[The following guest post is contributed by Dhanush. M, a 5th year student at the Jindal Global Law School]
On October 10, 2008, amendments to section 12g3-2(b) of the Securities Exchange Act of 1934 became effective. The amendment allowed a foreign private issuer to have its equity securities traded in the U.S. over-the-counter market without registration under Section 12(g) of the Act, thereby indirectly paving the way for the for the unprecedented growth in Unsponsored American Depository Receipts Programs (UADR).
Following the amendment, a depository bank could independently make the determination that a foreign issuer meets the exemption for purpose of establishing an UADR, so long as the depository represents that it has a “reasonable, good faith belief after exercising reasonable diligence” that the issuer electronically publishes the information required by Rule 12g3-2(b) of the Act.
In the past, issuers had to apply for exemption under Rule 12g3-3(b) of the Act. Under the new rules the exemption became automatic, conditional on the electronic publication of the information. The exemption did not have any material effect on Indian companies as the Depository Receipts Scheme of 1993 allowed companies to issue only sponsored depository receipts (DRs).
However, the 2014 Depository Receipts Scheme envisaged that DRs could either be sponsored by the issuer company or even unsponsored. Unsponsored DRs mean DRs issued without specific approval of the issuer of the underlying securities. Unsponsored DRs can be issued on the back of listed eligible securities only if such DRs give the holder the right to issue voting instruction and are listed on international stock exchange.
The aforementioned change in the depository scheme led to the establishment of several UADR programs of Indian companies without the knowledge or consent of the Indian companies. UADR programs was advantageous from the investor’s viewpoint as it allowed existing investors to have a viable exit option along with access to alternate foreign capital markets. For example, private equity and venture capital funds could exit through an UADR in case the Indian company delays or resists going public.
However, with regard to the Indian Companies, the UADR could be cumbersome from the reporting and compliance standpoint. Indian companies with UADR should be cautious to determine that the existing UADR has not increased interest in the issuer’s securities in the US market and resulted in the issuer having more than 300 holders of a class of its equity securities in the United States, as such a scenario would trigger the requirement that the issuer register the class of securities with the SEC under Section 12(g) of the Securities Exchange Act of 1934 which could be stringent and burdensome.
Why Indian companies must set up a Sponsored Level 1 Depository Receipt program
A Sponsored Level 1 ADR program refers to a program where, ADRs are non-capital raising and not listed on a US stock exchange but are traded in the US Over-the-Counter (OTC) market, mainly on the Pink Sheets market.
An Indian company can foreclose the establishment of an unsponsored ADR program by setting up its own sponsored Level I ADR program. The SEC has stated (in response to Question 105.04) that a sponsored program cannot coexist with an unsponsored program. Therefore, depository banks will be forced to disband the UADR and negotiate with investors for the settlement of the terms a UADR program, if the issuer company establishes a sponsored level 1 ADR program.
The benefits of a sponsored program over an unsponsored program are numerous. The issuer could directly negotiate the appropriate share to ADR ratio with the depository and exercise more control over the voting, dividend payment and other provisions through a deposit agreement under a sponsored program, in contrast to a UADR, where multiple depositories could establish numerous depository programs, where the terms of the agreement could be unknown to the market, creating a market perception and corporate governance problems.
UADR programs, created without the consent of the company could be disadvantageous to the shareholders as depository banks could create multiple UADR, with DRs having multiple ratios for the company’s shares, increasing the liquidity concerns in a company’s shares, in the event of a disbanding an UADR by a depository. Furthermore, multiple depositories could create confusion among investors by offering ADRs at different prices and ratios.
In an UADR program, the level of visibility and the investor awareness of the issuer`s shares is minimal as the DRs are not traded on any recognised exchange, in contrast to a Level I ADR program, which is traded on the “Pink sheet market”, where the company is more likely to experience better visibility and liquidity. The issuer could leverage the support received by investors in the “Pink sheet market” to raise its profile in the US market with a view towards raising overall US share ownership.
UADR programs may also be of concern if the issuer’s lack of control over one or more UADR programs may lead to market perception problems arising from investors who may draw negative conclusions in respect of the issuer’s securities, particularly if the investor is unaware that an ADR program is unsponsored.
With regard to the liability concerns between a Sponsored Level 1 program and an UADR from the company’s viewpoint, the level of risk in a sponsored program could be minimized, and potentially reduced below that which exists in an unsponsored program, through the use of exculpatory provisions inserted into the deposit agreement that can be designed to protect the Indian issuer.
For instance, since the ADR holders in a Sponsored Level 1 program are deemed to be parties to the deposit agreement and are bound by its terms, the investors’ ability to assert claims against the issuer can be contractually limited under the deposit agreement, in contrast to the UADR program where the issuer has no legal relationship with ADR holders, and therefore no ability to control its risk with respect to such holders.
With regard to the fears of Indian issuers of secondary claims liability for criminal or tort actions a sponsored level 1 ADR program entails, the U.S supreme court in the case Morrison v. National Australia Bank highlighted that sponsored level 1 ADRs were not traded on an official exchange-such as New York Stock Exchange or NASDAQ, but were rather traded over the counter, and therefore section 10(b) of the Securities Exchange Act of 1934 would not apply to what the court considered a “predominantly foreign securities transaction”. The Court also stated that Level I ADRs are characterized by their trading in the over-the-counter market, reduced reporting requirements, and inability to raise new capital in the U.S. and therefore should not attract liability under rule 10-b-(5) of the Act.
In respect of civil liability through a sponsored Level 1 ADR program for an Indian issuer, the likelihood of liability is minimal as proving civil securities fraud involving securities that do not trade on the markets can be very difficult, as the plaintiff cannot rely on the “fraud-on-the-market theory”, which is a common ground for securities fraud claims in the United States.
It is necessary to assess whether an Indian issuer on setting up a Sponsored Level 1 ADR program would be liable under the U.S Foreign Corrupt Practices Act, 1977 (FCPA) exposing the Indian issuer to potential fines, costly compliance measures, loss of sources of business revenue and reputational harm. The FCPA exposes Indian issuers to the risk of criminal and civil penalties that U.S. enforcement authorities can obtain for violations. Corporations can face criminal fines of up to $25 million for a violation of the FCPA’s accounting provisions and a maximum of $2 million for a violation of the FCPA’s anti-bribery provisions.
It is pertinent to note that in a legal dispute for an FCPA violation by BAE Systems plc, which has a Sponsored Level 1 ADR program and traded under the symbol BAESY on the Pink Sheets market, the U.S. District Court in the District of Columbia stated that because Level 1 ADRs do not trigger Exchange Act registration or reporting, foreign issuers whose securities underlie these ADRs do not expose themselves to U.S FCPA jurisdiction.
With regard to the tax liability on conversion or transfer of a DR into a share, the Finance Act, 2015 has stated that tax benefits would to be available to only sponsored global depository receipts (GDRs) issued by listed companies, which could dampen the investor sentiment for the company’s shares globally through the UADR route. Indian companies could take advantage of this favourable tax regime to gain by setting up a sponsored Level 1 ADR program as the investor sentiment would be favourable in regards to a Sponsored Level 1 program.
I conclude, stating that Indian companies could avail the opportunity of market visibility, widened investor base in the U.S markets with minimal legal liabilities by setting up a Sponsored Level 1 ADR program.
- Dhanush. M