Participatory Notes

[The following guest post is contributed by Rishi A, a
fourth year student of Hidayatullah National Law University]
The Supreme Court appointed Special
Investigations Team (“SIT”), in its report on how best to curb black money,
made a number of recommendations. One of these was to check the misuse of participatory
notes (“p-notes”). When the markets opened on the following Monday, the fear
caused by the possible government action on investments through p-notes saw the
Indian stock markets decline by 2%.
The Securities and Exchange Board of
India (“SEBI”) had permitted the issuance of p-notes in 1992, following the ‘balance of payments’ crisis in 1991, to
encourage foreign investments. P-notes are instruments used by foreign funds,
not registered in India, for trading in the domestic market. Issued by Foreign
Institutional Investors (FIIs), they are a derivative instrument issued against
an underlying security which permits the holder to share in the capital
appreciation/income from the underlying security. As an Expert
Group has noted
, p-notes are like contract notes, issued to their overseas
clients who may not be eligible to invest in the Indian stock markets. At
last count
, Rs. 2.75 lakh crore came in through p-notes, representing
around 11.5% of the total assets held by foreign portfolio investors.
is believed
that p-notes generally attract four kinds of investors, (1)
ones who are looking for attractive returns, (2) foreign governments/entities
who want to invest to acquire/control Indian entities by taking them over, (3)
terror financiers, and (4) people, including politicians, trying to generate
profits by investing their black money in these instruments. While the first
two types could encourage/ stimulate a healthy market, the other two kinds are
the ones that need to be curbed.
Regulatory Approach to P-Notes
The Reserve Bank of India (“RBI”) has always been against the
idea of p-notes. Raising the concern of the hidden identities of the investors,
it feared that further trading of p-notes will lead to ‘multi-layering’ and therefore, it would become impossible to tell
who the actual beneficiary is of the investment. Once, a p-note is acquired by
a foreign investor from an FII, it gets re-bought/re-sold by various other
foreign investors creating layers of beneficial owners. This is also commonly
referred to as the problem of ‘multi-layering’.
Believing that restrictions of suspicious flows would  enhance the reputation of markets and lead to
healthy flows, the RBI has stated over and over again, following the
recommendations made by the ‘Tarapore
that they should be banned.
However, SEBI has sought to place
stricter rules for p-notes on an ongoing basis, but has refused to shun it so
far. Initially, FIIs dealing in p-notes were required to submit an undertaking
stating that the offshore derivative instrument (“ODI”) issued to the person
and its beneficial owner were in compliance with Regulation 15A of SEBI
(Foreign Institutional Investors) Regulations, 1995. Regulation 15A
required that the FIIs issue these ODIs or p-notes only to ‘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’.
Thus, they also had to ensure that the
know-your-customer (“KYC”) compliance norms had been complied with by the
beneficial owner of the ODI.[1]
However, this requirement proved to be quite ineffective when considering the
number of times the p-note could change hands. The multi-layering caused by
these investments made identifying the actual/ final beneficial owner extremely
The regulations regarding the issuance of ODIs were subsequently
revamped, and henceforth, as per Regulation 22(4), any issuances of ODIs, like
p-notes, under the SEBI (FII) Regulations, 1995, before the commencement of
these set of regulations, would be deemed to have been issued as per the SEBI
(Foreign Portfolio Investors) Regulations, 2014
. These new norms restrict
certain categories of FPIs from investing in ODIs. They also place the burden
on the FPIs/ FIIs to make sure that the instruments are not sold to anyone who
is not regulated by an appropriate foreign regulatory authority.[2]Furthermore,
-notes cannot be issued by a resident
of a country identified by Financial Action Task Force as a ‘jurisdiction having a strategic Anti Money Laundering
or Combating the Financing of Terrorism deficiencies to which counter measures
SEBI also has all the powers to obtain
information regarding the final holder/beneficiaries or of any holder at any
point of time in case of any investigation or surveillance action. FPIs/ FIIs
will thus be obliged to provide the information to SEBI.[3]
Additionally, while stating that two or more p-note
subscribers with the same beneficiary would be considered as one subscriber, the
market regulator has also said that fund structures need to be transparent,
failing which they will not be allowed.
At this juncture, it will be interesting to point
out that SEBI later went on to clarify in their FAQs that the unregulated funds
under the FII regulations, which were no longer eligible under the FPI
regulations, could continue under the FPI regime.[4] Had SEBI refused to let
these unregulated funds continue, it would have resulted in a large withdrawal
of investments from the market, which could have possibly led to a market
crash. Regulation 15A of the FII regulations states that any entity, who has
already been issued an ODI, prior to February 3, 2004, but does not meet the
eligibility criteria under clause (1), the contracts for such transaction would
expire on the maturity of the transaction or within a period of five years
fromFebruary 3, 2004, whichever is earlier.[5] This would mean that all
unregulated funds, to transact in the future, would have to fulfil the KYC
requirements laid down.
The SIT Report
The Third SIT report suggested that
all details of the ‘beneficial owner’
must be disclosed in accordance with the KYC norms. Thus, in case the p-notes
change hands, SEBI can still identify the ‘final
beneficial owner’
. And if these final beneficial owners end up being a
company, then the details or information of its promoters/ directors must be
obtained. It went on to further recommend that to avoid multi-layering the
regulator should establish norms that will encourage investors to purchase
p–notes issues afresh, instead of buying them from an existing owner.[6]
The SIT strongly
suggested that the Securities and Exchange Board of India
(SEBI) put in place more stringent regulations to help identify individuals
holding p-notes or other ODIs, and take other steps required to curb black
money and tax evasion through the stock market route.
P-note holders find it conducive to
side-step the capital gains tax (CGT) that is normally levied on the sales of
any stocks/ securities on the stock exchange. In practice, p-notes are just
taxed once, that is when they are finally sold from the FIIs account, but the
numerous times that the p-notes may change hands in the middle, escapes getting
Moreover, when considering capital
inflows, due to the above stated provisions of the SEBI (FPI) Regulations,
2014, they could see a large dip as most offshore investors who would want to
invest in p-notes in India may no longer wish to do so for reasons such as not
being incorporated in a jurisdiction recognised by SEBI. This could affect the
investments made in p-notes. While, this might sound like a desirable
phenomenon, it is important to keep in mind that majority of foreign portfolio
investments in India are made in ODIs or p-notes.[7]
It is estimated
that the notional value of p-notes is somewhere around $90 billion.
In the author’s opinion what must be
considered instead, is to, firstly, place stricter regulations regarding the
information to be disclosed, via KYC Compliance norms, by not just the
FIIs/FPIs but also the investors purchasing the p-notes, so that identities can
be easily established when needed. The 2004 amendment in the FII regulations
placed a compulsory maturity period of 5 years: this would effectively stop the
issuance of ODIs/ p-notes to entities who have not complied with the KYC norms
as provided for by clause (1) of Regulation 15A.[8]Therefore,
this could prove to be a step towards transparency as now clients/ entities
would have to disclose their identity and other information, to further transact
in the future. Also, like stated by the SIT, SEBI must consider making p-notes
more available for direct purchase, so that the inter-changing of the notes
between people can be stopped. If the above stated recommendation can be
implemented, then the issue of tax evasion would diminish, but in the chance
that it is not, taxation will remain an issue. SEBI must consider implementing
measures that will stop ‘cross-cutting’ that
allows people to take their black money outside the country and subsequently,
reinvest the same amount in p-notes. This will also require some heavy
restrictions on ‘hawala’.
Secondly, with regard to RBI’s
opinion to ban P-notes outright can prove to be harmful for the Indian market.
In a market where 50% of the foreign institutional investment is through
p-notes, any ‘knee-jerk’ reaction
like a ban of the instrument, can spook the foreign investors and thus poses a
huge systemic risk. An investor in that case, would immediately withdraw their
investment made in the market, which could lead to the collapse of the entire
market. What must be considered instead is to slowly phase out p-notes and
simultaneously, provide other lucrative instruments, where regulation is not an
insurmountable issue as in the p-notes, for the investors to invest in? This
will provide an alternate avenue for the investors to invest their funds.­­­­
– Rishi A

[1] SEBI Circular CIR/IMD/FIIC/2011, January 17th, 2011, available at:
(July 28th, 2015)

[2] Regulation 22(2), SEBI (FPI) Regulations, 2014.

[3] Regulation 22(3), SEBI (FPI) Regulations, 2014.

[4] Q.70, Frequently Asked Questions (FAQs), SEBI (Foreign Portfolio
Investors) Regulations, 2014, available
(July 28th, 2015).

[5] Regulation 15A (1), SEBI (FII) (Amendment) Regulations, 2004.

[6]‘Recommendations of SIT on
Black Money as contained in the Third SIT Report,
Information Bureau, Ministry of Finance, Government of India, July 24th,
2015, available at:
(July 28th, 2015).

[7] Mohan, TT Ram. “Neither Dread Nor Encourage Them.”
Economic and Political Weekly (2006): 95-99.

[8] SEBI (FII) (Amendment) Regulations, 2004.

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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