Thursday, April 26, 2012



By K P C Rao., 

Two decades after economic liberalisation, we are the world’s second-fastest growing economy. Decades of scarcity of everything, from telephone and gas connections to foreign exchange, are gone. Isn’t it ironic then that on the 20th anniversary of the end of licence raj, what has grabbed the nation’s interest is the systematic, large-scale plunder of national resources through ever-larger scams? Each scam was improved on by the following one in fine larceny. Our netas and businessmen, with the intermediation of clever lobbyists and venal babus, dreamt up new ways to skim the cream off every deal, contract, license, statutory clearance or mining site while at the same time evading and suppressing any inquiry or media attention.

In the past decade, corruption in infrastructure contracts and land deals has raged unchecked because those in power began to share the loot with anyone who was likely to object. Throwing crumbs at opposition politicians to buy their silence and rewarding babus through allotment of undeserved flats became a regular feature. “A flat for a signature” seems to have been the policy in the Adarsh Housing Society scandal, where almost every bureaucrat whose concurrence or clearance was crucial (for denotification and conversion of user status) has been allocated super-expensive real estate in Mumbai.

The entry of Foreign Institutional Investment (FIIs) into India and provided the perfect opportunity for ‘round-tripping’ of money. Black money left India through hawala channels and returned as super-clean ‘foreign investment’. Is it surprising that demands to disallow non-transparent FII sub-accounts have always been ignored?


The black money that was stashed away abroad in the 1970s and 1980s has now multiplied manifold due to rupee depreciation and the interest earned on such funds. Now the same black money is being round-tripped for investment in India by some quarters, through FDI by shell companies, investment in the stock market through participatory notes (PNs), etc.

Participatory notes are instruments issued by FIIs to investors whose identity is not revealed even to SEBI (Securities and Exchange Board of India). However, this is only a small part of the black money stored abroad,  that is flowing back to India.

What Does Participatory Notes Mean?

Financial instruments used by investors or hedge funds that are not registered with the Securities and Exchange Board of India to invest in Indian securities. Indian-based brokers buy India-based securities and then issue participatory notes to foreign investors. Any dividends or capital gains collected from the underlying securities go back to the investors.

In other words, participatory notes (PNs) are derivative instruments which are issued by FIIs to foreign investors. Underlying securities in participatory notes are Indian Stocks. Foreign investors who want to trade in Indian securities anonymously use PN route without obtaining registration from SEBI. It is an understanding between a foreign institutional investor (FIIs) who is registered here and the other one who is not registered. The registered Investor (broker) places an order for an un-registered investor in anonymous name and these types of trade are carried through the internal account of the FIIs.

PNs can be misused for money laundering and there is an added risk in allowing those offshore investors to invest in India as the Indian regulators may not be able to catch hold of them. Though SEBI has made certain regulations on FIIs and made certain know Your Client norms applicable to them, there has been much non-compliance in this regard. Maximum level of transparency and comfort regarding the kind of players and origin of money is what is imperative to remove such lapses.

Tight regulatory monitoring and availability of alternative avenues to invest in India have reduced fund inflows through the Participatory Notes route. FII money flowing directly has more than made up for the reduced inflow via P-notes.

Regulatory Monitoring
The India story continues to appeal to foreign investors, P-notes or otherwise Participatory notes gained notoriety in the last quarter of 2007 when market regulator, SEBI clamped down on the issue of these instruments. Both the Securities and Exchange Board of India and the Reserve Bank of India (RBI) were then worried about funds from questionable sources entering equity markets through this route.

The turbulence that followed this move eventually led to the reversal of the runaway bull-market. But there is scarcely any mention of P-notes or offshore derivative instruments (ODIs), as they are also called, these days. Regulators, both the RBI and the SEBI, also seem more sanguine on this score. The reason is not far to seek. There is considerable reduction in the outstanding P-notes over the last three years. These instruments are viewed askance by the regulators because of the anonymity that it provides to unregistered foreign entities that invest in Indian markets through this route.

It may be recalled that excessive FII participation in the derivative market through offshore derivative instruments had made SEBI ban further issue of P-notes with derivatives as underlying in October 2007.

Problems associated with Participatory Notes (PNs)

1) Encourages anonymous transactions by brokers as identity of investors is not known.

Participatory Notes permits FIIs to transact for a foreign investor who is not registered or who has not fulfilled the formalities relating to KYC norms. They transact through their internal account for this purpose without disclosing the details of the ultimate invest.

As PNs are freely transferable, trading of these instruments makes it all the more difficult to know the identity of the owner. Some of the money coming into the market through PNs could be unaccounted wealth of some rich Indians in the disguise of FII investment.

2)     Creation of multi-layers

The ultimate unregistered investor/beneficiary, who explores the Indian market without evolving himself into any regulation, is not known because of many artificial layers created between FII and the ultimate investors. Many a times Participatory Notes are held indirectly with an account holder of the clearing systems through a chain of intermediaries and custodians and identifying and linking this chain is really a difficult task.

3)     Abuse of system by unknown investors and suspicious transactions

PN routes leads to round tripping of Indian capital moved out and routed back through the various FII accounts and sub-accounts, taking advantage of the tax breaks. The existing system encourages the flow of unaccounted money.
 Recent Regulatory Actions against FIIs[1]

During 2010-11, SEBI took action against two FIIs i.e. Barclays Bank PLC and Societe Generale for their failure to adhere to various reporting requirements under the Participatory Note (PN) regime.

a)    Barclays Bank PLC

Based on the Offshore Derivative Instruments (ODI) Reports submitted during the period January 2006 and January 2008 by Barclays Bank PLC, it was observed that it had issued ODIs to UBS AG, with Reliance Communications Limited (‘RCom’) as the underlying. When SEBI sought further information, Barclays submitted that upon review, the counterparty of the transactions was not UBS AG as earlier reported by it but was Hythe Securities Limited (‘Hythe’), an entirely new entity which did not form part of any of the submissions previously made by Barclays to SEBI. From the information submitted by Barclays, it was observed that the ODIs which were issued by it to Hythe Securities Limited (originally stated to be issued to UBS AG) were onward issued to another entity Pluri Emerging Companies PCC Cell E Emerging Markets Growth Fund. However, from the ODI monthly reports submitted by Barclays, it was observed that there was no mention of any back to back issuance of the ODI to any other entity. Barclays stated that the error in the reporting had occurred due to manual compilation of the ODI reports in December 2006 and error in data entry level and that after improvements in its systems for ODI reporting in 2008 and 2009, the errors in reporting continued to be carried forward in the new system. Barclays had not only failed to provide true, fair and complete details of the ODI activity undertaken by it but also prima facie violated the provisions of FII Regulations by furnishing false and incorrect information to SEBI. Full and fair disclosure forms the cornerstone of FII regulation by SEBI. As the source of funds available with an FII comes from offshore, by its very nature SEBI has no direct access to verifying the nature of the funds. In other words, SEBI places almost absolute faith and unqualified reliance on the ability of an FII to carry out the basic regulatory and prudential oversight.

SEBI as a regulator requires fair, true and correct information for assessing and monitoring FII activity in the securities market. When a registration is granted to an FII, SEBI presupposes that the FII has the capacity to exercise the necessary oversight and ensure the integrity and accuracy of the data it provides to SEBI under the regulations applicable. Given that Barclays had provided incorrect reporting Barclays has been non-compliant with the provisions of the FII regulations.

Accordingly, SEBI directed vide order dated December 09, 2009 Barclays Bank, PLC under Sections 11(1), 11(4) and 11B of the Securities and Exchange Board of India Act, 1992, not to issue/ subscribe or otherwise transact in any fresh/new Offshore Derivative Instrument till such time as Barclays satisfies SEBI that it has put adequate systems, processes and controls in place to ensure true and correct reporting of its ODI transactions to SEBI.

b)     Societe Generale

From the reports submitted by Societe Generale, during the period January 2006 and January 2008, it was observed that Societe Generale had issued certain ODIs/PNs to Hythe Securities Limited (‘Hythe’), with Reliance Communications Limited as the underlying. While providing details of all the ODIs/PNs entered into with Hythe, Societe Generale acknowledged that there had been errors in its reporting to SEBI of transactions with Hythe. Subsequently, it was also observed that those ODIs/PNs had been onward issued, and that Hythe is not the end beneficiary. Societe Generale failed to adhere to ‘Know Your Client’ norms as it had little or no relevant knowledge of the ultimate beneficiary of the ODIs issued by it. Societe Generale failed to provide true, fair and complete details of the ODIs/P-Notes activity undertaken by it and also prima facie violated the provisions of FII Regulations by furnishing false and incorrect information to SEBI.

SEBI vide its order under section 11(1), 11(4) and 11B of the SEBI Act, 1992, dated January 16, 2010, directed the Societe Generale, a registered FII, not to issue, subscribe or otherwise transact in any new ODIs or P-Notes in India till such time it provides a true and correct reporting of its ODI and P-Notes transactions to SEBI.

Participatory Notes Crisis of 2007
On the 16th of October, 2007, SEBI proposed curbs on participatory notes which accounted for roughly 50% of FII investment in 2007. SEBI was not happy with P-Notes because it is not possible to know who owns the underlying securities and hedge funds acting through PNs might therefore cause volatility in the Indian markets.[2]

However the proposals of SEBI were not clear and this led to a knee-jerk crash when the markets opened on the following day (October 17, 2007). Within a minute of opening trade, the Sensex crashed by 1744 points or about 9% of its value - the biggest intra-day fall in Indian stock-markets in absolute terms. This led to automatic suspension of trade for 1 hour. The then Finance Minister Mr P.Chidambaram issued clarifications, in the meantime, that the government was not against FIIs and was not immediately banning PNs. The SEBI chief, held an hour long conference on the 22nd of October to clear the air on the proposals to curb PNs where he announced that funds investing through PNs were most welcome to register as FIIs, whose registration process would be made faster and more streamlined. The markets welcomed the clarifications.

SEBI issued the fresh rules regarding PNs on the 25th of October, 2007 which said that FIIs cannot issue fresh P-Notes and existing exposures were to be wound up within 18 months.

Regulatory changes

When SEBI banned further issue of ODIs with derivatives as underlying and asked FIIs to reduce P-notes to 40 per cent of their assets under custody, it sent the signal that it was not going to allow unbridled inflow of money into equities through this route and was determined to keep a strict vigil on the end-users of these instruments. SEBI had also then stipulated that stricter KYC norms needed to be followed while issuing P-notes.

Another major regulatory change brought about in 2007 was the order that P-notes should be issued only to entities regulated by the regulatory authority in the country of their incorporation. This change barred many hedge funds that were unregulated entities from subscribing to P-notes. SEBI has also maintained a tight vigil over P-notes in the recent past.  As stated above, SEBI  banned ‘Barclays Capital’ and ‘Societe Generale’ from issuing fresh ODIs for inadequate disclosure and misrepresenting facts regarding the end-users of these instruments.

Though this ban was subsequently revoked, other issuers of P-notes would have got the message that the regulator was serious about filtering the ultimate users of participatory notes. Again the regulator had ordained FIIs with multi-layered opaque structures to broad-base or increase the number of shareholders to prevent funds from dubious sources from flowing in to the country. These measures could have deterred many who would otherwise have thrived in a lax regulatory environment. P-notes drawn on derivatives also reached alarming levels in mid-2007.

P-notes on derivatives

While P-notes in general are undesirable due to their opacity, those drawn on derivatives are even more so. Derivatives allow unregistered external investors to take leveraged exposure to Indian equities. In other words, the exposure of these investors is many times their outlay comprising mainly of margin payment. Needless to add, these inflows are extremely short-term in nature and can reverse abruptly, causing violent bouts of volatility in the market.

Trends in PNs
According to an expert group constituted by the finance ministry in India, in August 2004, participatory notes constituted about 46 per cent of the cumulative net investments in equities by FIIs. But, according to un-official estimates PNs contribute about 60% of investment by FIIs.

Participatory notes were never phased out completely as initially hinted by SEBI, while FII registration was streamlined and both cash as well as derivative markets moved to the latter platform. This stabilized inflows as well as increased FII participation. As a result FII participation through PN was down from 51% to 16% over three years.[3] The primary causes cited are:
1)     Regulatory changes - SEBI banned Overseas Derivative Instruments and asked FIIs to decrease PN participation to 40%
2)     Alternatives - FII registration was made easier


India did not invent corruption, but it seems to excel in it. Preoccupation with the subject is almost ancient. In the absence of effective institutions and the poor application of laws, perhaps the most crucial element in combating corruption is the social attitude towards corruption. Honesty cannot be legislated. No amount of legal restrictions would help so long as the society itself is lenient and tolerant. It is thus hard to decide which is the cause and which is the effect: Is the society permissive, or is a corrupt regime corrupting the society? The traditional Sanskritic usage, ‘yatha raja, tatha praja’ (as is the king, so is the populace) is often cited to blame the regime. Contrarily, there is the cynical theory that the people get the government that they deserve. Indeed, the top public leaders have to set an example with the political parties taking the lead, and the nation as a collective entity ought to show its intolerance, and give the corrupt the boot. A clear and clean sweep of the polity, it appears, thus is the task at hand. One cannot but wonder how much more developed India could have been, if only the rot is stemmed.

Indians have always valued a world beyond the material and have embraced spiritualism as a way of life. Instances abound in our epics of good behaviour, of the triumph of good over evil, of the wisdom of sages. Stories of the honesty, generosity and piety of legendry kings such as Vikramaditya, are told to our children even today. There is no reason why Ram Rajya cannot be attempted.
(Published in Corporate Secretary, Monthly Magazine  of ICSI, Hyderabad)


[1]SEBI ANNUAL REPORT-2011; Part Three: Regulation of Securities Market., Pgs 114-115
[2] Businessline, The Hindu, Feb 22, 2011.
[3]Business Line  The Hindu, Jan 28, 2011

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