Collecting Know Your Client (KYC) details of the ‘ultimate beneficiary’ of participatory note (P-note) holders, and not the middle entities that have been issued these contracts, will be key to checking the flow of black money in India’s stock market, say experts.
Legal and equity experts say P-notes go through multiple downward issuances, once issued by a foreign institutional investor (FII), making it difficult to track the ultimate holder, and thereby provide a perfect smoke-screen for routing black money.
A white paper on black money tabled in Parliament on Monday by Finance Minister Pranab Mukherjee says ultimate beneficiaries of P-notes could be Indians and the source of investments may be black money. The white paper suggests KYC norms for P-notes should be implemented. However, experts feel the ambiguity surrounding these norms should be clarified first.
“The idea to track black money coming through P-notes may not be foolproof unless KYC of ultimate beneficiary is done by an FII, which issues these instruments,” said Deven Choksey, managing director of one of Mumbai’s oldest broking firm, K R Choksey Shares and Securities.
P-notes have been under the tax department’s scanner for their opaque nature. Efforts by the Securities and Exchange Board of India (Sebi) to acquire details of ultimate holders of these instruments have not yielded any results. However, they play an important role in Indian markets as FIIs continue to hold over Rs 1.65 lakh crore of their overall Rs 11 lakh crore investment, through these instruments. Any panic selling by P-note holders can cause a huge impact on stocks as trading volumes or market depth is shallow.
Moreover, today’s white paper mentions jurisdiction over persons to whom P-notes were issued are from known tax havens like the Cayman Islands, British Virgin Island, Switzerland and Luxembourg, among others.
According to current regulations, the onus of knowing the ultimate beneficiary of P-notes is on FIIs and they should not issue it to prohibited entities. However, there have been instances where FIIs have failed in this as they cannot bind other entities under a contract to re-issue P-notes and keep a check on further issuances. It is this multiple downward issuance that renders the KYC of a mere middle entity a worthless exercise.
“In case of P-notes, KYC cannot be made any more effective than it already is,” says Sandeep Parekh, former executive director at Sebi and currently a partner with Mumbai-based Finsec Law Advisors. He says it is difficult for an FII to make a third party implement an Indian law when it issues the P-note to another party, which in turn may issue it to a fourth or fifth player.
In such a scenario, if the government or Sebi cannot track down the ultimate beneficiary of the P-note, the whole purpose of KYC is defeated. Sebi’s earlier actions against UBS Securities, Société Générale and Barclays were based on such non-compliances. UBS was unable to provide information on the top five shareholders of P-note purchasers in the chain of downward issuances.
As a result, a Sebi circular issued in January 2011, required FIIs to give an undertaking that the beneficial owner and purchaser of offshore derivative instruments are regulated entities and KYC norms have been followed for the ultimate owner.
Although, FIIs may obtain such an undertaking from the first P-note purchaser, they have no tools to ensure downward issuances would be subject to similar compliances.
“The KYC norms should be prescribed with clarity and practicality. Punishing a gun seller for his inability to stop murders done by his licensed client may not be the best of ideas,” said Parekh.
P-notes can be issued to only regulated entities, which are registered and regulated by a foreign securities/futures regulator or a person regulated and licensed by a foreign central bank.
