New regulations by Sebi reflect greater maturity

LEGAL EYE

The clamp down on participatory notes (PN) does not appear to have prejudicially impacted the Indian capital markets. India is regarded a safer market than most developing nations. While foreign institutional investors' (FII's) advantage lies in increasing non-debt creating inflows, the potential danger lies in its speculative nature, which can destabilise the economy on sudden withdrawal. In order to regulate inflows, its important to identify the sensitivities and devise measures which can be enforced without disruption.

Indian regulators are primarily the Securiites and Exchange Board of India (Sebi) and the RBI who have identified national security, money laundering, ownership and control as the key concerns. Most regulations, including the recent policy decisions on PN exit seem to focus mostly on double tripping by OCBs, NRIs and PIOs.

The Sebi requires FIIs to register and obtain a licence for its activities. FIIs are permitted to operate through sub-accounts, also registrable. Recently, the single investor limit for broadbased FIIs whether operating through sub-accounts or otherwise has been hiked from 10 per cent to 49 per cent of the company's paid-up capital.

The FII Regulations defines 'sub-account' to include foreign corporates individuals, institutions established or located outside India, on whose behalf the FII invests in India except any company or other entity owned directly or indirectly up to sixty per cent by non-resident Indians (NRI). An NRI is an Indian citizen residing outside India or a Person of Indian Origin' (PIO), that is person having Indian grandparent(s) or former passport holders.

In the event a sub-account is registered in the name of NRI, it would render the FII liable for punitive action. Any FII who fails to comply with any conditions attached to its certificate or contravenes any other provisions thereof, is liable to be dealt with under the Sebi (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty), 2002. If such sub-account is established inadvertently, but not intentionally, that factor maybe taken into account in mitigation.

If the violation is deliberate, then a more rigid view is taken. The FII's custodial services are provided at global and domestic levels. The key person liable under the Sebi (FII) Regulations is the domestic custodian. The FII or the global custodian has to enter into an agreement with the domestic custodian, who holds a certificate of registration for providing such services, under The Sebi (Custodian of Securities) Regulations, 1996 ("Custodian Regulation").

For availing custodial services in India, it's the FII's responsibility to ensure that such custodian duly monitors investments, maintains records and reports to Sebi, as required.

A custodian's role is similar to an FII, but limited to monitoring and reporting. The custodian cannot make decisions on the FII's behalf in relation to purchase or sale of securities. If the client is in breach of any compliance obligations under the FII regulations, the custodian would normally not be liable unless it is party to the client's act.

The Prevention of Money Laundering Act, ("PMLA"), requires every intermediary to maintain record of all transactions of substantial value. Such transactions include single transactions or a series of interconnected ones, occurring within a short time span. The intermediary is registered under Section 12 of the Sebi Act, which considers both custodians of securities and FIIs as intermediaries.

The intermediary has to maintain and verify the records of its clients' identities and furnish information to Sebi periodically. "PML"Rules require records to be maintained of all cash transactions or suspect ones, particularly cashier cheques, demand drafts and pay orders.

Sebi has also promulgated "Guidelines for Anti-Money Laundering Measures" (GAMLM) requiring registered intermediaries to adopt stringent due diligence measures.

Under GAMLM, every registered intermediary is required to adopt written procedures to implement a "Client Due Diligence Process" and verify the customers identity using reliable, independent source information. Exercising a higher degree of due diligence in case of NRI and high-net worth clientele classified as highest in terms of risk factors regular update of their profile. That the existing regulations are inadequate is established by the phenomenal increase in PNs and derivatives. It is acknowledged that most sub-accounts were carrying on only business for PN holders, and Sebi's final decision to delay a regime of KYC/AML/CFT certification on foreign entities, as well as the 18-month moratorium combined with the conversion offers to sub-accounts is a graceful exit/conversion to FIIs. This will definitely improve market health, if followed up by speedy registration. Sebi's dilution of its initial knee jerk reaction reflects maturity.

Kumkum Sen is a Partner at Rajinder Narain & Co, and can be reached at kumkumsen@rnclegal.com