Don't throw the baby with the bathwater

WITHOUT CONTEMPT

The Reserve Bank of India (RBI) has published the report of the committee on fuller capital account convertibility. The report has triggered yet another debate over investment in Indian securities through participatory notes (PNs).

PNs are structured instruments or derivative contracts that may be issued by any holder of securities to pass on all the economic benefits of owning such securities to the holder of the PNs.

In other words, the instrument issued by the person actually holding securities would mirror all the benefits of such ownership other than legal rights of ownership, if any, thereby providing the note-holder virtually all the benefits of holding such securities.

PNs are popular among foreign institutional investors (FIIs) and their clients. Regulations made by the Securities and Exchange Board of India (Sebi) expressly acknowledge and permit such issuance, and require disclosure of the beneficial holders of PNs . Varying estimates suggest that approximately half the funds flowing in through the FIIs can be attributed to the holders of PNs.

The committee's report, which recommends a progressive three-phased road map to full capital account convertibility by 2011, has suggested that FIIs should be prohibited from investing in India funds raised by issuing of PNs. The committee has also recommended that all existing PNs should be unwound over the next one year.

News reports suggest that the finance ministry has been swift to react by stating that PNs as a route of investment in India will not be abolished. The finance ministry has assuaged the market by stating it would come out with more transparent norms to enable a wider range of entities to invest freely in India by notifying transparent norms for disclosure of ultimate owners of Indian securities.

One should not lose sight of the context of the RBI committee's recommendation. When full capital account convertibility is introduced, that is, when inflow and outflow of foreign currency is freely permitted, the economic rationale for PNs as an instrument could vanish. The committee report suggests that any foreign corporate should be freely allowed to invest in India through mutual funds, portfolio management schemes and through Sebi-registered intermediaries, which should be made responsible for knowing their clients.

In other words, if foreign residents are freely permitted to invest in Indian securities and Indian legal procedures transparently enable smooth investment and divestment, there would be no charm for a foreign resident to invest through PNs. However, there is little point in banning PNs first and then going about gradually freeing investment by foreign residents. For all one knows, such complete freedom to invest may continue to remain elusive for a long time to come.

The RBI committee's rationale for recommending a ban on PNs is that the nature of beneficial ownership or the identity of beneficial owners of the PNs is not clearly known, unlike in the case of FIIs. Moreover, PNs could be freely transferable and the identity of the owner can keep changing. The committee acknowledges that it would not be possible to restrain entities subscribing to PNs from issuing further PNs or other securities on the strength of the PNs held by them.

PNs have a market only because the law governing getting registered as an FII in India can be very cumbersome, and at times, downright illogical. For instance, non-resident Indians (NRIs) are not permitted to invest in P-Notes. While any company incorporated anywhere in the world can be a PN holder, if it is a company owned 60 per cent or more by NRIs (overseas corporate bodies "� OCBs), it cannot invest in PNs. Even a broad-based foreign mutual fund, in which more than 60 per cent of the assets under management are from different NRIs and OCBs, would not be able to register as an FII with Sebi.

In any case, structured securities and products such as PNs have been a long-standing feature of mature securities markets. The key is to make life simple for investors in India to enter the system, make legitimate gains and exit without undue fetters. Blind prohibition, on the basis of concerns of identity of beneficial owners, however, genuine such concerns may be, will not help. What is necessary is a transparent set of laws governing registration of FIIs, and removal of misgivings relating to NRIs. One need not provide any special benefit to NRIs and OCBs, but one ought not to positively discriminate against them. The baby should not be thrown out with the bath water.

(The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.)

somasekhar@jsalaw.com