Conduits of this illegal money flow are lying low, hitting market liquidity.
Fear of a regulatory crackdown on illegal investments by promoters in stocks of their own companies through the Foreign Institutional Investors (FII) framework has gripped the market and led to losses in the latest sell-off, say market participants. “The conduits and vehicles used in the repatriation of promoter money are lying low. They are not buying and are keeping a low profile. This is taking away liquidity from the market,” said a senior official with an institutional brokerage. He requested anonymity since the issue is sensitive.
Such fears have been accentuated by a report on Friday in the Financial Times that quoted an unnamed Indian investor to say that at least 25 Indian businessmen used controversial investment vehicles to repatriate money from abroad to Indian stock markets. However, on the same day, speaking at an event in Bangalore, UK Sinha, chairman, Securities and Exchange Board of India (Sebi), said, “There is a belief or suspicion that a lot of Indian money might be coming through that (p-note) route. I would like to clarify the position that a very strong KYC (know your customer) is done whenever any participatory note is issued.”
According to data from Sebi, participatory notes account for 17.6 per cent or a little over a sixth of total FII investments in India. As of October 2011, the latest data available, total value of PNs stood at Rs 1.8 lakh crore.
However, since the revelation of Indian promoters using illegal investment routes, FIIs have turned net sellers in Indian markets. In each of the 10 sessions after a trial involving private bankers in a UK tribunal on December 12, they have been found to be net sellers. Even on days, when Sensex closed with gains, they sold more stocks than they bought. For example, on Wednesday (Dec 21) and Thursday (Dec 22), when the index gained 510 points and 128 points, the FIIs were net sellers for Rs 434 crore and Rs 37.10 crore. In the 10 sessions of trading they have sold stocks worth Rs 2,487 crore. This is in sharp contrast to the first six trading sessions of December, when the overseas investors bought Rs 2,243 crore worth of shares, net of selling.
This has added to the slowdown fears and a depreciating rupee which are already making some foreign brokerage analysts see 11,000 levels on the Sensex. For many years, it was a whisper in the Street. In the broking circles though, it was an open secret. But, not many knew how the big boys really pulled it off. Those who knew did not speak. The past couple of weeks have changed all that. The modus-operandi of the fabled promoter-FII-broker nexus has been laid bare in London following court room revelations and orders by the UK financial sector regulator Financial Services Authority (FSA).
Saurabh Mukherjea of Ambit Capital said, “FII money comes in different shades. The regulatory awareness of the darker shades of this money seems to be growing now.” A final notice issued by FSA against an alleged offender last week has clearly laid down how the p-note was exploited by Indian promoters.
It is all official now: participatory notes (p-note) were the preferred instruments, protected cell companies were the vehicles and Mauritius was the entry point. According to the FSA notice, “The customer in question consisted of a large group of Indian companies (Customer A) headed by a wealthy Indian individual.”
According to the FSA, a fund was set up in Mauritius using a fund manager based in France with whom wealth management officials had had prior dealings. The fund was established as a Protected Cell Company (PCC).
A PCC is a single legal entity comprising a series of self-contained cells. This structure allowed an investor to invest in a particular cell, the assets and liabilities of which were ring fenced from the rest of the company.
The wealth management officials arranged for the fund manager to create a new cell in the fund for investment by the Indian customer. Customer A wanted to invest in an Indian company within its own group.
Thus, an indirect investment route was created to circumvent FII regulations, which prohibited Indian nationals and companies from using FII vehicles to invest in India.
The structure is arranged so that it would appear that it was the fund manager who was directing cell’s investments.
But in fact, the fund manager’s role was merely to execute the instructions of Customer A. These instructions are passed on to the fund manager through the wealth management officials. In accordance with those instructions, the cell invested in Indian-listed equities and derivatives of the Indian company in Customer A’s group of companies, which is listed on an Indian stock exchange.
Ajay Pandey, vice president, institutional sales, ITI Securities, said, “Many big corporates use this channel. In many cases, it is common knowledge in the Street that a certain portion of the FIIs holding in a company’s official shareholding is indirect holding by promoters through these channels.” According to him, this was often done to boost the image of the company as having strong fundamentals that it has attracted “FII interest.”
Pandey said even the government authorities were well aware of these channels. “After all, they are the ones who have created the Mauritius channel.”
It is not easy to close down the Mauritius route since it has implications beyond the financial world. An official with one of the custodians, who handle stocks bought by FIIs, said, “Government agencies are aware of the misuse of the Mauritius route. But they can’t shut it overnight for strategic reasons. Indian influence over Mauritius is important because it is our key base on the Indian Ocean.”
