Tighter P-note KYC? but Sebi rules anyway demand that of FIIs

Santosh Nairmoneycontrol.comLeading business dailies and television channels today have reported that the Securities and Exchange Board of India may tighten participatory notes (P-notes or PNs) rules in a bid to make them less attractive for foreign investors looking to invest in India through this instrument.PNs are derivative instruments issued by FIIs to foreign clients who want to invest in Indian securities, but do not want to register with SEBI, for reasons perfectly legitimate or even dubious. The underlying asset could be shares, derivatives or debentures.According to the reports, the way SEBI plans to do this is by asking for increased disclosures from the FII client to whom the PNs have been issued, and curbs on transfer of the PNs by one client to another client. Interestingly, current SEBI rules on PNs already specify these.This what existing Sebi regulations say on disclosures relating to P-notesRegulation 15A as on February 3, 2004:  A Foreign Institutional Investor or sub account may issue, deal in or hold, off-shore derivative instruments such as Participatory Notes, Equity Linked Notes or any other similar instruments against underlying securities, listed or proposed to be listed on any stock exchange in India, only in favour of those entities which are regulated by any relevant regulatory authority in the countries of their incorporation or establishment, subject to compliance of "know your client" requirement: (emphasis supplied) ……….. Regulation 15A as on May 22, 2008: “(1) No foreign institutional investor may issue, or otherwise deal in offshore derivative instruments, directly or indirectly, unless the following conditions are satisfied: (a) such offshore derivative instruments are issued only to persons who are regulated by an appropriate foreign regulatory authority; (b) such offshore derivative instruments are issued after compliance with ‘know your client’ norms: (emphasis supplied)"Also, in case client A holding the PNs onward issues them to another client B as a back to back instrument, SEBI rules require the FIIs (which issued the PNs) to provide the information about the regulated status of the new entity to whom the ODIs have been issued including the jurisdiction, the regulator with whom the entity is regulated.In addition, SEBI rules are clear if the PNs are onward issued to another client, the responsibility for identifying and the accountability for reporting the end beneficial owners rests entirely with the issuer, the FII. The onward issuances--one or more--of PNs are done to create a layer to shield the actual beneficiary from the regulator's glare. FIIs are bound to disclose the details of P-note issuances to SEBI whenever asked to.Regulation 20A of FII regulations states that : “Foreign Institutional Investors shall fully disclose information concerning the terms of and parties to off-shore derivative instruments such as Participatory Notes, Equity Linked Notes or any other such instruments, by whatever names they are called, entered into by it or its sub-accounts or affiliates relating to any securities listed or proposed to be listed in any stock exchange in India, as and when and in such form as the Board may require.”The rules are already in place, but enforcing it is the biggest challenge for the regulator, given the magnitude of the foreign funds coming in through the P-note route.At presently, rough USD 30 billion of FII holdings are through the P-note route. It is near impossible for SEBI to keep track of every entity to which P-notes are issued. Still the regulator has detected violations in the past and taken action.In 2009-10, SEBI pulled up FIIs Barclays and Socgen for misreporting the identity of the clients to which P-notes were issued.Barclays initially claimed that the PNs were issued to UBS. On questioning by SEBI, Barclays admitted that it had not issued the PNs to UBS, but to Hythe Securities, which then onward issued it to another entity by the name of Pluri.In the case relating to Socgen, the FII had issued PNs to Hythe Securities, which then reissued them to Opportunite S.A and then to Pluri. Socgen was unable to provide the details about Opportunite and Pluri.Both Barclays and Socgen were banned from issuing PNs for a brief while and the ban was reversed a year later.