the foreign security
in its home market, adjusted for the ratio of DRs to foreign company shares. In
the case of companies domiciled in the United Kingdom, creation of ADRs
attracts a 1.5% stamp duty reserve tax (SDRT) charge by the UK government
Depositary banks have various responsibilities to DR holders and to the issuing
foreign company to DR represents.
ADR programs (facilities)
When a company establishes an ADR Program, it must decide what exactly it
wants out of the program, and how much time, effort and other resources they
are willing to commit. For this reason, there are different types of programs, or
facilities, that a company can choose.
Unsponsored ADRs
Unsponsored shares trade on the over-the-counter (OTC) market. These shares
are issued in accordance with market demand, and the foreign company has no

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formal agreement with a depositary bank. Unsponsored ADRs are often issued
by more than one depositary bank. Each depositary services only the ADRs it
has issued.
Due to a recent SEC rule change making it easier to issue Level I depositary
receipts, both sponsored and unsponsored, hundreds of new ADRs have been
issued since the rule came into effect in October 2008. The majority of these
were unsponsored Level 1 ADRs, and now approximately half of all ADR
programs in existence are unsponsored.
Sponsored Level 1 ADRs (OTC facility)
Level 1 depositary receipts are the lowest level of sponsored ADRs that can be
issued. When a company issues sponsored ADRs, it has one designated
depositary who also acts as its transfer agent.
A majority of American depositary receipt programs currently trading are issued
through a Level 1 programs. This is the most convenient way for a foreign
company to have its equity traded in the United States.
Level 1 shares can only be traded on the OTC market and the company has
minimal reporting requirements with the U.S. Securities and Exchange
Commission (SEC). The company is not required to issue quarterly or annual
reports in compliance with U.S. GAAP. However, the company must have a
security listed on one or more stock exchange in a foreign jurisdiction and must
publish in English on its website its annual report in the form required by the
laws of the country of incorporation, organization or domicile.
Companies with shares trading under a Level 1 program may decide to upgrade
their program to a Level 2 or Level 3 program for better exposure in the United
States markets.


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Sponsored Level II ADRs (Listing facility)
Level 2 depositary receipt programs are more complicated for a foreign
company. When a foreign company wants to set up a Level 2 program, it must
file a registration statement with the U.S. SEC and is under SEC regulation. I
addition, the company is required to file a Form 20-F annually. Form 20-F is the
basic equivalent of an annual report (Form 10-K) for a U.S. company. In their
filings, the company is required to follow U.S. GAAP standards of IFRS as
published by the IASB.
The advantage that the company has by upgrading their program to Level 2 is
that the shares can be listed on a U.S. stock exchange. These exchanges include
the New York Stock Exchange (NYSE), NASDAQ, and the American Stock
Exchange (AMEX).
While listed on these exchanges, the company must meet the exchanges listing
requirements. If it fails to do so, it may be delisted and forced to downgrade its
ADR program.
Sponsored Level III ADRs (offering facility)
A Level 3 American Depositary Receipt program is the highest level a foreign
company can sponsor. Because of this distinction, the company is required to
adhere to stricter rules that are similar to those followed by U.S. Companies.
Setting up a Level 3 Program means that the foreign company is not only taking
steps to permit shares from its home market to be deposited into an ADR
program and traded in the U.S.; it is actually issuing shares to raise capital. In
accordance with this offering, the company is required to file a Form F-1, which

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is the format for an offering Prospectus for the shares. They also must file a
Form 20-F annually and must adhere to U.S. GAAP standards or IFRS as
published by the IASB. In addition, any material information given to
shareholders in the hole market, must be filed with the SEC through Form 6K.
Foreign companies with Level 3 programs will often issue materials that are
more informative and are more accommodating to their U.S. shareholders
because they rely on them for capital. Overall, foreign companies with a Level 3
program set up are the easiest on which to find information. Examples include
the British telecommunications company Vodafone (VOD), the Brazilian oil
company Petrobras (PBR), and the Chinese technology company China
Information Technology, Inc. (CNIT).
Restricted Programs
Foreign companies that want their stock to be limited to being traded by only
certain individuals may set up a restricted program. There are two SEC rules
that allow this type of issuance of shares in the U.S.: Rule 144-A and
Regulation S. ADR programs operating under one of these 2 rules make up
approximately 30% of all issued ADRs.
Privately placed (SEC Rule 144A) ADRs
Some foreign companies will set up an ADR program under SEC Rule 144A.
This provision makes the issuance of shares a private placement. Shares of
companies registered under Rule 144-A are restricted stock and may only be
issued to or traded by Qualified Institutional Buyers (QIBs).
US public shareholders are generally not permitted to invest in these ADR
programs, and most are held exclusively through the Depository Trust &
Clearing Corporation, so there is often very little information on these
companies.

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Offshore (SEC Regulation S) ADRs
The other way to restrict the trading of depositary shares to US public investors
is to issue them under the terms of SEC Regulation S. This regulation means
that the shares are not, and will not be registered with any United States
securities regulation authority.
Regulations S shares cannot be held or traded by any U.S. person as defined
by SEC Regulation S rules. The shares are registered and issued to offshore,
non-US residents.
Regulation S ADRs can be merged into a Level 1 program after the restriction
period has expired, and the foreign issuer elects to do this.
Sourcing ADRs
One can either source new ADRs by depositing the corresponding domestic
shares of the company with the depositary bank that administers the ADR
program or, instead, one can obtain existing ADRs in the secondary market.
The latter can be achieved either by purchasing the ADRs on a US stock
exchange or via purchasing the underlying domestic shares of the company on
their primary exchange and then swapping them for ADDs; these swaps are
called corssbook swaps and on many occasions account for the bulk of ADR
secondary trading. This is especially true in the case of trading in ADRs of UK
companies where creation of new ADRs attracts a 1.5% stamp duty reserve tax
(SDRT) charge by the UK government; sourcing existing ADDs in the
secondary market (either via crossbook swaps or on exchange) instead is not

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subject to SDRT. US brokerages can continue to hold foreign stock, but may
lack the ability to trade it overseas.
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Thus, in a sense, US investors gain access to the world through ADRs without
having to leave the comfort of their own living rooms.
ADRs vs. Stocks
Like normal stocks, ADRs tend to trade at levels that track the financial health
of their underlying companies. Still, there are important differences between an
ADR and a directly held stock.
For example, there are different flavors of ADRs, each of which carries a
different level of reporting responsibility in other words transparency in
reporting their financial health to US regulators and investors.
Unsponsored shares: These offer the lowest level of entry into the American
market. Unsponsored shares trade only or over-the-counter markets not on the
major US stock exchange and bear no responsibility to report to US regulatory
agencies. They are rarely issued today.
Level 1: The shares can also only be traded on over-the-counter markets, but
they are generally issued through only one US agent their depositary
sponsor. Regulatory reporting requirements are still minimal. Quarterly or
annual reports are not required. Even if such reports are issued, they are not
required to adhere to US standards of generally accepted accounting principles,
or GAAP, and the companies can post their results in a foreign currency.
Level II: Companies that want to sell ADRs to US investors at this level have to
register with the Securities and Exchange Commission and file an annual report
that complies with GAAP standards. This is the lowest level of shares that can
be listed on a US stock exchange.

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Level III: This is the gold standard to ADR ratings. It allows foreign companies
to issue shares directly into the US, rather than simply allowing the indirect
purchase of already created shares. In exchange, the company is required to file
annual reports that comply with GAAP standards, typically something known as
a form 20-F (compared to the regular 10-K filing by companies in the United
States). And it is required to share any news that it distributes within its home
country to US investors as well.
ADRs Special Risks
Of course, even though they trade in US dollars and can, at least on the surface,
closely mimic the look and feel of American stocks, ADRs come with their own
set of special considerations to keep in mind.
Currency risk: If the value of the US dollar rises against the value of the
companys home currency, a good deal of the companys intrinsic profits might
be wiped out in translation. Conversely, if the US dollar weakens against the
companys home currency, any profits it makes will be enhanced for a US
owner. For more information on how this could damage or inflate your results,
read The Danger of Investing in International Bonds.
Political risk: ADR status does not insulate a companys stock from the
inherent risk of its home countrys political stability. Revolution,
nationalization, currency collapse or other potential disasters may be greater risk
factors in other parts of the world than in the US, and those risks will be clearly
translated through any ADR that originates in an affected nation.
Inflation risk: Countries around the globe may be more, or less, prone to
inflation than the US economy is at any given time. Those with higher inflation
rates may find it more difficult to post profits to an US owner, regardless of the
companys underlying health.

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In other words, ADRs are just what they seem: a representation of a foreign
stock, rather than actual holding in the company. Because of all of the
considerations listed above an ADR of a foreign company in the US may trade a
little ahead or a little behind the price the company commands in its own
currency in its own home base. But its safe to say that buying an ADR is the
closest an American investor can come to participating directly in the rest of the
worlds economy.
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http://beginnersinvest.about.com/lw/Business-Finance/Personal-finance/American-Depositary-Receipts-
ADRshtm

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Chapter 5 A critical study of ADR and
IDR
An Indian Depository Receipt is an instrument denominated in
Indian Rupees in the form of a depository receipt created by a
Domestic Depository against the underlying equity of issuing
company to enable foreign companies to raise funds from the Indian
securities Markets.
33

The foreign company IDRs will deposit shares to an Indian depository. The
depository would issue receipts to investors in India against these shares. The
benefit of the underlying shares (like bonus, dividends etc) would accrue to the
depository receipt holders in India.
Where as an American Depository Receipt, or ADR, is a security issued by a
U.S. depository bank to domestic buyers as a substitute for direct ownership of
stock in foreign companies. An ADR can represent one or more shares, or a
fraction of a share, of a non-U.S. company.
A depository is an organization which holds securities (like shares,
debentures, bonds, government securities, mutual fund units etc.) of
investors in electronic form at the request of the investors through a
registered Depository Participant. It also provides services related to
transactions in securities. At present two Depositories viz. National
Securities Depository Limited (NSDL) and Central Depository
Services (India) Limited (CDSL) are registered with SEBI. The
minimum net worth stipulated by SEBI for a depository is Rs. 100
crore.

33
Issues by foreign companies in India (India (Indian Depository Receipts) IDRs) Securities and Exchange Board
of India (SEBI)

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Since each ADR represents a share or shares of the foreign company, the price
of the ADR change in tandem with the price of the foreign stock. Therefore, any
change in price in the foreign companys stock applies to the change in price of
the ADR. In this way, investors can benefit from price changes without
worrying about currency conversion.
ADRs take into account currency fluctuations and foreign company, its ADR
would rapidly decrease in real value. Investors do have to worry about inflation
and currency changes in the foreign nation despite not having convert currency
to buy foreign shares.
At present there are two depositories in India. National Securities
Depository Limited (NSDL) and Central Depository Services (CDS).
NSDL is the first Indian depositor, it was inaugurated in November
1996. NSDL was set up with an initial capital of US$28mn, promoted
by Industrial Development Bank of India (IDBI), Unit Trust of India
(UTI) and National Stock Exchange of India Ltd. (NSEIL). Later,
State Bank of India (SBI) also became a shareholder.
The other depository is Central Depository Services (CDS). It is still in the
process of linking with the stock exchanges. It has registered around 20 DPs and
has signed up with 40 companies. It had received a certificate of
commencement of business from Sebi on February 8, 1999.
These depositories have appointed different Depository Participants (DP for
them. An investor can open an account with any of the depositories DP. But
transfer arising out of trades on the stock exchanges can take place only
amongst account-holders with NSDLs DPs. This is because only NSDL is
linked to the stock exchanges (nine of them including the main ones-National
Stock Exchange and Bombay Stock Exchange).

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In order to facilities transfer between investors having accounts in the two
existing depositories in the country the Securities and Exchange Board of India
has asked all stock exchanges to link up with the depositories. Sebi has also
directed the companies registrar and transfer agents to effect change of
registered ownership in its books within two hours of receiving a transfer
request from the depositories. Once connected to both the depositories the stock
exchanges have also to ensure that inter-depository transfers take place
smoothly. It also involves the two depositories connecting with each other. The
NSDL and CDS have signed an agreement for inter-depository connectivity.
Some ADRs are traded on major stock exchanges such as the Nasdaq Stock
Market (NDAQ) and the New York Stock Exchange, which require these
foreign companies to conform to many of the same reporting and accounting
standards as U.S. companies. Other ADRs are traded on over-the-counter
exchanges that impose fewer listing requirements.
Stock dividends and similar adjustments to the underlying shares are paid in
cash or ADR dividends by the bank.
American Depositary Receipts, or ADRs, are one of the most important items in
an international investors tool kit. To see why, lets consider the following
example.
Say youre interested in investing in France. One option is to open ca brokerage
account in Paris, wire some money over there, convert your dollars into Euros,
and the go shopping for French stocks. To say the least, this would be a difficult
and time-consuming process. And your accountant would hate you at tax time.
ADRs are designed to eliminate these hassles. An ADR is a security
that represents ownership of shares of a foreign company. When you
buy an ADR, you technically dont own the foreign stock directly.

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Instead, you own a piece of paper that entitles you to one or more
shares of a foreign stock being held on your behalf at a depositary
bank.
The first ADR was created in 1927 by J.P. Morgan, to allow Americans
to invest in shares of Selfridges, a British department store. Today there
are more than 2,200 ADRs available, representing shares of companies
located in more than 70 countries. The Bank of New York, JP Morgan,
Deutsche Bank and Citigroup are among the leading depositary banks,
which create and issue ADRs.
The popularity of ADRs has surged over the years because they have a
number of distinct advantages that appeal to both small investors and
professional money managers alike.
Advantages of ADRs
ADRs can be bought and sold just like shares of IBM or Coca-Cola.
You dont need a foreign brokerage account or a new broker; you can
use the same broker that you normally deal with.3
Price for ADRs are quoted in U.S. dollars, and dividends are paid in
dollars.
ADRs trade during U.S. market hours and are subject to similar
clearing and settlement procedures as American stocks.
You can customize your portfolio however you like, depending on
which countries or sectors you are interested in.

The Bottom Line
Once you have a bit of international investing experience under your belt,
ADRs can be a powerful tool to customize your portfolio or make targeted

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investments in specific companies, sectors and countries. But if you are just
getting started in international investing, its much easier to stick with a good
international mutual fund or ETTs until you have a firm grasp of the basics.
Where as According to SEBI guidelines. Financial Institutions like banks,
custodians, stockbrokers etc. can become participants in the depository. A IDP
is one with whom you need to open an account to deal in electronic from. While
the Depository can be compared to a Bank, DP is like a Branch of your bank
with which you can have an account.
34

IDR issue Process
According to SEBI guidelines, IDRs will be issued to Indian residents in the
same way as domestic shares are issued. The issuer company will make a public
offer in India, and residents can bid in exactly the same format and method as
they bid for Indian shares. The issue process is exactly the same: the company
will file a draft red herring prospectus (DRHP), which will be examined by
SEBI. The general body of investors will get a chance to read and review the
DRHP as it is a public documents, available on the websites of SEBI and the
book running lead menagers. After SEBI gives its clearance, the company sets
the issue dates and files the documents with the Registrar of Companies. In the
next step, after getting the Registrars registration ticket, the company can go
ahead with marketing the issue. The issue will be kept open for a fixed number
of days, and investors can submit their application forms at the bidding centers.
The investors will bid within the price band and the final price will be decided
post the closure of the Issue. The receipts will be allotted to the investors in
their demat account as is done for equity shares in any public issue. On 256
th

October 2010, SEBI notified the framework for rights issue of Indian
Depository Receipts (IDRs). Disclosure requirement for IDR rights would

34
http://internationalinvest.about.com/od/investinginadrs/a/whatisadr.htm.

104

more or less be in line with the reduced requirement applicable for domestic
rights issue.
35

Price Determination
ADRs are just like any other security. The initial price or listing price, in case
the ADR is being listed, is determined by using the predetermined ration as we
have just seen. Once listed, ADRs are trade just like other stocks in the market.
This means that the price of the ADR will be determined by the market
mechanism of demand and supply. Let us recollect our earlier illustration
wherein Reliance is going to the U.S. market to raise capital. Let us assume that
Reliance wishes to list on the NYSE through JP Morgan. JP Morgan fixes a
ratio of 10:1, i.e. 1 ADR for every 10 shares of Reliance. Reliance is currently
trading at Rs. 300 per share on the BSE. This equates to $45 for 10 shares in
Reliance. So, after the initial listing, the Reliance ADR increases from $75 to
$85 per ADR, it implies that 10 shares in Reliance are now worth $85. This
translates to Rs. 340 per share as against the Rs. 300 that Reliance is trading at
on the BSE.
Two important factors in the price determination of ADRs are the shares ADR
ratio and the exchange rate of the home currency. While changes in the ratio are
predetermined, the exchange rate can prove to be extremely volatile. Hence,
there arises an opportunity for arbitrage. With the availability of real time
news from all across the globe and modern technology that enables on line
transactions, ADR prices of companies have come to follow the trend of the
share prices in the home country.



35
Standard Chartered IDR lists at Rs. 106 on NSE. Economic Times. 11 June, 2010
http;//economictimes indiatimes.com/IPOs/articleshow/6035719.cms.

105

CONCLUSION

ADRs are designed to eliminate these hassles. An ADR is a security that
represents ownership of shares of a foreign company. When you buy an ADR,
you technically dont own the foreign stock directly. Instead, you own a piece
of paper that entitles you to one or more shares of a foreign stock being held on
your behalf at a depositary bank.
An Indian Depository Receipt is an instrument denominated in Indian Rupees in
the form of depository receipt created by a Domestic Depository against the
underlying equity of issuing company to enable foreign companies to raise
funds from the Indian securities Markets.
As per the above discussion I feel that both the depositories are good enough in
their own countries. They work similarly at their options. Both gives the
domestic investors to reach to the international securities. In this way these give
wide scope to the companies as well to the investors. At last I say these are very
helping for the international financial market.








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News papers
1. Economic Times.
2. Times of India
3. The Hindu
Guidelines
1. Issues by foreign companies in India Indian Depository Receipt)(IDRs)
Securities and Exchange Board of India (SEBI)
2. Issue of Indian Depository Receipts Reserve Bank of India, July 22,
2009.
3. Securities and Exchange Board of India (Issue of capital and disclosure
requirements) regulations, 2009 Securities and Exchange Board of India
SEBI), August 26, 2009.
4. IDR listing to enhance Stan Charts commitment to India: CEP Business
Standard, Mumbai November 12, 2009, 17:37 IST
5. IDR listing to enhance StanCharts commitment to India: CEP Business
Standard, Mumbai November 12, 2009, 17:37 IST
6. Standard Chartered to be listed in Mumbai The Times, March 4, 2010
StanChart plans India listing in June quarter Money Control, Mar 4, 2010.
7. Standard Chartered Plc pdf SEBI, March 30, 2010.
8. Standard Chartered set to make IDR history at Rs. 105-115 DNA,
May 14, 2010
9. Standard Chartered Allocates 36 Million Indian Depository Receipts To
Anchor Investors Morning Star, May 25, 2010.
10. Standard Chartereds Indian share offering opens BBC, 25 May, 2010
11. Standard Chartered IDR lists at Rs. 106 on NSE.v Economic Times.
11 June, 2010.