November - 2000 - issue > Cover Feature

The US capital markets have steadily gained in popularity, with foreign entities seeking to raise capital and long-term financing. This trend has reversed the foreign perception of the US markets as an over-regulated marketplace, requiring disclosures of the most intimate corporate financial details, further translated into the US Generally Accepted Accounting Principles (GAAP), onerous ongoing regulatory compliance, and fear of tough anti-fraud provisions and the generally litigious climate prevalent in the United States.

However, it is precisely these very disclosures that have inspired investor confidence and encouraged investment and trading, giving the American capital markets unparalleled liquidity and depth. This, in turn, has meant access to capital also unequaled anywhere else in the world.

The United States has created laws to allow foreign companies to raise capital in American markets. Of these, the American Depositary Receipt (ADR) programs have found special favor with overseas entities. ADRs allow US investors to trade in foreign securities in dollars, receive dividends in dollars and have a five-day settlement. The ADR holder may also exchange the ADRs for the underlying shares at any time.

The mechanism for issuing ADRs requires the foreign company seeking to raise capital to “sponsor” an ADR program. This is done in conjunction with a US commercial bank. The sponsoring company has the freedom to decide the ratio of ADRs to shares. The price of each ADR is determined based upon what is believed to be the most attractive price to the US investor, with the expert guidance of the underwriter for the offering. To issue these ADRs to the public, the foreign company sponsoring the ADR program must comply with the registration requirements under US federal and state securities laws, and typically list with one of the US stock exchanges or with the Nasdaq and have an underwriting arrangement with a firm of investment bankers.

Foreign companies sponsoring the ADR program must file a registration statement, which has to be declared “effective” by the US Securities and Exchange Commission (SEC) before the company can offer its ADRs to the public. The registration process involves filling out certain forms, together with preparing and filing the prospectus that is to be offered to the public, an underwriting agreement, and the depository agreement. It is designed to elicit all information regarding the issuer’s business and financial condition, so that the investor can make an informed decision. The underlying principle of the US securities laws is complete, accurate and truthful disclosure; it is not a licensing process.

The registration process requires filing of financial statements for the last five years and audited statements for the last three years. This data includes total assets, net sales, income/loss from continuing operations and income/loss from continuing operation per share, cash dividends declared per common share, and long-term obligations. The audited financial statements are filed in conjunction with an auditor’s report that will be acceptable to the SEC. The independence of the auditors is strictly reviewed.

A key aspect of the prospectus is the Management’s Discussion and Analysis of Financial Condition and Results of Operations (commonly known as MD&A) for the periods covered by the financial statements included in the filing. The MD&A is designed to communicate an understanding of the history and state of affairs of the company’s financial condition and results of operations from the management’s viewpoint and any known trends that could affect future results. Those who have obtained venture capital or other private finance should take note that the MD&A cannot have an overly optimistic approach that is characteristic of business plans, as the object is to provide a full disclosure and inform the prospective investor.

Listing

Each exchange and Nasdaq have their own separate criteria for listing a company. Thus, the New York Stock Exchange’s (NYSE) criteria for listing ADRs of a foreign entity are 2.5 million publicly held shares worldwide of the issuing company, with a market value of those shares being at least $100 million, and the net assets of the company being $100 million, annual pretax income being $100 million, and a minimum of 5,000 shareholders worldwide.

By contrast, the American Stock Exchange (AMEX) has recently decided that it will not have any “strict numerical standards” for a foreign company, but will consider “laws, customs and practices of the applicant’s country of domicile.”

The listing requirements for Nasdaq are the following: A minimum of 100,000 publicly held shares, with a minimum of 300 shareholders, with the company having net assets of at least $2 million, and two or more market makers.

Both these stock exchanges and Nasdaq have a one-time listing fee and ongoing annual fees. All three have certain requirements of corporate governance and financial reporting, to ensure corporate responsibility, although a particular exchange may waive or modify these requirements on a case-by-case basis. Thus, foreign companies often request waivers where the obligations imposed by the exchange are inconsistent with those in their country of domicile. Some requirements of NYSE, for example, are that the listed company publish quarterly statements of earnings, provide its shareholders annual audited financial statements within three months of the close of its fiscal year and at least fifteen days before its annual meeting of shareholders, and have at least two outside directors on its board. With respect to foreign companies, it requires that the company make available to US shareholders of ADRs, the opportunity to participate in rights offerings on “substantially the same terms as their domestic shareholders.” AMEX and Nasdaq have similar requirements.

The choice of listing will be determined by a variety of factors, including the size of the issuing company, its annual receipts, the size of its offering, the particular industry that the offering company belongs to, and an evaluation as to which market will provide the best liquidity for the shareholders.

Underwriting

Public offerings of securities, including stocks and ADRs, are typically made through an investment banking firm that acts as the underwriter. The underwriters will usually act as a syndicate, with one or more acting as the “lead” underwriter. The function of the underwriter is basically to market and distribute the securities offered to the public. In this endeavor, the underwriter will assist the foreign company sponsoring the ADR program in determining the offering price of the issue, and whether and how much of the issue should be placed with institutional investors or in the retail sector.

Further, they will undertake active steps in marketing, including having “road shows.” With their experience, contacts and dealings with institutional investors, knowledge of the market place, and understanding of the industry, they accomplish their task with much expertise and efficiency. Their success-based fees range between 6 percent and 8 percent of the selling price; additionally, warrants will often be issued to the underwriter for the purchase of a percentage of the stock of the company. However, all costs and expenses incurred by reason of the underwriting agreement are paid by the issuing company, independently of the fees.

Considerations

The general rule of thumb is that companies offering shares on the American market should have minimum annual sales of approximately $10 million. Further, companies should have professional management teams, with a significant market share or a niche in the market where they sells their products or services. The product or service should be one with demonstrable high growth potential within the next five years. Companies also must have audited financial statements that will be used for registration, well before initiating the registration process. Finally, it is important that companies sponsoring the ADRs clean up any contingent liabilities, such as lawsuits, tax or pension plan liabilities, and not have been the subject of any governmental audits.

An issue of less than $7.5 million dollars is regarded as a “small issue” by the SEC. When viewed in the context of the high cost of a public offering, the amount of the offering should be a very relevant consideration.

With respect to the cost of a public offering, the sponsoring company should be aware of the following major expenses that it will undertake: fees of accountants, attorneys, depositories, Exchange or Nasdaq listing, printers, underwriters, and the cost of registration.

With appropriate evaluation of a company’s needs, viewed within the context of the regulatory framework and the expense involved, the American markets can be the largest watering hole in the world.

Krishna Malhotra is a partner in the Los Angeles law firm of Malhotra & Malhotra.