Acting upon recommendations of the Supreme Court-appointed Special Investigation Team on black money, Sebi tightened the due diligence requirements for issuance and transfer of controversy-ridden P-Notes and put the onus on investors to ensure the AML compliance.
The issuers would have to conduct periodic review and report the complete transfer trail of Offshore Derivative Instruments (ODIs) -- commonly known as Participatory Notes or P-Notes -- to Sebi on a monthly basis in addition to the present requirement of reporting details of their holders.
After the meeting here today, Sebi said its board has approved additional measures for the purpose of enhancing the transferability and control over the issuance of ODIs.
P-Notes are typically instruments issued by registered foreign institutional investors to overseas investors, who wish to invest in the domestic stock markets without registering themselves directly in India, but still need to go through a proper due diligence process.
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P-Notes make up for about 10-12 per cent of the total FII inflows, as against over 50 per cent at the peak of stock market bull run in 2007. Total investment through ODIs stood at Rs 2.2 lakh crore at the end of March 2016.
While Sebi (Securities and Exchange Board of India) has been of the view that the regulations have already been strengthened to check any misuse of this route for money laundering like activities, it decided to put in place additional safeguards as suggested by the SIT.
The SIT last year had suggested that Sebi should further strengthen its norms to keep a tab on beneficial ownership of P-Notes as these are widely used by foreign investors and could be prone to misuse.
Under the existing norms, an ODI subscriber cannot be a resident in a country with an inadequate framework for compliance to the global standards for Anti-Money Laundering or Combating the Financing of Terrorism Regulations.
Besides, ODI subscribers are not permitted to have an Opaque Structure -- meaning any structure such as protected cell company, segregated cell company or equivalent, where the details of the ultimate beneficial owners are not accessible.
Sebi said its Board noted that in view of strict norms for ODI issuance, the notional value of ODIs to the Asset Under Control of FPIs has declined over the years from a high of 55.7 per cent in June 2007 to 10 per cent in March 2016.
However, the concerns raised by the SIT with regard to identification of Beneficial Owners and transferability of ODIs were also discussed and the Board approved additional measures for the purpose of enhancing the transparency and control over the issuance of ODIs.
In order to bring about an uniformity in the KYC/AML norms, it has been decided that Indian norms will now be applicable to all ODI issuers. These norms will be the same as that applicable for all other domestic investors.
Also, ODI Issuers will be required to identify and verify the beneficial owners in the subscriber entities, who hold in excess of the applicable threshold -- 25 per cent in case of a company and 15 per cent in case of partnership firms, trusts or unincorporated bodies.
As per existing regulations, ODI subscribers are not required to take prior permission of the issuer for transfer of ODIs to another investor offshore.
In order to tighten the ODI regime and have more control over issuance and transfer of ODIs, it has been decided that the ODI subscribers will have to seek prior permission of the original ODI issuer for further or onward issuance, as also for transfer of ODIs.
On reporting of complete transfer trail of ODIs, Sebi said the details of the holder of ODIs have to be mandatorily reported to SEBI on a monthly basis at present.
The Board today decided that in the monthly reports on ODIs all the intermediate transfers during the month would also be required to be reported.
On KYC review, Sebi said it needs to be done on the basis of the risk criteria -- at the time of on-boarding and once every three years for low-risk clients and at the time of on-boarding and every year for all other clients.
On filing of Suspicious Transactions Reports (STRs), Sebi said ODI Issuers would need to file suspicious transaction reports, if any, with the Indian Financial Intelligence Unit (FIU), in relation to the ODIs issued by them.
On periodic operational evaluation, Sebi said ODI Issuers would need to put in place necessary systems and carry out a periodical review and evaluation of its controls, systems and procedures with respect to the ODIs.
The changes have been finalised after discussing with concerned stakeholders including some major issuers of P-Notes and they have broadly agreed to the suggested measures in the interest of the markets.
Officials said the norms have been very robust to check any misuse of P-Notes and the proposed changes might not affect the flow of funds in a big way as they are mostly procedural in nature and do not drastically change the regulatory framework.
As of March 31, 2016, as many as 37 foreign portfolio investors (FPIs) reported outstanding ODIs, out of which the top 10 accounted for 73 per cent share. The biggest FPIs in this regard included arms of Morgan Stanley, Copthall Mauritius Investments, Goldman Sachs, Credit Suisse, HSBC, Merrill Lynch, Citigroup, Swiss Financial Corp and JPMorgan.
While Sebi has been of the view that the regulations have
already been strengthened to check any misuse of this route for money-laundering like activities, it has decided to put in place additional safeguards as suggested by the SIT.
The regulator has put in place six specific changes to the KYC (Know Your Client) norms and transferability of ODIs in this regard.
The foreign investors, however, said that increasing the KYC-related requirements as such would not effectively curtail any market conduct violations.
Recently, Sebi Chairman U K Sinha had said strong measures have been put in place to check any misdemeanors including misuse of P-Notes, as he sought to put to rest concerns that these instruments were misused to bring back black money into the country.
He had said sufficient safeguards have been put in place to check any possible gaps and Sebi is now in a position to identify and check details of beneficiary owners of such funds to the second, third and even fourth levels.
In case of any irregularities, Sebi can take penal action and also share the details with the tax department and other authorities for further action on their part.
Earlier it was difficult to identify the end-users of such instruments, but since 2014 Sebi has limited the rights for who can subscribe to these instruments to only two of the three classes of Foreign Portfolio Investors. These are sovereign funds and regulated entities, while others are already debarred others from using P-Notes.
"It has been said that PNs are a big source for bringing black money into the country. Prior to 2011, we did not know who were subscribers of P-Notes and who were the subsequent beneficiary owners. Now, by regulations, every month Sebi is getting the information who are the latest beneficiary owners of the P-Notes," Sinha had said in an interaction.
Earlier in 2011, Sebi had introduced comprehensive reporting framework for ODI issuers, whereby ODI issuers are required to provide reports on monthly basis in a prescribed format containing detailed information pertaining to their ODI activities such as name and jurisdiction of the end beneficial owner, details of underlying trade in the Indian market, etc.
With the new Foreign Portfolio Investors (FPI) Regulations introduced in 2014, ODIs can be issued by or subscribed to only by appropriately regulated entities.
An entity is said to be regulated by an appropriate foreign regulatory authority if it is regulated or supervised by the securities market regulator or the banking regulator of the concerned foreign jurisdiction, in the same capacity in which it proposes to make investments in India.
For example, Category III FPIs (such as Endowments, Charitable Societies/ Trust, Foundations, Corporate Bodies, Trusts, Individuals, Family Offices) or sections of Category II FPIs (unregulated broad based funds, which are classified as Category II FPI by virtue of their investment manager being appropriately regulated) are not permitted to issue or to subscribe to ODIs.