Mutual funds may not attract participatory note investors

SEBI has, over a period of time, constricted investments in securities through participatory notes (P-Notes). Is it to compensate for this that Budget 2011 proposes allowing foreign investors to subscribe to equity mutual funds?

According to the Budget, this move would widen the class of foreign investors in the equity market.

Only FIIs and sub-accounts registered with SEBI, and NRIs, are allowed to invest in mutual funds. So which is the new class of investor that is being sought?

One reading is that investors who do not want to register as FIIs or sub-accounts with SEBI may choose to invest in mutual funds. Some overseas companies and non-NRIs would presumably fit this bracket, said a regulatory expert.

Budget 2011 said SEBI-registered mutual funds will be allowed to accept subscriptions from foreign investors who meet the KYC requirements for equity schemes.

However, those who prefer anonymity would still choose the P-Notes route to investment in India.

“Only select foreign investors who can be KYC-compliant as per mutual fund regulatory norms would be able to take advantage of the new proposal. Hence there can be a slight impact on the investments through P-Notes but it won't be substantial,” said Mr Tejesh Chitlangi, Senior Associate at Finsec Law Advisors.

“Mutual fund KYC norms are clear and comprehensively defined by SEBI as compared to FII KYC requirements, which are vague. Hence foreign investors who prefer P-Notes will continue to do so as there is more uncertainty in that route.”

Participatory Notes (or offshore derivative instruments) are issued to overseas investors who do not wish to directly invest in India as an FII or sub-account. FIIs purchase the underlying security in India and issue P-Notes to foreign investors who may issue P-Notes to other entities. Because this led to worries that black money may be involved in the investment route, SEBI issued a circular this year asking FIIs to make an undertaking that the owner and purchaser of P-Notes are regulated and that KYC norms have been followed for the ultimate beneficiaries at the end of the chain. Because of this the P-Note component of assets managed by FIIs has come down from 50 per cent to 13-14 per cent, it has been generally estimated.

However, most regulatory experts say it is impossible for FIIs to do due diligence beyond the first level of P-Note issuance. “It is not possible for an FII to find out about the shareholders or individual constituents of P-Note holding entities and do due diligence on them. A number of FIIs have been pulled up by SEBI for this and even the Securities Appellate Tribunal has once opined that the regulations are vague.”

There might be fresh foreign investors for equity mutual funds but those who are using P-Notes will continue to use that route, say experts.

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