Participatory Notes and Disclosure Requirements

In an earlier post, we had discussed the decision of the Securities Appellate Tribunal (SAT) setting aside a SEBI order that imposed a penalty of Rs. 1 crore on an FII for giving a false declaration regarding its issuance of participatory notes. Our guest contributor, Somasekhar Sundaresan, has written a column in The Business Standard analysing this decision. Of particular relevance are the implications of the decision on participatory notes in general. He states:

“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.”

About the author

Umakanth Varottil

Umakanth Varottil is an Associate Professor at the Faculty of Law, National University of Singapore. He specializes in corporate law and governance, mergers and acquisitions and cross-border investments. Prior to his foray into academia, Umakanth was a partner at a pre-eminent law firm in India.

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