The Hindu Business Line : SAT order on UBS case

IN YET another high-profile case, the Securities Appellate Tribunal (SAT) has overturned an order of the Securities Exchange Board of India. In May, SEBI had issued an order prohibiting UBS Securities Asia from issuing offshore derivative instruments for one year, highlighting regulatory concerns on the issue of participatory notes. However, the latest SAT order specifically states: "We do not find any reason to uphold the orders issued by the market regulator under the SEBI Act."

In certain respects, SEBI's order pulling up UBS for being one of the largest sellers in the course of the market meltdown on May 17, 2004, seemed to rest on weak ground. SEBI's claim in the original order was that UBS had made substantial profits of Rs 42 crore by deliberately selling in the cash market to profit from its short position in the futures market.

Given the political instability at the Centre in the second week of May 2004, which had led to an unprecedented single-day fall in the Sensex and Nifty, any knowledgeable institutional investor would have hedged his position the way UBS did. Moreover, as a single investor, it did not trade a sizeable position that would have altered the trading turnover in both the stock exchanges. In that sense, the SAT order has been on expected lines.

Having said that, SEBI's order was predicated largely on the regulatory, rather than the market, angle. According to the order, there was a lapse on the part of registered intermediaries (foreign institutional investors) in maintaining high standards of regulatory compliance and independent professional judgement in handling security transactions. Surprisingly, even on this issue, the SAT order states: "We do not find there is violation of SEBI (Foreign Institutional Investors) Regulations."

Regulatory, not a market lapse

Though the SEBI order has been struck down, the SAT move does raise interesting questions on the need to amend and tone up the FII regulatory framework in India. The original SEBI order had raised two key concerns which, incidentally, have been dismissed by the SAT:

`Know Your Client' requirement: In the UBS probe, SEBI had highlighted that at least five out of the 12 clients of UBS either did not furnish full information or submitted partial information, citing client confidentiality. But the SAT has highlighted that the `Know Your Client' requirements prescribed are vague and not defined anywhere by the market regulator.

Apparently, the essential condition behind knowing the client, to whom the participatory notes are issued, is to establish the ultimate beneficiary of these PNs, even if a multi-layered structure is created. But, going by the SAT's order, this is not evident from the FII regulations.

Considering the sensitive nature of investment flows into any country, the regulatory framework needs to be toned up to ensure that this requirement is spelt out at the earliest, unequivocally and unambiguously.

Disclosures of top five investors: In the Ketan Parekh scam in 2001 involving technology company shares, the Joint Parliamentary Committee Probe had suspected that some promoters of technology companies had used the NRIs/ OCBs/Persons of Indian Origin route to purchase shares in their own companies.

Since then, the FIIs have been restricted from entering into an "Offshore Derivative Transaction" with a fund that might have a shareholder who is an Indian National, an NRI, an OCB or a Person of Indian Origin.

To establish the identity of such entities, SEBI had asked UBS to furnish the names of the major shareholders — the top five investors in respect of its top five clients. It initially claimed that it had misunderstood the requests from SEBI and later furnished the required information in a phased manner. But the SAT pointed out that it is not clear whether it is obligatory for the FIIs (such as UBS) to provide this information on clients. If such a perception still exists, it is time to plug this loophole in the regulation. Otherwise, establishing the client background will be a futile exercise.

Ultimately, the SAT has relied heavily on the fact that it did not help SEBI's case for it to have invoked Sections 11B and 11(4) of the SEBI Act, which relate to protecting the interest of the investors, or the securities market, in this case. Instead, it claims that Section 15A, which refers to penalties, could have better addressed the issues raised. Since SEBI's order was issued with the intention of establishing the ultimate beneficiaries in participatory notes and ensuring that they are not Indian Nationals, NRI or OCBs, a review of the FII regulations appears to be in order.

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