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P-Note policy faces existential questions

The saga of Indian securities laws regulating offshore derivative instruments (popularly called “participatory notes” or “P-Notes”) has just had a new chapter. The Securities Appellate Tribunal (“SAT”) has ruled that the Securities and Exchange Board of India (“Sebi”) was wrong in insisting that foreign institutional investors (“FIIs”) should furnish an undertaking that they have not issued P-Notes to certain select types of persons.

A quick look at the law regulating FIIs would be useful. FIIs are persons resident outside India who, once registered with Sebi, enjoy a right to freely buy and sell securities on Indian stock exchanges, and to freely remit funds into and outside India for such trading.

P-Notes are instruments issued contractually by FIIs to third parties reflecting a right to participate in the economic benefits of price movements and corporate actions in 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 would get to enjoy the economic benefits of underlying Indian securities without having to hold legal title to the actual underlying securities and without having to wield the attendant voting power. In 2003, Sebi issued a circular that required FIIs to report details of the P-Note holders every fortnight in a specified format. The format had an undertaking that would confirm that the FII had not contracted any P-Note “directly or indirectly” with Indian residents, non-resident Indians (“NRIs”), persons of Indian origin and overseas corporate bodies (entities in which NRIs hold at least 60 per cent beneficial interest).

The Sebi circular was issued under the Sebi (Foreign Institutional Investors) Regulations, 1995 (“FII Regulations”). However, the FII Regulations prescribed no such prohibition. The provision in the FII Regulations under which the circular was issued, in fact, required FIIs to provide such information as may be sought by Sebi from time to time. An FII, in consultation with Sebi, qualified the undertaking by using the words “as far as we are aware”. So also, the undertaking excluded a reference to persons of Indian origin on the basis of an agreement reached with Sebi officials owing to difficulties faced in complying with the requirement.

However, subsequently, Sebi initiated adjudication proceedings and imposed a penalty of Rs 1 crore against the FII, which challenged the penalty. In appeal, the SAT has ruled that Sebi could not have insisted on such an undertaking confirming that P-Notes were not issued to specified persons, without any such prohibition having been prescribed in the FII Regulations. Moreover, from the evidence on record, it was apparent that Sebi officials had been sympathetic to the difficulties posed by the sweeping circular and had permitted the FII to modify the undertaking, and yet Sebi had gone on to penalise the FII.

The latest decision from the SAT is yet another pointer to the pervasive ambiguity that the legal framework governing P-Notes is riddled with. Numerous fundamental concepts have remained undefined, and several prohibitions and policy positions have been developed within Sebi files, without the law actually containing requisite provisions (See Without Contempt – editions dated March 31, 2008, October 22, 2007).

An earlier bench of the SAT had set aside an order passed by Sebi charging an FII with failure to comply with “know your client” because the FII had been unable to confirm that no NRIs or persons of Indian origin were beneficially interested in any manner in any upward layer of shareholding in the P-Note counterparty entity. The FII Regulations had not required recording of such detailed data at such level. SEBI's position had been that the plain English meaning of the term “know your client” took care of this requirement.

Funnily, the very term “P-Note” or “offshore derivative instrument” remains undefined. Therefore, the very applicability of the regulatory edifice created by Sebi can be ambiguous depending on the nature of the instrument. For instance, an FII could well issue a P-Note without holding the underlying securities, if it does not care to hedge its exposure. Till date, there is no provision making it mandatory to issue P-Notes only against an underlying holding of Indian securities in the hands of the FII. It is completely unclear if the P-Note policy restrictions would affect such unhedged P-Notes.

While issuance of P-Notes against underlying holding in exchange-traded options and futures was banned by Sebi last year, there can obviously be no legitimate ban on a foreign person issuing P-Notes against holdings in Nifty futures ((Nifty is the National Stock Exchange's flagship index) that are traded on the Singapore Exchange. It would be foolhardy to believe that movements in the Nifty futures in Singapore would be insulated from impacting price movements in Indian securities. Therefore, the ban on derivatives-based P-Notes can become quite meaningless.

It is time to take an intense and hard look at the regulatory framework for P-Notes and ask some existential questions.

Source: Business Standard

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