The Growth of Unsponsored American Depository Receipts of Indian Companies

[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

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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