| The draft policy can turn out to be a significant change agent in the Indian market's position in the world. Phone lines to Mumbai are being scorched with frenetic activity from institutional investors getting excited about direct access to Indian markets instead of having to invest through P-Notes. |
| If policy-makers were to use this opportunity to provide access to the Indian market in a transparent and predictable manner, the economic rationale for the existence of the P-Note market could itself vanish, without disturbing the substantial legitimate funds that are invested in India through the P-Note market. |
| A quick look at the law on foreign institutional investors (FIIs) would be useful. FIIs are persons resident outside India who are registered as such by SEBI. Once so registered with SEBI, an FII gains a right under Indian exchange controls to freely buy and sell securities on Indian stock exchanges, and to freely remit funds into and outside India for such trading. |
| Now, P-Notes are instruments issued contractually by FIIs to third parties reflecting ownership of the economic benefits of specified underlying Indian securities. P-Notes conventionally come into being through the execution of an over-the-counter derivative contract between the P-Note holder and the FII. Through a P-Note, the counterparty of the FII could acquire an exposure to the value of the economic benefits holding the underlying securities without the legal benefits such as voting power. |
| An FII could well issue a P-Note without holding the underlying securities, if it does not care to hedge its exposure. However, as any prudent person would, an FII would hedge its obligations owed to the P-Note holder by either holding the underlying securities, or by hedging the exposure on the futures and options segment in India. |
| The draft policy announced by SEBI appears to be a product of detailed consideration between the Reserve Bank of India (RBI), which, as India's central bank and exchange control regulator, has been fundamentally opposed to the very existence of the P-Note market. The RBI has historically recorded dissent in reports of committees that considered policy on P-Notes. The RBI's concerns primarily revolve around the regulatory difficulty in ascertaining the real source of funds flowing into India through FII investments, and the exponential supply of dollars into India adding to the strengthening of the Indian Rupee against the US Dollar. |
| The private banking coffers of Indian-resident politicians and industrialists held offshore, are widely believed to be the source of investments through the P-Note route. Intelligence agencies are reported to have warned the government that terrorist funds too are benefiting from the exponential upsurge in Indian stock prices using the P-Note route. However, neither the RBI nor SEBI have actually specified what precisely an FII needs to adopt in order to satisfy Indian regulators that they "know their clients". An appeal filed by SEBI challenging an order of the Securities Appellate Tribunal setting aside legal action against an FII is pending before the Supreme Court. |
| Until a few years ago, there was no provision of law acknowledging or prohibiting the issuance of P-Notes. SEBI amended its regulations to acknowledge their existence and to expressly permit them, subject to the requirement that P-Notes ought to be issued only to "regulated entities". While this began as a measure that would have given access only to entities that are regulated by a special regulator, significant political pressure appears to have led to the government getting SEBI to clarify that any company registered with a registrar of companies in any jurisdiction would be regarded as "regulated entity". In short, the term "regulated entity" amounted to being a "registered entity" thereby making a mockery of the rule, which now practically excludes only individuals from access to P-Notes. |
| The proposed policy has a threefold approach to contain inflows driven by P-Notes. First, P-Note exposures leveraging on the exposure in India, to the futures and options segment, are sought to be banned. It is unclear what the regulatory stance would be towards FIIs that proclaim that they are not interested in hedging with any underlying transaction in the Indian market. An FII could claim that it is taking the risk on P-Notes on their own balance sheet without any underlying hedge. In parallel, nothing prevents the FII from trading in the derivatives market on its own account in the same security. It would be impossible to administer the intent behind every derivative exposure of an FII and check whether it is a P-Note that is being hedged. |
| Second, it is proposed that FIIs alone ought to issue P-Notes and not their 'sub-accounts'. Sub-accounts are entities registered as such under the aegis of the registration of any FII, which route too permits a foreign person to invest into the Indian market. The rigor in grant of registration to a sub-account is perceived by SEBI itself as far lower than that in registering an FII. Most of the regulatory concerns on source of funds are caused by sub-accounts rather than by FIIs. Whether this proposed measure will indeed carry itself into regulations or if it would fade away like the attempt to restrict access to "regulated entities" will be a function of political will. |
| Third, the size of exposure an FII could provide its clients through P-Notes is sought to be curtailed through a quota system. FIIs that currently have an exposure to P-Notes to the extent of less than 40 per cent of their total investments in India would be permitted to enhance such exposure only by 5 per cent of the incremental investments in India. However, FIIs that already have an exposure of above 40 per cent would be permitted to continue at their current percentage exposure levels. This measure, if adopted, would lead to two classes of FIIs in the system, depending on where their exposures currently stand. It could be far simpler to fix a reasonable percentage as a uniform limit for any FII, and not distinguish between FIIs on the basis of where their current exposure stands. |
| One outcome of the proposed policy would be that the conventional P-Note holder would cut out the middleman FII and directly register in India as an FII. However, SEBI's power to register a foreign person as an FII is discretionary. Unless SEBI is comfortable with the applicant, SEBI is not obliged to grant or extend registration. Of course, SEBI's actions as a licensing authority have to be fair and reasonable in order to sustain challenge in courts. However, the leeway SEBI has with its powers to deny registration is of very wide amplitude. |
| Unfortunately, not all the dislikes of the regulator in relation to processing applications for FII registration are transparently reduced to writing. For instance, the historical antipathy to registering hedge funds and stock brokers is not backed by a single stated provision of law or policy. A whole body of internal policy thinking has developed in the regulator's files, but is not published for all to see. |
| Consequently, only practitioners with experience are able to guide foreign investors with registration. Even SEBI and RBI officials find it embarrassing to explain to institutions that work in rule-based or principle-driven regulatory jurisdictions why Indian policy does not precisely set out regulatory likes and dislikes. The churn caused by the proposed policy has caused immense interest among institutional investors worldwide. This is the opportunity for the regulators to streamline the registration process and bring out transparent procedural guidelines on registering FIIs. |
| The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own. |
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