Economic vs. Voting Rights

Direct Investing vs. Indirect Investing

Direct investing occurs when an investor purchases foreign equity securities directly in the issuer’s domestic market. This approach requires establishing local securities and cash accounts, navigating foreign trading rules, clearing procedures, settlement systems, tax regulations, and operating across different time zones and languages. Large institutional investors have the resources to invest directly, whereas individual investors rarely do so.

Indirect Investing involves gaining exposure to foreign equity without purchasing shares directly in foreign markets. The primary vehicle for indirect investing is the depositary receipt.

Depositary Receipts (DRs)

A depositary receipt is created when a domestic bank (the depository) holds shares of a foreign company and issues receipts representing those shares. DRs trade on local exchanges in local currency and represent proportional economic interests in foreign companies.

$$ \textbf{Sponsored vs. Unsponsored DRs} \\
\begin{array}{l|l|l}
\textbf{Feature} & \textbf{Sponsored DR} & \textbf{Unsponsored DR} \\ \hline
\textbf{Foreign company involvement} & \text{Direct involvement in issuance} & \text{No involvement} \\ \hline
\textbf{Voting rights} & \text{Investors retain voting rights} & \text{Depository bank retains voting rights} \\ \hline
\textbf{Reporting requirements } & \text{Greater (e.g., SEC registration in the US)} & \text{Lesser}
\end{array} $$

Example: Unsponsored DR Voting Rights

When a US investor holds unsponsored ADRs of a German company, the depository bank, not the investor, votes the underlying shares. The investor receives only the economic benefits of share ownership.

Types of Depositary Receipts by Market

1. American Depositary Receipts (ADRs): Trade on US exchanges, represent non-US equities, denominated in USD
2. European Depositary Receipts (EDRs): Trade on European exchanges, represent non-European equities, denominated in EUR
3. Global Depositary Receipts (GDRs): GDRs are typically listed on exchanges outside the US, such as London or Luxembourg, and are not registered with the SEC for public trading in the US.
4. Indian Depositary Receipts (IDRs): Trade in India; Standard Chartered PLC issued IDRs in 2010 but delisted them in 2020
5. Chinese Depositary Receipts (CDRs): Allow Chinese Mainland companies listed overseas to become available to domestic investors

Key Advantage of GDR is that they avoid foreign ownership and capital flow restrictions imposed by the issuer’s home country because trading occurs outside that country.

Dual Class Share Structures

A dual-class structure distributes economic and voting rights unequally among share classes. The controlling class (held by founders, family, or insiders) receives superior voting rights despite potentially holding minority economic ownership.

Example: The Apex Innovations Dual-Class Structure

Consider Apex Inc, a hypothetical privately held robotics and artificial intelligence firm founded by Dr. Elena Vance and her co-founder, Dr. Marcus Webb. After a decade of breakthrough research, the founders decided to take the company public to raise capital for global expansion. However, both founders insist on retaining strategic control over the company’s long-term R&D direction, fearing that short-term profit pressures from public investors could derail their core mission.

To achieve this, Apex Innovations structures its initial public offering (IPO) with two distinct classes of common equity:

• Class A Common Stock: Offered to the public in the IPO. This class comprises 45 million shares. Each Class A share carries 1 vote and is fully transferable on the public exchange.
• Class B Common Stock: Held exclusively by Dr. Vance, Dr. Webb, and a small group of early-stage venture capital partners. This class comprises 15 million shares. Each Class B share carries 10 votes per share. The Class B shares are subject to a strict transfer restriction; they convert automatically into Class A shares (on a one-for-one basis) upon sale to any party outside the founder group.

Now, we can analyse the economic rights relative to the voting rights of Apex Inc. Following the IPO, the economic ownership (cash flow rights) is distributed strictly proportionally by the total share count:

• Total shares outstanding: \(45 \text{ million (Class A)} + 15 \text{ million (Class B)} = 60 \text{ million shares}\).
• Public investors collectively own \(\frac {45M}{60M} = 75\%\) of the total economic equity.
• Founders and insiders collectively own \(\frac {15M}{60M} = 25\%\) of the total economic equity.

However, voting power is calculated by the total votes each class commands:

• Total votes outstanding: \((45M \text{ Class A shares} \times 1 \text{ vote}) + (15M \text{ Class B shares} \times 10 \text{ votes}) = 45M + 150M = 195 \text{ million total votes}\).
• Public investors command \(\frac {45M }{ 195M} = 23.1\%\) of the total voting power.
• Founders and insiders command \(\frac {150M }{ 195M} = 76.9\%\) of the total voting power.

On the other hand, the strategic implication for Apex Inc is as follows:

Despite owning only a 25% economic stake, Dr. Vance and Dr. Webb control over three-quarters of the voting rights. This allows them to unilaterally elect the entire board of directors, block any hostile takeover bid, and approve or reject any shareholder proposal, even if 75% of the public economic owners oppose their decision.

$$ \textbf{Key Distinctions Summary} \\
\begin{array}{l|l|l|l}
\textbf{Characteristic} & \textbf{Direct Investment} & \textbf{Depositary Receipts} &
\textbf{Dual Class Shares} \\ \hline
\textbf{Voting rights} & \text{Full rights (if shares held directly) } & {\text{Sponsored: full rights; Unsponsored:} \\ \text{no rights}} & \text{Unequal across classes} \\ \hline
\textbf{Economic rights} & \text{Full rights} & \text{Proportional rights} & \text{May be equal or unequal} \\ \hline
\textbf{Currency exposure} & \text{Full currency exposure} & {\text{Foreign currency exposure remains} \\ \text{(trades in domestic currency)}} & \text{Same as the underlying shares} \\ \hline
\textbf{Trading hours} & \text{Foreign market hours} & \text{Domestic market hours} & \text{Domestic market hours}
\end{array} $$

Question

An institutional investor holds unsponsored American Depositary Receipts (ADRs) representing shares of a Japanese automobile manufacturer. A shareholder vote is required to approve a proposed merger. Which party is most likely to hold the voting rights for the underlying Japanese shares?

1. The depository bank that issued the ADRs
2. The institutional investor as the beneficial owner of the ADRs
3. The Japanese automobile manufacturer is the issuer of the shares

Solution

The correct answer is A.

In an unsponsored depositary receipt structure, the depository bank purchases the foreign company’s shares in the domestic market and holds them in trust. The bank then issues receipts to investors. The depository bank retains all voting rights associated with the underlying shares. ADR investors hold only the economic interest and have no voting authority.

B is incorrect. While the institutional investor is the beneficial owner of the ADRs, unsponsored DRs do not convey voting rights to the receipt holders. The investor’s ownership extends only to the depositary receipts themselves, not to the underlying shares held by the depository bank.

C is incorrect. The Japanese automobile manufacturer issued the shares and has no role in holding or exercising voting rights on shares already sold to investors. The issuer cannot vote shares that it no longer owns.