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Govt's volte face on P-Notes leaves questions unanswered


Somasekhar Sundaresan  |  New Delhi 

This fortnight’s column is yet another (reluctant) comment on the regulatory framework governing foreign institutional investors (FIIs). In the last fortnight, in a short terse communiqué, the Securities and Exchange Board of India (Sebi) announced a complete volte face with the policy governing participatory notes (P-Notes).

It may be recalled that amidst huge publicity, in October 2007, Sebi had announced a draft policy imposing restrictions on the quantum of P-Notes that FIIs may issue. The market reacted violently. The new policy was front-page news for weeks.

However, Sebi was unfazed and implemented the draft policy. Overnight, the size of P-Notes that any FII could issue was curtailed to 40 per cent of the assets invested in India by the FII. FIIs that had issued P-Notes of a size below such a threshold were severely restricted from taking on more P-Note exposure — not more than 5 per cent growth in size was permitted.

For the uninitiated, P-Notes are derivative instruments contracted by FIIs with third parties. Such instruments reflect ownership of the economic benefits of specified underlying Indian securities. Counterparties to P-Notes get an exposure to the economic benefits accruing on the underlying securities without having to be a legal owner of the securities.

Therefore, the legal incidents of ownership such as voting power on the securities would continue to be with the FII issuing the P-Note, but the economic benefits such as dividend, price appreciation etc. and all such returns would totally belong to the P-Note counterparty.

P-Notes could also be issued against a position in derivative instruments held by the FII and the economic benefits of the holding in derivatives could be passed on through the P-Note. In last year’s policy change, issuance of P-Notes with derivatives as the underlying got prohibited altogether.

Any issuance of any P-Note by a sub-account too became totally prohibited. The most significant feature of the policy change was that no arm of the government ever issued a rationale for the changes, apart from toeing the “we always told you P-Notes would have to be phased out” line.

The substantial amendments effected in October last year did not even get translated into amendments to the Sebi (Foreign Institutional Investors) Regulations, 1995 (FII Regulations) until May 2008. In other words, substantial changes to conduct of business as expected from FIIs were prescribed by a press release, without the law being amended.

Now, in less than five months of the amendments having been put in place, all the amendments, we are told, have been effectively removed — again, by press release. Amendments to the FII Regulations are expected to follow, and one can only hope that they follow shortly.

Another interesting element of the legal framework is that P-Notes could also be issued by an FII without even physically holding the underlying securities. So also, the FII could issue a P-Note against the movements in a popular stock index — say the Sensex, and, instead of holding an index future as the underlying, the FII could hedge its risk on the P-Note by holding a variety of stocks represented in the index.

In fact, after the May 2008 amendments, which for the first time provided a definition for P-Notes, the applicability of the entire edifice of the P-Note policy of last year became suspect. P-Notes got defined as derivative instruments issued by an FII against a security “held” by the FII. Moreover, there is no provision of law that makes it mandatory for an FII to issue P-Notes only against an underlying holding of Indian securities in the hands of the FII. Therefore, if an FII chose not to hold the underlying securities while issuing a P-Note, it would not have to comply with the provisions governing P-Notes contained in the FII Regulations.

The fanfare with which last year’s amendments had been introduced left one startled. The policy change was so significant that it was an important regulatory event of the year. The repeal this year, in relative terms, could be regarded as having gone through virtually unnoticed. Both measures were short of articulated reasons that justify the measures.

It is important to have the regulatory will power to reverse a regulation when it is found that it has not served its purpose. On the other hand, it is even more important to ensure that no new policy measures are introduced unless the new policy measures are indeed imperative.

It must not be forgotten that the Reserve Bank of India (RBI) had once held a view on P-Notes that was divergent from that of Sebi. In fact, in the report of a committee set up to review P-Note policy, the RBI nominee had recorded a dissent note, calling for an abolition of issuance of P-Notes and proposed a law to make it illegal for FIIs to issue P-Notes.

Whatever be the merits of each regulator’s position, it is important that the market is given clear articulated reasons for the position taken by the regulator. Else, the Indian regulatory regime can’t help being considered to be an indecisive, tentative and unarticulated one.

The author is a partner of JSA, Advocates & Solicitors. The views expressed herein are his own.