A Lesson in ADR and SOX Comparative Intl. Labor Relations By: S. Carpenter, A. Caccamo, and K. O’Brien

What is an ADR? American Depositary Receipt (ADR) American Depositary Receipt (ADR) A stock that trades in the U.S. but represents a specific number of shares in a foreign corporation A stock that trades in the U.S. but represents a specific number of shares in a foreign corporation Bought and sold on American markets Bought and sold on American markets Issued/sponsored in the U.S. by a domestic bank or brokerage Issued/sponsored in the U.S. by a domestic bank or brokerage

History of ADR Introduced to the financial markets in 1927 Introduced to the financial markets in 1927 Result of: (1) complexities in buying shares in foreign countries and (2) difficulties with trading at different currency values Result of: (1) complexities in buying shares in foreign countries and (2) difficulties with trading at different currency values U.S. banks purchase bulks of shares from the foreign company, bundle the shares into groups, and reissue on the NYSE, AMEX or the Nasdaq U.S. banks purchase bulks of shares from the foreign company, bundle the shares into groups, and reissue on the NYSE, AMEX or the Nasdaq In return, foreign company must provide detailed financial information to the sponsor bank In return, foreign company must provide detailed financial information to the sponsor bank The depositary bank sets the ratio of U.S. ADRs per home- country share; this ratio can be anything less than or greater than 1 The depositary bank sets the ratio of U.S. ADRs per home- country share; this ratio can be anything less than or greater than 1 Majority of ADRs range between $10 and $100 per share Majority of ADRs range between $10 and $100 per share

Pricing Example Russian Vodka Inc. wants to list shares on the NYSE to gain exposure to the U.S. market and to tap into the growing demand for vodka Russian Vodka Inc. wants to list shares on the NYSE to gain exposure to the U.S. market and to tap into the growing demand for vodka Russian Vodka already trades on the Russian Stock Exchange at 127 Russian roubles (equivalent to US$4.58) Russian Vodka already trades on the Russian Stock Exchange at 127 Russian roubles (equivalent to US$4.58) A U.S. bank purchases 30 million shares from Russian Vodka Inc. and issues them in the U.S. at a ratio of 10:1. This means each ADR share you purchase is worth 10 shares on the Russian Stock Exchange A U.S. bank purchases 30 million shares from Russian Vodka Inc. and issues them in the U.S. at a ratio of 10:1. This means each ADR share you purchase is worth 10 shares on the Russian Stock Exchange The new ADR should have an issue price of around US$45.80 each (10 times $4.58) The new ADR should have an issue price of around US$45.80 each (10 times $4.58)

Three Types of ADRs Level 1: Foreign companies either don't qualify or don't wish to have their ADR listed on an exchange Level 1: Foreign companies either don't qualify or don't wish to have their ADR listed on an exchange over-the-counter marketover-the-counter market loosest requirements from the SECloosest requirements from the SEC Level 2: Listed on an exchange or quoted on Nasdaq Level 2: Listed on an exchange or quoted on Nasdaq slightly more requirements from the SECslightly more requirements from the SEC higher visibility trading volumehigher visibility trading volume Level 3: Issuer floats a public offering on U.S. exchange Level 3: Issuer floats a public offering on U.S. exchange able to raise capital and gain substantial visibility in the U.S. financial marketsable to raise capital and gain substantial visibility in the U.S. financial markets

Benefits of ADRs? For individuals, ADRs are an easy, cost-effective way to buy shares in a foreign company For individuals, ADRs are an easy, cost-effective way to buy shares in a foreign company Foreign entities like ADRs because they get more U.S. exposure, allowing them to tap into the wealthy North American equities markets Foreign entities like ADRs because they get more U.S. exposure, allowing them to tap into the wealthy North American equities markets

Risks of ADRs Political Risk Political Risk Is the government of the ADR’s home country stable?Is the government of the ADR’s home country stable? Exchange Rate Risk Exchange Rate Risk Is the currency of the home country stable?Is the currency of the home country stable? Inflationary Risk Inflationary Risk Extension of exchange rate riskExtension of exchange rate risk

What is SOX? Sarbanes-Oxley Act of 2002 (also: Public Company Accounting Reform and Investor Protection Act of 2002) Sarbanes-Oxley Act of 2002 (also: Public Company Accounting Reform and Investor Protection Act of 2002) US Federal law enacted in response to a number of major corporate and accounting scandals US Federal law enacted in response to a number of major corporate and accounting scandals

Background on SOX Applies new standards for all U.S. public company boards, management and public accounting firms Applies new standards for all U.S. public company boards, management and public accounting firms Does not apply to privately held companies Does not apply to privately held companies Act contains 11 Titles and requires the SEC to implement rulings on requirements to comply with the new law Act contains 11 Titles and requires the SEC to implement rulings on requirements to comply with the new law

11 Titles in SOX Public Company Accounting Oversight Board (PCAOB) Public Company Accounting Oversight Board (PCAOB) Auditor Independence Auditor Independence Corporate Responsibility Corporate Responsibility Enhanced Financial Disclosures Enhanced Financial Disclosures Analyst Conflicts of Interest Analyst Conflicts of Interest Commission Resources and Authority Commission Resources and Authority Studies and Reports Studies and Reports Corporate and Criminal Fraud Accountability Corporate and Criminal Fraud Accountability White Collar Crime Penalty Enhancement White Collar Crime Penalty Enhancement Corporate Tax Returns Corporate Tax Returns Corporate Fraud Accountability Corporate Fraud Accountability

Effect on Non-US Companies Depends if country is developed/well- regulated or less developed Depends if country is developed/well- regulated or less developed i.e. poorly regulated countries – benefit from better credit ratings by complying to regulations; developed countries – incur costsi.e. poorly regulated countries – benefit from better credit ratings by complying to regulations; developed countries – incur costs Displaces business from NY to London Displaces business from NY to London Alternative Investment Market claims that its growth in listings almost entirely coincided with SOX legislation Alternative Investment Market claims that its growth in listings almost entirely coincided with SOX legislation

Praise of SOX Improved investor confidence and more accurate, reliable financial statements Improved investor confidence and more accurate, reliable financial statements "Sarbanes-Oxley helped restore trust in U.S. markets by increasing accountability, speeding up reporting, and making audits more independent.“ – SEC Chairman Christopher Cox, 2007"Sarbanes-Oxley helped restore trust in U.S. markets by increasing accountability, speeding up reporting, and making audits more independent.“ – SEC Chairman Christopher Cox, 2007 Auditor conflicts of interest have been addressed - prohibits auditors from having lucrative consulting agreements with the firms they audit Auditor conflicts of interest have been addressed - prohibits auditors from having lucrative consulting agreements with the firms they audit Improved investor confidence in financial reporting; improvements in board, audit committee, and senior management engagement in financial reporting; improvements in financial controls Improved investor confidence in financial reporting; improvements in board, audit committee, and senior management engagement in financial reporting; improvements in financial controls

Criticisms of SOX Reduced America's international competitive edge against foreign financial service providers, by introducing a complex and regulatory environment into U.S. financial markets Reduced America's international competitive edge against foreign financial service providers, by introducing a complex and regulatory environment into U.S. financial markets Following the act's passage, smaller international companies were more likely to list in stock exchanges in the U.K. rather than U.S. stock exchanges (Journal of Accounting Research, 2008)Following the act's passage, smaller international companies were more likely to list in stock exchanges in the U.K. rather than U.S. stock exchanges (Journal of Accounting Research, 2008) Overall reluctance of small businesses and foreign firms to register on US stock exchange Overall reluctance of small businesses and foreign firms to register on US stock exchange “These regulations are damaging American capital markets by providing an incentive for small US firms and foreign firms to deregister from US stock exchanges” – Ron Paul“These regulations are damaging American capital markets by providing an incentive for small US firms and foreign firms to deregister from US stock exchanges” – Ron Paul

How SOX Regulates ADRs Level 1 ADRs do not have to have to comply with SOX Level 1 ADRs do not have to have to comply with SOX Not registered with the SECNot registered with the SEC Level 2 and Level 3 ADRs must comply with SOX Level 2 and Level 3 ADRs must comply with SOX Can be costly for a company beginning a U.S. ADR ProgramCan be costly for a company beginning a U.S. ADR Program Costs include a significant intangible cost: diversion of senior management timeCosts include a significant intangible cost: diversion of senior management time

Compliance with SOX Establish a full-time investor, or investor relations team, based in the U.S. Establish a full-time investor, or investor relations team, based in the U.S. Senior executives must visit institutional investors and securities analysts at least twice a year, if not more Senior executives must visit institutional investors and securities analysts at least twice a year, if not more

The Future of SOX and ADRs Currently, interest by foreign companies to have shares traded in the U.S. is on rise because of two new SEC rules Currently, interest by foreign companies to have shares traded in the U.S. is on rise because of two new SEC rules Japan, Hong Kong, and AustraliaJapan, Hong Kong, and Australia Companies are not looking to list on NYSE or Nasdaq Companies are not looking to list on NYSE or Nasdaq Want to set up Level 1 ADRs and trade over the counter (OTC)Want to set up Level 1 ADRs and trade over the counter (OTC) Two Rules: Two Rules: Automatic exemption from listing on SECAutomatic exemption from listing on SEC Brokers must report trades within 90 seconds and information on each trade must be available in real timeBrokers must report trades within 90 seconds and information on each trade must be available in real time Will make pricing more transparent Will make pricing more transparent

The End Questions, comments?