SEBI Order on Participatory Notes

Just when it appeared that the din surrounding offshore derivative instruments (ODIs) and participatory notes (PNs) had subsided, the significance of regulating these instruments has resurfaced in an order passed by SEBI yesterday in the case of Barclays Bank PLC, a foreign institutional investor (FII) registered with SEBI. By this order, Barclays has been prohibited from issuing, subscribing or otherwise transacting in any ODIs until reporting systems are put in place to the satisfaction of SEBI. The order seems to rest on two principal grounds.

First, under the SEBI (Foreign Institutional Investors) Regulations (Reg. 20A) as well as certain notifications issued by SEBI, FIIs are required to comply with certain disclosure obligations in respect of ODIs issued by them in respect of underlying Indian shares. In its present order, SEBI states that Barclays had failed to properly report certain ODI transactions. For example, it was found that the counterparty to certain transactions was not UBS AG as earlier reported by Barclays, but it was Hythe Securities Limited.

Second, Reg. 15A of the SEBI FII Regulations provides that ODIs can be issued only to “persons who are regulated by an appropriate foreign regulatory authority”. Even further downstream issuances of ODIs can be made only to such regulated entities. It is SEBI’s case that the ODIs issued by Barclays to Hythe Securities Limited were subsequently issued to an entity named Pluri, prima facie in contravention of this requirement.

While this order also doubles up as a show cause notice providing further opportunity to Barclays to reply, and in that sense is somewhat preliminary in nature, it makes some pertinent observations about the policy reasons for regulation (through disclosure) of such ODI transactions:

… Full and fair disclosure forms the cornerstone of FII regulation by SEBI. As the source of funds available with an FII comes from offshore, by its very nature SEBI has no direct access to verifying the nature of the funds or whether the funds will be misused for the purpose of the market manipulation or for perpetrating any type of fraud in the market. The very essence of the amendments to the FII regulations in Regulations 15A and 20A reflects this pressing regulatory concern on the part of SEBI. In other words, SEBI places almost absolute faith and unqualified reliance on the ability of an FII to carry out the basic regulatory and prudential oversight. Once this faith is violated and the integrity of the process vitiated, then FII inflows can potentially become conduits for large scale manipulation and fraud in the market. Therefore, SEBI as a regulator requires fair, true and correct information for assessing and monitoring FII activity in the securities market. When a registration is granted to an FII, SEBI presupposes that the FII has the capacity to exercise necessary oversight and ensure the integrity and accuracy of the data it provides to SEBI under the regulations applicable. …

Due to the extra-territorial nature of ODIs (as offshore instruments) and the consequent inability of SEBI to directly regulate them, it appears to place tremendous reliance on disclosures by the FIIs (who are amenable to SEBI’s jurisdiction), and hence breaches of disclosure obligations are take seriously. Whether this strategy will be effective is open to debate, but if past track record is anything to go by there is little cause for optimism.

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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