The Hindu Business Line : Participatory note policy driven by a short-term view of market

The proposed policy changes about PNs (participatory notes) seem to be a reflex action in an attempt to contain the inflow and thereby the Sensex that seems to be gaining momentum of a runaway train, says Mr Vipul R. Jhaveri, Partner-Direct Tax in Deloitte, Haskins & Sells, Mumbai.

The proposal of the market regulator SEBI (Securities and Exchange Board of India), as you would remember, triggered an immediate reaction in the market, causing a big fall in the indices in the opening session, and trading had to be suspended for an hour. The Finance Minister had to quickly make a statement to pacify the market sentiments, and he has since then been, in response to high volatility in the bourses.

"While SEBI's objective of protecting the investors and preventing speculative trading by offshore investors is desirable and well intended, the real question is whether SEBI's assessment is right - that the current unabated rise in the stock market is speculative in nature and if so, the ODIs are the cause," Mr Jhaveri asks, during the course of an e-mail interaction with Business Line.

An error in assessment could prove counter productive and instead cause a flight of capital from the country, and the solution may well be worse than the problem, he fears.

"Further, subsequent backtracking and Ministerial statements would demonstrate system weakness and encourage speculation."

Mr Jhaveri is of the view that SEBI should perhaps have taken a closer look at the reporting requirements and KYC (know your client) norms and strengthened them with a view to gather adequate information on the antecedents of the subscribers / investors of ODI (offshore derivative instrument) and improve its visibility with regard to them.

"It seems that SEBI's reaction is driven by the shortterm view of the market and not recognising the fact that consistent flow of investment is critical of the healthy growth of any capital market," he postulates.

"SEBI should consider having the above restrictions only for a particular period of time till adequate system is implemented to seek and scrutinise required information from the foreign institutional investor (FII) or sub-accounts before issuance of ODIs."

For starters, Mr Jhaveri answers a few questions.

Excerpts.

What are PNs?

PNs or participatory notes are derivative instruments issued by SEBI-registered FIIs against underlying Indian securities held by them. An FII may collect funds from various unregistered foreign investors, pool the funds against underlying Indian securities, issue PNs to such investors and provide a return on the PNs linked to equity index. The FII may buy or sell Indian securities, on its proprietary account, on behalf of foreign investors not registered in India for trading in the domestic market. PNs in a sense are extra-territorial instruments.

How are these instruments regulated?

SEBI Regulation 15A inserted on February 3, 2004 regulates the issuance of PNs. This regulation speaks of two points:

One, FII can issue ODIs, as for example PNs, against underlying Indian securities only to entities that are regulated by any relevant regulatory authorities in the countries of their incorporation. Further, the FII shall ensure that no further down stream issue or transfer of such ODIs is made to any person other than a regulated entity.

Secondly, the ODI issue can be made subject to compliance with KYC requirement.

How is all this monitored?

Investment through PNs is monitored by SEBI by prescribing reporting requirements on the FIIs viz.

a) Any FII or its sub-account which issues/renews/ cancels/redeems PNs is required to report to SEBI on a monthly basis.

b) FIIs/sub-accounts merely investing/subscribing in/to the PNs/access products/ ODIs or any such type of instruments/securities with underlying Indian market securities are required to report on a quarterly basis.

Who is permitted to issue PNs?

In order to regulate and monitor investments in the Indian stock market made by such unregistered foreign investors through the PN route, SEBI has specified who can subscribe to/invest in such notes. The type of foreign investors permitted to do so are:

a) Any entity incorporated in a jurisdiction that requires filing of constitutional and/or other documents with a registrar of companies or comparable regulatory agency or body under the applicable companies legislation in that jurisdiction;

b) Any entity that is regulated, authorised or supervised by a central bank or any other similar body provided that the entity must not only be authorised but also be regulated by the aforesaid regulatory bodies;

c) Any entity that is regulated, authorised or supervised by a securities or futures commission, or other securities or futures authority or commission in any country, state or territory;

d) Any entity that is a member of securities or futures exchanges or other similar self regulatory securities or futures authority or commission within any country, state or territory provided that the aforesaid organisations which are in the nature of self regulatory organisations are ultimately accountable to the respective securities / financial market regulators;

e) Any individual or entity (such as fund, trust, collective investment scheme, Investment Company or limited partnership) whose investment advisory function is managed by an entity satisfying the criteria of (a), (b), (c) or (d) above.

Aren't these checks enough?

It would appear that the investment into India through the PN route had been effectively and adequately regulated with the specification of who can issue and who can subscribe to or invest in the PNs coupled with a quarterly reporting requirement by the issuers after insertion of Regulation 15A in February 2004.

SEBI has however come out with a discussion paper on ODIs (October 16, 2007) proposing restrictions on issuance of ODI.

In the paper, SEBI has highlighted the constant increase in the issuance of ODIs, the anonymity that the ODI provides to the investors and the copious inflows into the country from foreign investors as key reasons for such policy amendments.

Mr Jhaveri has experience of more than 20 years in the field of corporate taxation, both domestic and international. He has lead large projects involving multiple service lines, structuring of transactions and operations, tax management and compliance-related services, litigation support, tax due diligence for acquisitions / privatisations, advising on tax issues for re-structuring and re-organisations of businesses etc. Mr Jhaveri services some of the largest financial services and FII clients of the firm. He has also played a key role in advising clients bidding to acquire some of the biggest privatisations offers made by the Government of India.

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