Penalising P-Notes

It has for long been a complaint of domestic investors that, while their stock market investments are put through the wringer with onerous know-your-customer norms, some foreign investors get away scot-free by using offshore derivative instruments (also known as Participatory Notes). The veil of anonymity offered by P-Notes has also made them alleged conduits for all manner of doubtful capital flows — from global hot money to round-tripping of domestic black money. SEBI has initiated a series of steps over 2014-15 to tighten its rules governing P-Notes. Only regulated investors and intermediaries are now allowed to issue them, and opaque/unregulated global investors can no longer subscribe to them. Still, it has stopped short of a complete ban on P-Notes for fear of a market meltdown. But with the Special Investigation Team pressuring SEBI to take a harder line, and the Centre plugging tax evasion through the treaty route, it has now become imperative for SEBI to establish a water-tight regime for P-Notes. The curbs on P-Notes proposed in SEBI’s latest board meeting are yet another indirect attempt to render this route unattractive, by tightening the screws on issuers.

The controls mooted for P-Notes are threefold. One, Indian market players issuing P-Notes will now have to apply Indian KYC norms to P-Note subscribers and if they are offshore firms, verify the ultimate investors who control them. But with the threshold stake for such ‘control’ set at 25 per cent for companies and 15 per cent for partnerships/proprietorships, such verification is seen as not too difficult. Two, SEBI has also curbed the free transfer of P-Notes, by requiring issuers to approve such transfers and report them. This increases the compliance burden for Indian issuers. Three, issuers are also required to report any suspicious P-Note transactions to the authorities by having internal systems to identify them. Clearly, SEBI’s intent is to place such a heavy responsibility on the regulated market players who issue P-Notes that they think twice about soliciting dubious investments through this route. But the rules will be effective only if SEBI is able to detect infractions and take penal action against offenders, which has proved quite difficult in the past.

While this tightening is necessary, lower foreign portfolio investment (FPI) flows could prevent Indian stock markets from pushing higher in the near-term. The proportion of FPIs taking the P-Note route has seen a sharp decline — from a high of 55.7 per cent in June 2007 to 10 per cent by March 2016. Even partial withdrawal of the ₹1.9 lakh crore P-Note flows can have a serious impact on market liquidity. This makes it imperative for the Government and SEBI to redouble their efforts to encourage domestic investments in equities, including popularising it, and making it easier for investors in the National Pension System, as well as other mutual funds.

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