Recent Measures to Curb ODI Abuse – Do They Represent an Equilibrium Point?

[The following guest post is contributed by Arka Saha, who is a 4th Year B.A.LL.B.
(Hons) & Executive Student in CS (ICSI) at National Law University Odisha
Offshore Derivative Instruments (ODIs) such as Participatory Notes (P-Notes)
and equity linked notes constitute a significant chunk of total investments by
Foreign Portfolio Investors in India, thus posing an imminent threat to market
stability by virtue of the volatile nature of such investments resulting in the
markets being susceptible to short term fund flows, and the issue of
indeterminate ownership structures. A detailed discussion pertaining to the
nature of these products and the issues inherent to them is contained here.
One major conundrum befuddling the market regulator pertaining to
such instruments is the problem of multi-layering, which leads to difficulty in
identification of beneficial owners of such instruments. This is a function essential
to prevent domestic stocks that serve as the underlying from being rigged by
unscrupulous investors routing monies illegally stashed abroad, and the
financing of terror activities. This challenge of indeterminate ownership was
further stressed upon by the Supreme Court appointed Committee on Black Money
in its third
, wherein the committee observed that more stringent norms needed to
be introduced to mitigate the ills of multilayering. In light of the report, the
Securities and Exchange Board of India (SEBI) in its board meeting
on 19 May 2016, approved measures in addition to those prescribed by the SEBI
(Foreign Portfolio Investors) Regulations, 2014
and the circular
dated November 24, 2014
to further regulate the issuance, holding, and
transferability of ODIs.
Recent Measures
SEBI, in its recent board meeting, decided to mandate Indian Know
Your Client (KYC)/Anti Money Laundering (AML) Norms to issuer entities, which to
date follow the KYC/AML norms of either the home jurisdiction of the entity, or
that of the end beneficial holder. This move is touted to bring in consistency
in the standards of scrutiny required prior to the issuance of ODIs. Issuer
entities will also be required to identify beneficial owners in subscribing
non-natural entities in concurrence with the thresholds posited in Rule 9 of
Prevention of Money Laundering (Maintenance of Records) Rules 2005, which
establishes that beneficial owners are those that have a controlling ownership
interest in the entity in question. Through these rules, controlling interest
has been defined to be a percentage holding of above 25% in case of companies
and 15% in case of unincorporated entities such as partnership firms, trusts
etc.  ODI issuers will have to
mandatorily identify and verify the person(s) who control the operations of
such entities. This stringent KYC procedure has to be undertaken at the time of
issuance of ODIs and reviewed at periodic intervals based on the risk criteria
as determined by the issuing entities. For low risk entities, KYC reviews are
mandated every three years as opposed to all other entities, for whom such
review has to occur every year.  Another
obligation placed on issuer entities is the reporting of all transactions in
ODIs issued in the course of a calendar month to the market regulator, which is
an improvement on the present norms, which mandate the reporting of only
holders at the end of each month. Through this move, SEBI will now receive
information pertaining to all intermediate transactions in ODIs in a calendar
month, thereby helping the regulator keep track of complete transfer trails.
Apart from these requirements placed on issuer entities, these
entities by virtue of acting as intermediaries, will also be required to file
‘suspicious transaction reports’ with the Indian Financial Intelligence Unit
(FIU-IND), in case of suspicious transactions pertaining to transfer of ODIs.[1]
Reconfirmation of ODI positions also have to be carried out bi-annually. The
press release following the board meeting further envisages the requirement of
the development of proper internal systems, and the obligation to review such
systems to ensure compliance with all requirements and obligations pertaining
to issuance of ODIs.  The most important
measure, in the opinion of the author, is the proposed restriction on transfers
of ODIs without prior permission and approval of the issuer entity, which is
obligated to approve transfers only to eligible investors as per all extant
Multiple onward transfers to offshore entities by holders of ODIs have always
been one of the most problematic features of ODIs, contributing to layers of
beneficial owners, which this measure is focused on curtailing.
Critics of ODIs believe that streamlining of the regime for
secondary market investments by portfolio investors through the FPI Regulations
has made the entry of ‘front door’ funds easier thus doing away with the need
for ODIs.[3]
However, there still exist numerous credible reasons for opting for the alternative
route to gain exposure to Indian stocks, such as avoiding access fees and other
transactional costs that are beyond the means of a  small genuine investor resident offshore, and
need-based structuring of ODIs that allows flexibility unafforded by investing
as an FPI or as a sub-account. In light of this, an equilibrium point is to be
arrived at, as the recent press release seeks to achieve, wherein the needs of
the genuine investor is not compromised to prevent unscrupulous activities by
way of these instruments. Although it is true that the recent measures will
make investments through ODIs more expensive both for the issuer due to a
projected rise in compliance costs, and (in turn) for the subscribers, it will
deter unlawful/illegal use of this route due to increase in transparency and
accountability in the process of issuance and transfer of ODIs.
– Arka Saha

[1]     ‘Suspicious transactions’
are to be determined in light of the Prevention of Money Laundering Act 2002
and rules made    thereunder. See SEBI
Circular (2008) available at

[2]     Investment in ODIs by
certain categories of investors who are not regulated by securities regulator
or banks of their respective jurisdictions in a similar capacity in which they
propose to make investments in India are barred by the FPI Regulations.
Further, by way of the circular dated November 24, 2014, SEBI restricted
companies that are residents of a jurisdiction that has been identified by the
Financial Action Task Force (FATF) as one having strategic Anti-Money
Laundering or Combating the Financing of Terrorism deficiencies or a
jurisdiction that has not made progress in addressing the said deficiencies, or
has not committed to an action plan developed in tandem with the FATF to
address the same, from investing in ODIs. Further, entities with opaque
structuring, wherein the identities of the beneficial owners are hard to be
ascertained, are further excluded from investing in P-Notes.

[3]     “Why are we insisting on the anonymity of
the investor and the sources? Why not have confidence in the India story and
realise that we can get funds with addresses since we have arrived on the
global arena?” asked R. Vaidyanathan in his article entitled “Why Participatory
Notes are Dangerous”. Available at

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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