Nowadays, in the global financial markets, the activity of rapidly developing countries such as Brazil, India, China, Argentina, etc. is increasing. This is not accidental, as the developing countries, not having enough domestic resources to finance the economic activity, enter the financial markets of developed countries with great savings to attract capital. A classical method of capital acquisition is the direct distribution of securities in the market, in other words, the sale of the company’s shares via the direct listing on the stock exchange. However, to use at first sight this attractive version, the issuer should have the full right over the securities registration, the rules for disclosing information about the company, the requirements for the structure of statutory capital and for submitting financial reports. The foreign issuers very often prefer using depositary receipts conditioned by the availability of the above mentioned problems. Unlike other securities, this tool is relatively new. The territorial distance between investors and issuers, the political instability in developing countries challenged a group of economists to create a tool that would allow to attract funds from foreign markets while spending less financial resources. However, it should be noted, that the weak legislative regulation led to the formation of low interest for depositary receipts at the initial stage. Despite the fact that the volumes of issuance and circulation of depositary receipts are increasing, many countries have legislative gaps that limit the scope of this tool.
It should be noted that the main function of depositary receipts is the acquisition of capital from the markets of developed countries. This process takes place between two or more countries, where there are different economic, political, cultural environments, which cause legal problems.
From the scientific point of view, depositary receipts are those financial tools that have not become o subject for a broad research. The main research on this tool has been conducted in the USA. In their research many scientists have basically touched upon its financial economic features and possible legal problems and obstacles. Depositary receipts as attractive tools for capital acquisition, have been referred to in the following work.
The Definition of Depositary Receipt
According to the general definition, depositary receipt is a derivative security, which is issued by a depository bank and confirms its owner’s right of ownership over certain amount of shares of a foreign company. The shares are held in the capacity of a custodian bank of that country. The owner of a depositary receipt enjoys the rights set to the shares: for example, receiving dividends, participation in the shareholders’ meeting, etc. In other words, the holder of the DR owns a certain part of the issuer’s capital. It is noteworthy that the owner of the DR implements his ownership rights in the frameworks of his own country’s legislation. That is, staying in the frameworks of one’s own country’s legislative regulation, he has the right to possess and manage a certain amount of foreign capital. The action mechanism of the DR can be presented in the following diagram.
Many financial markets have partially solved this problem, introducing depositary receipts as a special mechanism for capital attraction. In the post-Soviet era, the Russian Federation had a certain practice of capital acquisition through the DRs. Two of the largest Russian organizations, Gazprom and VTB Bank, are regularly collecting monetary funds from the European and American markets. The inexpensive essence of depositary receipts, ease of transaction, and the relatively small tax burden make this financial instrument a profitable investment asset for both issuers and investors. Armenia, as a developing country, need its economy to be financed, especially at the expense of attracting foreign capital. The fact that direct subscription to foreign exchanges is associated with tremendous costs, makes the mechanism of the DR a more attractive alternative. Besides, this is also promoted by the legislative privileges set by the US and European governments for the young and small organizations. Such an example is the law of the JOBS Act (The Jumpstart Our Business Startups Act), entered into force on 4 April, 2012, in the United States, which can be very promising for small organizations. According to this law, the following privileges are set for the organizations not exceeding $1 billion with a gross income a year:
When an investor instructs his broker to buy a depositary receipt, the broker either buys the receipt from the American (foreign) securities market or (if it is impossible or too expensive to purchase the receipt from the market) buys from the broker of the issuer’s financial market (from the broker of local market). In the second case the process is the following.[i]
- The broker of the local market buys the securities from the local financial market.
- The local broker records the securities at the custodian. The custodian is registered in the joint stock companies as a sub-custodian of securities.
- The custodian deposits the securities and gives an instruction to the Depository Bank of the developed country to issue depositary receipts on the basis of deposited securities.
- The Depository shall issue a depositary receipt.
- On behalf and expense of the investor, the broker obtains depositary receipts from the financial market.
The first depositary receipt was used in the US. It was issued in 1927, on the basis of the shares of the British “Selfridge” by the Morgan Guaranty Trust Company[ii]. The reason for this issue was the new law adopted in Britain, according to which the physical movement of the stock from the country was not allowed to the British companies. There was not an appropriate legislative framework regulating the issuance and circulation of depositary receipts at that time. Over time, along with the spread of depositary receipts, legislative developments took place. In sum, we can say that through the DR, the organization, which is sufficiently profitable and successful, and at the same time needs capital for further development and corporate issues, has the ability to engage from those developed countries which have liquid capital markets.
The Premise of Setting Depositary Receipts and the Current Issues Related to the DR Process in Armenia
The necessity of stimulating investments is constantly stressed at the current phase of the economic development of the RA, as for a country with low savings and poor socio-economic conditions, like Armenia, it is almost impossible to create a viable economy, to solve financial and social problems without foreign investments. Despite the development of the sector of the newest technologies, the availability of inexpensive labor force and other material and non-material resources, Armenia remains a high-risk country in terms of investments. This fact is conditioned not only by the war situation and political instability, but also by the high level of bureaucracy, weak legislation and corruption risks. This, in its turn, leads to a decrease in the investment attractiveness of the Republic of Armenia. On the other hand, attracting foreign capital is quite expensive in Armenia. That’s why many companies prefer to attract the necessary capital from the domestic market.
- Companies may submit the audited financial statements required for IPO only for two years, instead of three.
- There is no mandatory requirement to hire an independent auditing firm to provide a financial management conclusion.
- Companies may provide potential investors with analytical reports on their own securities both before and after the public suggestion of securities (in the past it was forbidden for the public to prevent disclosure).
Thus, this law enables the so-called rapid growth companies to reduce the cost of being an open public organization. Organizations may benefit from this privilege for a period of maximum 5 years.
Capital acquisition from foreign markets can significantly promote to the economic growth and socio-economic development in the country. At the same time, there are many sectors that can have a considerable increase by attracting huge means from the foreign market. Capital recruiters using the DR in Armenia may be companies involved in the following sectors:
- Export-oriented organizations having huge perspectives to enter the foreign market (large companies in the sphere of light industry and chemistry).
- New, developing and prospective companies in the sphere of the newest technologies.
- Organizations in the financial and banking sector.
Investments in the above-mentioned sectors can have a serious impact both on the organization’s development and on the entire economy.
At first glance, the mechanism of the DR seems to be an effective option for the Armenian big organizations being in the need of financial aid for their further development. However, there are certain factors that need to be taken into account. Are the Armenian companies not considered to be at high risk, and whether investors in the United States or other developed countries issueing depositary receipts, will invest in the Armenian high-tech companies? In this case, it is necessary to understand the risk of foreign investors investing in Armenia. Although Armenia has tangible (raw materials and natural resources) and intangible (labor and intellectual resources) resources, the following economic indicators and political situation can be a serious obstacle in terms of attracting investments.
|The Major Macroeconomic Indicators Related to the GDP||2014||2015||2016||2017|
|Growth of GDP (%)||3.6||3||0.2||3|
|Inflation (average annual)(%)||3||3.7||-0.5||2|
|Budget Balance (% ՀՆԱ)||-1.9||-4.8||-5.6||-3|
|Current Account Balance (% ՀՆԱ)||-7.6||-2.7||-2.5||-3|
|External Debt (% ՀՆԱ)||41.4||46.9||50.6||51.6|
According to Table 1, in parallel with the slow-unstable growth rates of the GDP, the external debt of Armenia and the negative balance of current account grow as well. These indicators allow the investor to conclude that the Republic of Armenia is an economically poor developed and risky country for investments.
It should be noted that for capital acquisition and for taking advantage of its opportunities, countries with transitional economies should have certain infrastructures that are on the appropriate level of development, which implies a well-developed legal system, protection of shareholders’ interests, high level of transparency of information provided to shareholders, and an established and functioning system of institutional investors as well. One can say that the problem of the development of the financial market of the Republic of Armenia as a country with transitional economy has a derivative character: it is in close contact with the overall macroeconomic situation. The privatization after independence was not effective in Armenia, and the evidence is the low capitalization indicators and the reduction of the number of OJSCs. Despite the fact that the funds collected through the equity securities are indefinite and are the cheapest way to attract money, the level of capitalization in Armenia is quite low and is supported by several major companies operating in the financial and mining sectors. Capitalization / GDP ratio does not reach 2%, which is a very low index of financial deepening. It is noteworthy that the majority of capitalization in Armenia belongs to 5 biggest companies, whose share in total capitalization is 98%[iv] (diagram 2).
For comparison, it can be noted that there are about 900 OJSCs in Armenia. This proves that the capital market and the financial sector in Armenia need serious developments and changes. In terms of using the mechanism of the DR as well, overcoming the above-mentioned issues is of great importance in raising the interest of foreign investors. The systematic and constructive macroeconomic policy is essential for the formation of competitive environment and for restraining the process of getting superprofits by fraud. It will ultimately lead to the need for more affordable sources of funding for organizations. As already mentioned, macroeconomic instability makes Armenia be at high risk. This suggests that transactions with the DRs issued on the basis of the Armenian securities will be less attractive for the investors, if we take into account the fact that there are organizations of developing countries with more stable macroeconomic indicators in the market. Despite this fact, the depositary receipts of Armenian companies theoretically may have certain demand, if we take into consideration the fact that the managers of securities portfolio use both low and high risk securities for portfolio diversification. Capital acquisition through the DRs is practically impossible for companies when they do not perform transparent activities: that is, they hide the profit, avoid tax. Despite the fact that currently there are companies in Armenia that have reached the level required for using the DRs, there are a number of problems, in particular, to enter the foreign stock market the company must meet the following requirements:
- Have an optimal financing structure;
- Have a modern organizational management system;
- Implement a clear dividend policy;
- Have a clear development strategy.
To take advantage of the DR’s mechanism in Armenia, it is necessary:
- Investment of corporate management in the biggest companies and confirmation of compliance to the international standards of the financial reports;
- Steps to the creation a favorable investment climate for foreign investors, ensuring equal competitive environment, separation of large business and state apparatus,
- Development and implementation of effective anti-monopoly mechanisms;
- fighting against the shadow and creating a more competitive and healthy business environment.
The financial and, in particular, the securities market is one of the important financial components of ensuring economic growth and solving many socio-economic problems in society. The problem is more important in Armenia, when, nowadays the Armenian economy needs investments and to ensure sustainable economic growth, increazing the volume of bank crediting is not enough. Thus, it is necessary to have an effective financing system and particularly, a developed securities market. On the one hand the DR is attractive from the point of capital acquisition, on the other hand, it is more preferred for the Armenian business, as through the DRs, the company’s securities are offered to a larger circle of investors in a much larger market, which reduces the risk of capital disruption and the risk of obtaining the controlling package by an individual. This is a fact that has always been noted by various researchers in the Armenian business environment to be a barrier to capital acquisition through shares.
In sum, it can be said that the depositary receipts can be quite effective for the profitable sectors of the economy in Armenia in terms of attracting and further development of capital. On the other hand, these organizations will gain international recognition, create an image and develop a corporate management system. In order to benefit from these advantages, first and foremost, it is necessary to find a proper solution to the multifunctional issues discussed above.
[ii] John Board, Charles Sutcliffe, Stephen Wells, “Distortion or Distraction: US Restrictions OnEU Exchange Trading Screens” (2004)
Author: Lusine Khachatryan. © All rights are reserved
Translator: Armine Poghosyan, English