WHAT DOES PARTICIPATORY NOTES (PNs)
MEAN? HOW BLACK MONEY IS BEING ROUND TRIPPED INTO INDIAN STOCK MARKET THROUGH
PNs?
By
Dr T Padma.,
LLM., Ph D (Law)
kethepadma@gmail.com
Background
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?
Round-tripping
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
Conclusion
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.
In modern India, poverty, insufficiency and
class conflicts are slowly giving way to a confident, inclusive, empowered
India. On the Transparency International’s Corruption Index, India’s position
has improved significantly, and hopefully will continue to do so. The vigilance
of our enlightened people and the civil society will ensure this. The manner in
which Anna Hazare's recent fast put pressure on the Government, will definitely
create an atmosphere to create the much needed legal framework to combat the
corruption in all spheres in the near future.
------------------------------------------------------------------------------------------------------------
[Published
in Supreme Court Journal / Weekly
October,
2011 Part – 40]
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