Rights, warrants and ADRs

Same company, different reasons

A right exists to protect existing owners. When a company sells new shares, each holder’s fraction of the company would shrink unless they buy their share of the new issue. So the company gives every existing share one right, sets a subscription price below the market to make sure the offer is taken up, and gives holders a few weeks to act. A right can be exercised, sold, or allowed to expire. Be clear about what has authority behind it and what does not: the FINRA rule defines a right by who receives it — the holders of record of the issued securities, usually on a pro rata basis — and says nothing about a subscription price or a term. The below-market price and the few weeks are ordinary market practice, which is what the exam expects and what almost every rights offering does, but no US regulator states them as a rule. Answer with them; do not treat them as law.

A warrant may be issued on its own or alongside another security. When a company issues bonds or preferred, it may attach a warrant: a long-term option to buy common at a fixed price. FINRA says that price is often a premium to the stock price when the warrant is issued, so the warrant pays off only if the stock climbs. In market practice warrants attached to an issue are called sweeteners, because they help it sell; that purpose is practice, not a rule. FINRA’s rule says a warrant is usually valid for several years.

An American Depositary Receipt solves a different problem: how to own a foreign company without a foreign brokerage account. A US bank holds the foreign shares and issues dollar-denominated receipts that trade on US markets and settle like any US stock. Dividends arrive converted into dollars.

The dollar price does not remove currency risk. The underlying shares are worth a certain number of yen, euros or pounds. If that currency weakens against the dollar, the same foreign value converts into fewer dollars and the ADR falls, even if the local share price never moved. Dollar convenience is packaging; the exposure underneath is foreign.

An American depositary receipt has more structure inside it than its one-line definition suggests, and the exam draws on that structure. The receipt is a negotiable certificate evidencing an ownership interest in American depositary shares, which in turn represent shares of a non-US company deposited with a US bank. It trades in dollars and clears through US settlement systems, which is what saves the holder from transacting in a foreign currency. The ratio need not be one-for-one: an ADR may represent several underlying shares or a fraction of one, chosen so the ADR prices at a level typical of the US market.

Sponsored and unsponsored is the distinction most often tested. A sponsored program is set up under an agreement between the non-US company and the depositary bank, which then handles recordkeeping, forwarding shareholder communications, paying dividends and the rest. An unsponsored program is created by a depositary bank without the company’s cooperation, often in response to broker-dealer demand for a US trading market, and it can only be Level 1, trading over the counter — a trading presence that may not be used to raise capital. A sponsored program can be Level 1, 2 or 3. Level 2 puts the ADR on a national securities exchange and obliges the company to register and file annual reports on Form 20-F, still without raising capital; only Level 3 may raise capital. No ADR may be established at all unless the non-US company is subject to Exchange Act reporting or exempt under it.

Trading in dollars removes the inconvenience of foreign currency, not the risk of it. The SEC puts the point exactly: when the exchange rate between the foreign currency and the dollar changes it can increase or reduce the return, and a foreign investment may rise in value in its home market while the value of that investment in US dollars actually falls. Some countries also impose currency controls that restrict or delay moving money out.

Exam terms

Pre-emptive right

An existing holder’s right to buy new shares first, in proportion to current holdings.

Subscription price

The price at which a right lets the holder buy the new shares; in practice set below the market so the offer is taken up.

Warrant

A long-term option issued by the company to buy its stock at a fixed price, often above the market at issue.

Sweetener

Market-practice name for a warrant added to a bond or preferred offering to help it sell; not a regulatory term.

ADR

A dollar-denominated receipt for foreign shares held by a US depositary bank.

Currency risk

The chance that a move in exchange rates changes the dollar value of a foreign investment.

Worked example

Tamsin owns 1,000 of Alderbrook Mining’s 25,000 shares, a 4% stake. Alderbrook offers 5,000 new shares through a rights offering: one right per share held, five rights plus $40 for each new share, while the stock trades at $48.

1. Tamsin receives 1,000 rights, one for each share she holds.
2. At five rights per new share she may subscribe for 1,000 ÷ 5 = 200 new shares, paying 200 × $40 = $8,000.
3. After the offering there are 30,000 shares outstanding. Her 1,200 shares are still 4% of the company — the pre-emptive right did its job.
4. If she ignores the offering, her 1,000 shares become 1,000 ÷ 30,000, about 3.3% — she has been diluted.
5. Because $40 is below the $48 market, the rights have value; if she does not want more shares she can sell the rights before they expire.

Check yourself

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Related practice

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