[Tushar Oberoy and Rishabh Sharma are 4th Year, BA.LL.B. (Hons.) students at NALSAR University of Law, Hyderabad]
In 2017, the Securities and Exchange Board of India (SEBI) had released a circular which practically rendered participatory notes (P-Notes) futile as an instrument for investment in India. The circular stated that foreign portfolio investors (FPIs) could not issue overseas derivative instruments (ODIs) which had derivatives as their underlying security, unless and until they were being used for the purpose of hedging the equity shares. The circular also directed investors to liquidate their P-Note investments having derivatives as the underlying security by the date of the instruments’ maturity or by 31 December 2020, whichever is earlier. With this circular, it was apparent that the securities market regulator wished to phase out P-Notes as an investment instrument and wanted FPIs to directly invest in the Indian market after registration with SEBI. However, on 23 September 2019, the SEBI (Foreign Portfolio Investors) Regulations, 2019 were notified, by virtue of which the regulator has rationalized the restrictions on P-Notes and has reversed its position yet again, by removing the restriction on investment through P-notes with derivatives. This move highlights the persisting dilemma faced by SEBI in its attempts to regulate the securities market and simultaneously attract foreign investment in India.
During the early 2000s, P-notes were a popular instrument for foreign investment in the Indian market. The investors could remain anonymous and were not subjected to any compliance or regulatory requirements before becoming eligible to invest in the Indian market. As a result, foreign investors extensively invested in the Indian market through P-notes and, consequently, they stimulated the growth of India’s economy and capital markets. However, investment through P-notes afforded the foreign investors an opportunity to hide behind a veil of anonymity, thereby posing grave risks of market volatility, financing terrorism, channeling black money, and multilayering. In multilayering, once a P-Note is acquired by a foreign investor from an FPI, it gets repurchased or resold by various other foreign investors, creating layers of beneficial owners and, hence, making it impossible to determine the actual beneficiary of the investment. This prompted SEBI to regulate foreign investment through P-Notes. However, the regulator has been struggling to strike an appropriate balance between two conflicting interests of great significance, i.e., investor protection and securities market regulation on one hand, and attracting foreign investment in India on the other.
After rationalization of P-Notes by way of the new FPI Regulations, an important question arises whether SEBI has reached the desired appropriate balance between the aforementioned competing considerations. The authors believe it has not. Though the regulator has allowed P-Notes on derivatives, they still remain heavily regulated as they are permitted to be issued only by Category-1 FPIs and that too only to those entities which are eligible for registration as Category-1 FPIs. Category-1 FPIs comprise sophisticated foreign investors like Governments, pension funds, certain specified entities from the Financial Action Task Force member countries. Thus, foreign investors like hedge funds, a class of investors who use P-notes for investment in India and contribute majorly to foreign investment, do not fall under Category-1 FPIs and, hence, are not permitted to invest in India through P-Notes.
Further, the FPIs are expected to follow the ‘know your client’ norms (KYC norms) and other conditions that SEBI may prescribe from time to time. It has been previously observed that KYC norms and beneficial owner checks that FPIs have to comply with have been pretty stringent. SEBI has even mandated monthly reporting of information about the P-Notes issued by FPIs in the past. Any subsequent transfer of the P-Notes can only be carried out if the transferee has fulfilled the aforementioned conditions and after prior consent of the FPI has been obtained. In addition to this, the regulator has continued levying fees of $1000 dollars on every subscriber of ODIs, which is to be deposited once in every three years.
From the above, it can be inferred that market access and compliance requirements for investment through P-Notes are still quite stringent even though the restriction on issue of P-Notes with derivatives has been removed. Less sophisticated investors, who prefer to take short positions and exit after making profits, consider investment through P-Notes more appropriate as it enables them to escape the compliance and reporting requirements, while also allowing them to keep their identity anonymous. However, such investors would not be able to use P-Notes for investment as they may not be Category-1 FPIs. By way of the new FPI Regulations, SEBI has eased regulatory norms for FPIs in order to promote more direct registrations by FPIs with itself. However, it should be kept in mind that certain foreign investors may not be interested in direct registration at all on account of compliance costs or India constituting a very small portion of their foreign portfolio or inability to meet the prescribed standards, among other reasons. Considering such disincentivizing factors, the investors might altogether decide against investing in India.
P-notes no longer remain an attractive investment alternative for FPIs as they formerly used to be. Even though SEBI has lifted its earlier restriction on FPIs issuing P-Notes with derivatives as their underlying security, a change in strategy by the regulator and further rationalization of ODIs seems unlikely. As has been observed over the years, it is extremely difficult to assume a single position on the use of P-Notes and the regulator has struggled with the tightening and easing of norms with respect to such instruments because of the competing interests of safety of investors and attraction of foreign investment. In this light, it is most appropriate for SEBI to adopt a cautious attitude and keep investments through P-Notes under check. It should also adopt strategies for promoting direct registrations by FPIs to avoid sabotaging foreign investment and keeping India an attractive jurisdiction for FPIs.
– Tushar Oberoy & Rishabh Sharma
 Regulation 21(1)(a) and (b) of the SEBI (Foreign Portfolio Investors) Regulations, 2019.
 Regulation 5(a) of the SEBI (Foreign Portfolio Investors) Regulations, 2019.
 Regulation 21(c) and (d) of the SEBI (Foreign Portfolio Investors) Regulations, 2019.
 Regulation 21(2) of the SEBI (Foreign Portfolio Investors) Regulations, 2019.
 2nd Schedule – Part C of the SEBI (Foreign Portfolio Investors) Regulations, 2019.