The paper will analyse the similarities, differences and the arguments in favor and against using an Initial Public Offering (IPO) vis-à-vis a Global or American Depository Receipt (GDR or ADR) in obtaining equity financing for a corporation. An IPO involves the selling of securities of a private limited company to the public for the first time. [1] ADR is a receipt or certificated issued in the name of the holder by a bank (international bank in most cases), evidencing the underlying securities in a foreign country, of which the price is close to the foreign shares. [2] For instance, ADR certificates are denominated in US dollars and can be traded as security in the US Markets. [3] Another example is the Indian Depository Receipts (IDRs) denominated in Indian rupees. [4] Therefore, it is important that we look at IPO and ADR process, in order to come up with similarities, differences, arguments for and against the use of two methods.
An IPO can be structured using the following three methods; (i) Offer of subscription; (ii) Offer for sale; and, (iii) placing and intermediaries. Under an offer of subscription is the issuer invites the public to subscribe to new securities, however new securities can still be combined with the sale of existing securities. Under an offer for the sale the issuer invites the public to buy securities that would have already been issued or allotted to an investment bank, which will then invites the public to subscribe the securities. However, the investment bank can still acquire securities from existing subscribers, and then offer them to the public; under placing and intermediaries offers, the investment bank will market the securities to its existing clients and other clients. [5]
Under IPO the issue price for the securities can be determined using two methods, underwriting and bookbuilding. Through underwriting the underwriter will determine the price at which sub-underwriters will be willing to issue at. Therefore, the price must be set and the underwriters must be contractually bound in order for the sub-underwriters and other issuing institutions to issue the securities to the public. A risk period for at list ten days to two weeks then follows, during this period the underwriter and sub-writer will determine the price in at which the shares are listed. The underwriting costs amount to 2 per cent of the IPO proceeds. Through this method a network of managers assess the level of interest at which shares are to be offered, using communications systems and computer programmes to monitor and analyse the level of demand. [6]
An IPO must be within the regulatory framework of the market. For instance, in UK the markets and IPOs are regulated by Part 6 of the Financial Services and Markets Act 2000 (FSMA 2000), FSA Prospectus Rules (PR), Disclosure Rules and Transparency Rules (DTR), Listing Rules (LR) and the Companies Act 2006. The regulation is pursuant to the EC Directives, which include Directive 2003/6 on insider dealing and market abuse, Directive 2003/71 on the publishing of the company prospectus.
A prospectus is defined by the Financial Services Authority (FSA), as 'a single or tripartite document, which contains information about the issuer, securities to be issued and a summary note.' [7] Therefore, there is a duty upon the issuer during an IPO to provide a prospectus in order to meet up with disclosure requirements that seek to enhance investors' due diligence and promote market confidence. However, such duty does not exist upon unregulated markets like the Alternative Investment Market (AIM). Furthermore, regulated markets can be subject to exemptions on mandatory prospectus requirements. For instance, under the European Commission prospectus law an IPO involving the offer of less than 2.5million euros, cannot be subject to such prospectus requirements. But looking at UK IPO prospectus requirements, there is also a minimum requirement of 100, 000 euros, which seem to be in contrast with EC requirement of 2.5million euros. [8]
Looking at the IPO content in according to section 87A (2) of the FSMA 2000, a prospectus must include, '(1) the assets and liabilities, financial position, profits and losses, and prospects of the issuer of the transferable securities and any guarantor; and, (2) the rights attaching to transferable securities.' However, the Prospectus Directive provides that non-equity transferable securities of below 50 000 euros may not be subject to prospectus requirement. [9] However, the FSA can give room for an investment prospectus to be outside 2 500 words, depending on the nature and characteristics of the securities to be issued. When it comes to financial content required, it must be in according to the financial standards set out in the International Financial Reporting (IFRS). As a result, an effort to harmonise the financial prospectus rules can be evidenced by IFRS' adoption of the Third Country National Generally Accepted Accounting Principles (GAAP) [10] , and the United States Securities Exchange Commission's (SEC) adoption of IFRS in 2007. [11] Furthermore, when it comes to prospectus content, the summary must be no longer than 2 500 words in its original language. Warnings of the risks associated with the IPO investment must be highlighted to investors. [12]
On top of the prospectus rules during IPO the listing rules must be noted. In UK they are subject to the Financial Services Authority (FSA) Handbook on Listing Rules, '(1). The company being floated must (unless an exception applies) have filed properly prepared and audited consolidated accounts for the last three years. (2). At least 75 per cent of the applicant's business must be supported by a historic revenue earning record covering the period of the required accounts; the applicant must control the majority of its assets and must have done so for at least the period of required accounts; and the applicant must carry on an independent business as its main activity. (3). A sufficient number of the class of shares to be listed (normally at least 25 per cent) must be held by the public in one or more states in the EEA when shares are admitted. (4). the applicants company's group must have available sufficient working capital for its requirements for at least the next twelve months. (5). the securities must be freely transferable and admitted to trading on a market for listed securities (such as the London Sock of Exchange's Market). (6). the expected market capitalisation of the listed securities must be at least £700 000 of shares (in practice the market capitalisation of the applicants will tend to be much higher because of the costs associated with listing makes it infeasible to proceed in this way, unless significantly larger amounts are involved).' [13]
ADR can be set up in two forms, as sponsored or unsponsored; For ADR to be sponsored an agreement between the foreign private issuer and a US depository bank must be met, on which the depository bank's responsibilities will include disclosing interim and annual reports, providing information about upcoming meetings, payment of dividends to ADRs holders. The sponsored ADRs can be listed on the New York Stock Exchange (NYSE), American Stock Exchange (AMEX) and the US securities exchanges or NASDAQ. Furthermore, as a foreign issuer the legal requirements provided by the Securities Act for instance, must be met. [14]
Through unsponsored ADRs there is no cooperation with the foreign private issuer, but a customary letter of non-objection is obtained from the issuer before the transfer of securities to an ADR holder, as the US depository bank also seek to cooperate with the ADR holders. However, the foreign company under the unsponsored program is still required to provide information under the Exchange Act. [15]
ADRs are offered in according to Level I, II or III. Under level I ADRs are not listed on US stock exchange or NASDAQ, provided less than 300 ADRs holders, resident in the US, or the Exchange Act Rule 12g3-2(b) [16] exemption rule is met, whereby the issuer is not required to register securities. Under level II there is a requirement that the US depository bank to register in according to the Securities Act, for representing its issuer. Furthermore, in under level II ADRs are listed on the US stock exchange or NASDAQ and registered in according to the Exchange Act. Like Level II, under Level III registration for ADRs under the Securities Act, as capital gathering and public offering is permitted. [17]
Therefore, in order to meet up the registration and legal requirements the foreign issuer or the company issuing ADRs must submit the required registration statement and prospectus to SEC, in according to the Securities Act. A foreign private company or issuer offering ADRs under Level III to the public must register the underlying ADRs. A foreign issuer is a company outside US with less than 50 per cent of the US voting or controlling shareholders, unless the following suffices; the majority of the director are US residents; more than 50 per cent of the company assets are located in the US; or the business is carried out in the US. [18]
Under section 11 of the Securities Act, company directors have a duty to ensure that the information provided in a company's prospectus is factual. Any misstatement or omission to the investors can result in penalties under both civil and criminal law (section 24 of Securities Act). Therefore, the directors have a duty to ensure effective due diligence into their business. Since under Rule 10b-5 of the Exchange Act it is unlawful '(a) to employ any device, scheme or artifice to defraud, (b) to make any untrue statement of fact or omit to state a material fact or to omit to state a material fact necessary in order to make the statements made, in light of the circumstances under which they were made, not misleading, or (c) to engage in any act, practice or course of business that operates or would operate as a fraud or deceit upon any person, in connection with the purchase or sale of any security'.
Therefore, in order to enable investors to carry out their due diligence, a company seeking to be listed must be able to make disclosure of its assets, financial position, future business prospects and any contractual liabilities.
The similarities between IPO and ADRs
Both IPO and ADRs allow a company to raise new finance from investors outside the company's shareholders and creditors, thereby expanding the source of finance. Furthermore, if an international IPO is structured using placing and intermediaries [19] , it can be argued that the process is similar to the issuing of ADRs by the issuer in his home state, to foreign investors through investment banks, on behalf of foreign issuers. As a result, both ADRs and IPO enhance the company and its business' foreign exposure, as they can be offered on foreign markets.
For Both IPO and ADRs there is a need for effective due diligence to be carried out on the companies' business in order to come up with a factual prospectus to investors. Companies listing on the London Stock of Exchange (LSE) and AIM for instance, an IPO must produce a prospectus. However a prospectus for securities listed at AIM is not mandatory but disclosure requirements still need to be met. But looking at ADRs (sponsored) listed on US stock exchanges or NASDAQ US due diligence is in according to section 11 of the Securities Act and Rule 10(b)-5 of the Exchange Act, which requires the disclosure of information through a factual prospectus.
Therefore, whether using an IPO or ADRs to raise finance, there is a responsibility on the company or directors to conform to the requirements of listing documents. However, it can be argued that using IPO can attract a lot of responsibility on the company's directors to ensure the disclosure documents than using ADRs, since the issuing of ADRs is undertaken by the depository bank on behalf of the issuing company. Furthermore, the disclosure of the company's financial position is another similarity which can be cited in using either IPO or ADRs. Such disclosure is also expected during a due diligence process, [20] as further information such as company and directors' contracts are also considered.
Both IPO and ADRs an annual and financial report must be published; under an IPO a financial report is within IFRS and GAAP. For ADRs the requirements under rule 4-01 of Regulation S-X, which allows a foreign issuer to prepare a financial report in according to his/her domestic as long as they are within GAAP.
The differences between an IPO and ADRs
Unlike ADRs where a foreign depository bank is used to offer securities in a foreign country, an IPO offers securities directly to investors. However, this also applies to an international IPO, since the issuer makes a global offering of securities directly to foreign investors. [21] Therefore, there is a possibility that some investors might confuse an international IPO and ADRs, as the two are similar but differ on the fact that there is no ownership of underlying shares on ADRs. As a result, it is the regulators' duty to ensure that a clear difference highlighted to investors.
Through an IPO, the shareholders subscribe to underlying shares, which results in voting rights depending upon the number of shares one holds, for example one share one vote. ADRs amount to the purchase of a mere receipt or certificate with no voting rights on the underlying shares. Furthermore, through the use of ADRs, the disclosure requirements are not as intense as the use of IPO. Since under IPO a company is expected to publish a half yearly report as soon as possible, in order to be act within a good corporate practice.
Advantages of using IPO
By using IPO a lot of capital can be raised on both local and foreign markets. Furthermore, with such participation in foreign markets the geographical exposure will result in marketing the company and its brand names. Also, since IPO does not involve any debt, the liquidity injected into the business reduces gearing, which signals financial distress and high risk to lenders. Gearing is the ratio of long term debt funding to all long term funding, or the ratio of long term debt funding to equity funding. [22]
There is a high chance of raising more finance from the banks and other lenders or debt finance. [23] Furthermore, a readymade market for buying or selling of the future company shares for business expansion is established. The existing shareholders of a company, for example Venture Capital firms can use IPO as an exiting strategy, whilst new shares are being offered at the same time. The market established by IPO will also enable shareholders to exit the business in future, as a result of a readymade market. Furthermore, after an IPO a company can attract a takeover through high priced acquisition than that of a private sale. It also enhances the company's bidding position in the takeover market by using its shares as liquid assets for acquisition.
Once a company has gone through IPO there is a clear separation of ownership and management, since voting rights are allocated in according to the number of shares, for example one share one vote. This is beneficial to the shareholders as they can be able to influence the company's decisions. As a result, an IPO can be used as an incentive to employees and shareholders to take the offer in order to effectively participate in the running of the company's business. Furthermore, it can be used to enhance the company's prestige, in order for the company to attract quality managers and shareholders as a result of the higher profile.It can also attract targeted customers, due to the company's credibility image, as a result of trading shares on the stock market. [24]
If an IPO is carried out by listing the securities at AIM for instance, this can be advantageous to the issuer since the AIM market is not subject to the regulation procedures, which involves the disclosure of price sensitive information [25] for example, even though for good market practice the issuer is expected to do so.
Disadvantages of IPO
IPO process is costly due to legal, underwriting and other direct costs. In according to Eversheds' survey legal costs in Europe are lower than that experienced in the US, but the total costs come to 6 per cent of the proceeds [26] . Furthermore, looking at the London Stock exchange research, it concluded that the process of IPO involved costs of up to 10 per cent of the capital raised. [27]
The IPO involves company reorganisation in terms of the constitution framework and management structure. Under the company's constitution framework review any restrictions that might hinder the trade of shares on the stock market. On management framework, there is a need for a company to be able to appoint independent executives in order to meet up the stock market expectations. The independent executives are also meant to enhance transparency or sound corporate governance in the business. This can also be a major challenge for a company going IPO, for instance family owned business might have to be able to fit in outsiders within the management structure. [28]
An IPO is typical to a growing successful and well performing company, therefore once a company has gone through an IPO, going back private can be very detrimental to the company, since it will signal a failure to attract investors and perhaps a failure in management. In order to promote the market and investor confidence as the Sarbanes-Oxley Act 2002 seeks to do so, regulators' scrutiny is likely to suffice as a result. However, regardless the failure of an IPO, it can be noted that regulation is burdensome when it comes to IPOs, especially in foreign countries. International IPOs can be difficult to regulate, since countries must come up with common rules, which can be difficult given factors like the difference in legal systems for instance non-English law countries. As a result, GAAP and IFRS are clear examples in which regulators have sought to harmonise the rules, but their effectiveness can still be questioned.
Advantages of ADR
The use of ADRs to raise finance can be less expensive, due to less administrative costs, stamp duties and legal costs. For instance the registration of Level I and Level III ADRs only Form F-6 is filled in by the depository bank on behalf of the issuer, which can result in low administrative and legal costs. Furthermore, ADR issuing can be argued to be simple since; it does not have voting rights attached to it and does not result in an open offer, whereby a shareholder has the opportunity to buy shares at lower price than the market price. There is no takeover call, since ADRs does not give rights on the underlying shares, as it is a mare issue of receipt or certificate to the investor. The US investors are familiar with the use of ADRs and, there can result in an easy transfer of the ADR title holder, with fewer complications.Furthermore, looking at the registration process for ADRs under Level II and Level III, since the depository bank is involved for the registration process and no disclosure is required on the issuer's behalf, it makes the process simple for both the issuer and investor since the relevant information will be disclosed by the depository bank.
Another point to be noted is that the use of ADRs in US might result in less disclosure and registration requirements for foreign issuers than that of US issuers, since foreign private issuers; under Section 14 of the Exchange Act, are not subject to the scrutinising rules applicable to the US issuers; are not subject to the reporting requirement, as the directors are not required to surrender short-swing profits under section 16 of the Exchange Act; not required to selectively disclose material information in according to Regulation RD. [29]
With ADRs there is no much restrictions for participating individuals, any individual or entity can be able to issue or be issued with ADRs, and at the same time there is no ceiling for the amount at which the issuer can raise. With such an opportunity ADRs can be used to source capital and funds for other purposes like the reduction of a company's foreign debt, for example company X in UK issues ADRs securities in the US Market, where it owes company Y some money, this can result in an easy transfer of funds, which can eliminate exchange rate and other costs. Therefore, it can be argued that it can be argued that ADRs can be best used for debt payments, foreign purchase of assets and goods, to a certain extent the acquisition of other companies from the ADRs proceeds can be possible.
When it comes to small and medium companies, the use of ADRs to raise finance, not only will it enable the company's sources of finance to flourish, but it will also enhance these companies and their business' foreign exposure, which is mostly associated to large multi-corporations.
The disadvantages of ADRs
There are also disadvantages of ADRs in the sense that they are dominated by foreign investors, of which domestic participation in the issuer's country is low, thereby relying on foreign investment. Therefore, unless the issuer is seeking to diversify the types of securities he/she offers a geopolitical effect for instance can affect his/her ability to raise finance using ADRs. Furthermore, since the sale of depository certificate is carried out to foreign investors, foreign exchange risks still exists. Since a company has to pay local listing fees and exchange fees in that jurisdiction. [30] For example, the instability of a local currency such Great Britain pound, can result in an unstable price at which ADRs will be issued in US dollar.
Since the sponsored ADRs can be listed on the stock markets, the signing of the registration form by the issuer, accountants and company directors, can result in a complicated disclosure procedure of which the issuer and other participants can be liable for misrepresentation or misstatement, under section 12 (a) (2) of the Securities Act which provides that 'any person…offers or sells a security…by means of a prospectus or oral communication, which includes an untrue statement of material fact or omits to state a material fact necessary in order to make the statements, in light of the circumstances under which they were made, not misleading…' A clear example of persons other than the issuer that have been found liable under section 12(a) (2) is the case of Pinter v Dahl [1988] [31] , furthermore the liability is also extended by section 10 of the Exchange Act and Exchange Rule 10b-5 which includes 'any act, practice or conduct during the course of business that might result in fraud or deceit'.
To conclude, the use of an IPO to raise finance can be effective since it might benefit the issuer, investor and other participants like investors. The issuer can raise more capital than resorting to debt, an investor will acquire a voting right as a result of subscribing to a security and to employees securities can be used as an incentive for employees to work hard and participate in the decision making process of the company. However, the use of IPO will also come up with some regulation burden especially upon the directors of the company as they are agents of the company in according to the Companies Act 2006. Another difficulty is also centred on the regulation of international IPOs as different countries have sought to harmonise the law by adopting regulatory regimes like GAAP, IFRS and the Sarbanes-Oxley Act in the US. But the presence of such laws seeking harmony with each other can also complicate international IPOs due to different legal systems. Since an ADR is a receipt issued in the name of the holder by a depository bank. The registration and transfer procedure is simple, however, there no voting rights accompanied with ADRs. Furthermore, with harmonisation of international IPOs the procedure raising finance using ADRs can be argued to be similar with international IPO. However, what is clear is that the use of ADRs can be more beneficial especially on the issuers' behalf, since no voting rights are accompanied with ADRs.
