Turn the screws on participatory notes

It was with a sense of déjà vu that one watched Finance Minister Arun Jaitley and junior minister Jayant Sinha go on television on Monday to calm the stock market after indices toppled over on fears of the government reining in participatory notes (PNs).

This is not the first time the government has had to scramble to “clarify” a possible regulatory change after markets resorted to a sell-off. The Double Taxation Avoidance Agreement with Mauritius has been at the centre of many such episodes. Even a mere hint of renegotiating the agreement has proved enough to send the market on a tailspin and push the government to a defensive corner.

A SEBI discussion paper in October 2007 proposing to place curbs on PNs elicited a similar reaction from the market forcing the government to backtrack.

To be sure, such “action-reaction” episodes between the government and the markets are not abnormal; there is nothing wrong in the government reacting to the market. Yet it is not healthy to capitulate time and again over important regulatory suggestions that are aimed at cleaning up the system. The markets do not always know best; certainly not when it comes to matters that require greater disclosure from its participants.

Monday’s protest sell-off was triggered by suggestions from the Supreme Court-appointed Special Investigation Team (SIT) on black money that the Securities and Exchange Board of India should obtain information on the final beneficial owners of PNs and that only those who fulfil SEBI’s KYC norms should be allowed to invest through this route.

The SIT has further suggested that PNs be made non-transferable, which will mean that they cannot be traded between investors.

What can possibly be wrong with these suggestions? The first one is meant to ensure that regulators know complete details of the PN investor. Remember, even the smallest of small domestic retail investors is required to fulfil KYC norms before she can invest in shares.

A genuine investor who is not investing ill-gotten funds should have no problem identifying himself or itself. And again, it is those trying to launder illegally acquired money who will be reluctant to reveal their identity.

The second suggestion on making PNs non-transferable is to ensure that the real investor does not conceal himself behind a maze of transactions.

A genuine investor wanting to invest through PNs should buy them from a registered foreign portfolio investor and not from another PN holder. This is a sensible suggestion and there can be little grounds to dispute it.

But what are the arguments against the SIT’s suggestions and in favour of PNs? The first and most important one is that PNs are a convenient instrument for those who invest with a short-term horizon and are, therefore, not interested in going through the registration process with SEBI.

These are typically hedge funds that have rapid entry and exit strategies from markets. Though these may be genuine investors, do we need such hot capital flows, especially when we don’t know who the owners of such funds are? The answer is: no.

The second argument is that PNs account for just 11 per cent of total foreign portfolio investment in the country and therefore they are insignificant.

Yet, as of June 2015, PN investment accounted for as much as ₹2,75,436 crore. This is a seven-year high — the last time that we had a higher amounted invested through PNs was in February 2008 when it was ₹3,22,743 crore. And the plain fact is that ₹2,75,436 crore — $43 billion — is a lot of money. So what’s wrong if the government wants to know the real identity of the investors and the provenance of the funds being invested?

The third argument is that SEBI has already tightened its regulations on PNs such that they can be issued only to entities that are regulated in their respective countries and are KYC compliant there. The foreign portfolio investor issuing PNs also has to declare that it has not issued them to Indian residents or NRIs.

Further, the FPI also has to submit a monthly report to SEBI that lists out the PN subscribers along with details of the underlying share. The SIT, however, is of the view these have not proved good enough to get details of the ultimate beneficial owners.

SEBI had tightened its rules governing PNs after the case of Societe Generale and Barclays Bank in 2009. These banks were hauled up for wrongly declaring the beneficial owners of the PNs that they issued. Investigations by Britain’s Financial Services Authority in the infamous UBS case in 2011 revealed that PNs were issued to an entity called Pleuri, whose beneficial owner was found to be the Anil Ambani group. The underlying security for the PNs was shares of Reliance Communications.

That brings us to why PNs need to be tightly regulated. By their very nature, PNs are an attractive vehicle for those who wish to invest while remaining anonymous; such anonymity cannot be for legal or justifiable reasons.

They can be used not just for money laundering but also by businessmen to rig prices of their own shares, as we have seen in the past. Worse, they are convenient instruments for routing terrorist funds into the country. A terrorist using Indian markets to multiply his funds and then using the same funds to unleash violence in India — can it get worse than that?

And now to the final argument from those opposing further PN regulation: that it will drive investors away from India.

Nothing can be farther from the truth. Genuine investors can and will invest through the FPI route by registering themselves with SEBI. Money will seek out markets with returns just as surely as rivers seek out the sea, come what may in their path.

And India is one of the very few markets in the world today that offer the promise of excellent returns over the long term.

The dubious investors will, of course, run away when SEBI tightens the rules, which is the objective of regulating PNs anyway.

The government should, therefore, ignore protests from the market and take the SIT’s suggestions seriously to stop misuse of the PN route.