Friday, July 31, 2015

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.

It 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 Committee’, 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 difficult.

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, p-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 apply’. 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 taxed.

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 at: (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, Press 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.

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