Tighter Restrictions on Offshore Derivative Instruments

The issue of offshore derivative
instruments (ODIs) such as participatory notes (PNs) have been the subject
matter of regulatory controversy for some time now. These are instruments
issued by foreign institutional investors (FIIs) (now foreign portfolio investors
(FPIs)) to investors overseas that mimic the risks and rewards on underlying securities
held by the FIIs/FPIs in Indian companies. These instruments have caused
difficulties from a regulatory standpoint as they have been issued overseas
within limitations on the long-arm jurisdictions of SEBI. These issues have
been discussed in a previous
paper
.
Yesterday, SEBI issued a circular
that imposes significant restrictions on the issue of ODIs by FPIs. In a
measure intended to align the applicable eligibility and investment norms
between the FPI regime and the ODI route, SEBI has prescribed that an FPI can
issue ODIs only to subscribers that meet the eligibility requirements under the
SEBI (Foreign Portfolio Investor) Regulations, 2014. These eligibility criteria
include that fact that the applicant is resident in a country whose securities markets
comply with IOSCO requirements, or a bank falls within the framework of BIS. It
excludes investors from countries that have been shortlisted for failing to
comply with transparency requirements. Furthermore, FPIs are not allowed to
issue ODIs to subscribers that have opaque structures as defined in the FPI
Regulations.
The above circular effectively
curbs a fairly significant market for ODIs. Investors find reason to invest in
ODIs only if they otherwise do not wish to register themselves as FPIs and
invest directly into the Indian markets. One of the reasons why ODIs are
attractive is because of the relative opacity it offers. The risk accompanying ODIs
is that it may be misused for money-laundering and for round-tripping by Indian
investors. SEBI’s circular effectively curbs such activity and makes the ODI
process more transparent as only investors that qualify to register as FPIs would
be entitled to take up ODIs. In other words, SEBI has in one fell swoop
eliminated the regulatory arbitrage that was available to foreign investors who
wish to remain opaque. This is indeed a welcome move from the perspective of
transparency. It also puts a significant onus on FPIs to ensure they issue ODIs
only to qualifying investors, which might mean tightening of the KYC norms.
There has been some tightening on
other incidental aspects as well. For instance, ODIs will be counted (in
terms of beneficial ownership) for determining the maximum limits for
investment by FPIs in Indian companies. It would not be possible to circumvent
the investment limits through indirect routes such as participation in ODIs.
This measure might likely result in
a significant reduction in the use of the ODI structure. This is relevant given
the substantial
increase
in ODI activity in recent times. While this may affect investment
flows in the short run, SEBI’s approach is necessary and timely from a
regulatory perspective.

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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