[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 (NLU-O)]
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 report, 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.
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. 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 regulations. 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. 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
 '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 http://www.sebi.gov.in/circulars/2008/suspicious.html.
 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.
 “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 http://www.thehindubusinessline.com/todays-paper/why-participatory-notes-are-dangerous/article1672845.ece