Earlier this year, HSBC won a case against HM Revenue and Customs involving the payment of stamp duty on ADRs as part of its ill-fated purchase of US sub-prime lender Household in 2003. It wasn’t exactly a high-profile case and I only stumbled across it recently while searching for something completely different. But looking at legal commentary on it, the judgment raised an awkward question about the legal status of American depository receipts (ADRs).
ADRs in brief
An ADR provides a way for shares in a foreign company to be traded on US exchanges. The underlying foreign shares traded on the overseas exchange are deposited in a custodian bank and the depository bank issues a receipt giving the buyer rights over these shares. This receipt can be traded in the US markets – either on exchange or off-exchange depending on the nature of the ADR – just like a normal share. See here for a fuller explanation of how ADRs work.
The buyer of the ADR is not recorded on the company’s shareholder register, but they are entitled to all the economic benefits from them and we usually work on the basis that the investor is the beneficial owner. This is actually how most domestic shares are held these days anyway – rather than the individual investor being on the shareholder register, they are held “in street name”/”in nominee”, which means the legal owner is a non-trading subsidiary of your broker, but you are the beneficial owner (English law, and systems derived from it, allowing strict legal title to be separated from beneficial rights).
Crucially, beneficial ownership separates the shares from the assets of the stock broker, meaning that in the event the firm fails, they are not available to the broker’s creditors – the investor still has rights over them. So HSBC’s case against HMRC was interesting because the tribunal found itself considering the question of whether an ADR actually carries a beneficial ownership in the underlying shares.
Do ADRs reflect beneficial ownership?
This is a matter of US law and so a UK tribunal couldn’t rule on this; instead, it wanted to establish as a matter of fact whether whether an ADR holder has a beneficial interest in the underlying shares. And after taking expert evidence, it found that it couldn’t. To quote a summary from Sullivan and Cromwell:
The experts agreed that under the New York law-governed contractual arrangements, ADR holders were given substantially the same economic rights as shareholders, but they disagreed on whether holders had a beneficial interest in the underlying shares. The FTT considered several aspects of US law, but found none of them conclusive of the question of beneficial ownership. For example, the FTT heard that the US tax position of an ADR holder does not turn on the nature of an ADR holder’s interest in the underlying share. It was not clear on the evidence given to the FTT that a bona fide purchaser without notice would be able to obtain good title to the underlying shares if Bank sold the underlying shares, contrary to the terms of the Deposit Agreement it entered into with HSBC. Nor was it clear to the FTT whether the underlying shares would be available to the general creditors of Bank on insolvency. One of the expert witnesses summarised her view that the true legal position under New York law of the holder of an ADR was unresolved in the courts. The only thing she could confidently predict was that “there would be a lot of litigation over whether the underlying shares and collateral were owned by the ADR holders or available to Bank’s general creditors”. [My emphasis]
This judgment obviously had some potential implications on taxation of UK ADRs, which HMRC seems to have addressed by saying that it will continue to regard ADR holders as beneficial owners. And it’s barely necessary to say that the considerations of a UK tribunal would have absolutely no impact on the question of whether ADR holders have a beneficial interest or not in the eyes of a US court – which would be all that matters as to their true status.
But I was struck by the opinion of one of the expert witnesses in bold in the paragraph quoted above: In essence, in the event that the depository bank issuing the ADR were to fail, there would be litigation over whether the underlying shares were ring-fenced from creditors and held solely for investors or not.
In practice, it may be an empty question. The big issuers of ADRs are hugely important institutions by virtue of their overall position in the financial system and it seems unlikely that they could be allowed to fail (the main issuers are BNY Mellon, Citibank, Deutsche Bank and JP Morgan).
For this reason, the question doesn’t really dissuade me from using ADRs. But even if a) this particular bankruptcy seems a very low probability event and b) the tribunal’s deliberations are a non-US verdict that determines nothing, it seems slightly concerning to note that the exact legal status of ADR holders in the theoretical event of a bankruptcy would not seem to be entirely certain.