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Accounting The Unaccounted: A SC-Appointed Committee Has Recommended SEBI To Enforce Tighter KYC Norms And Scrutiny Of Final Beneficial Owners Of P-Notes To Curb Money Laundering

The Supreme Court-appointed Special Investigative Team (SIT) recently suggested markets regulator Securities and Exchange Board of India (SEBI) to put in place regulations that would curb tax evasion and the influx of black money through stock markets. This directive caught media eye since many feel most unregistered foreign investors use participatory notes to invest in the Indian markets. So what are participatory notes and why is SEBI wary of it? Let us find out in this article.


There are two main ways by which foreign investments come into the Indian markets. One way is through foreign direct investments (NYSEARCA:FDIS) and the other way is through foreign institutional investors (FIIs).

However, there is yet another technique of investing in the Indian stock markets, which is known as offshore derivative investments (ODI). ODIs are investment products that are issued by foreign institutions to unregistered overseas investors that provide exposure to Indian markets through derivatives. Participatory notes or P-Notes, equity notes, capped return notes and participating return notes make up ODIs. Of these, participatory notes are quite popular with foreign investors as these have fewer registration requirements.

To elaborate further, participatory notes are offshore derivative instruments with Indian shares as underlying assets. These instruments are used to make investments in the stock markets. However, they are not used within the country. They are used outside India to invest in shares listed in the Indian stock market. That is why they are also called offshore derivative instruments.

Participatory notes are issued by brokers and FIIs that are registered with SEBI. The investment is made on behalf of foreign investors by registered brokers in India. This means that brokerages based in India buy shares of companies listed in India and then issue participatory notes to foreign investors. Any benefit in terms of dividend or capital gains is collected from the underlying securities. These brokers have to report the status of issuance of participatory notes to market regulator SEBI every quarter.

The reason why SEBI has been closely observing investments of foreign investors through participatory notes is due to the impact this instrument has had on the Indian markets in the past. It may be recalled that on 16th Oct '07, SEBI had proposed curbs on participatory notes, which accounted for roughly 50% of FII investments in 2007.

SEBI did not know about the beneficial ownership of participatory notes. It was believed that hedge funds were using participatory notes to invest in the markets, which were causing immense volatility in the Indian markets. When news of SEBI's likelihood of coming out with proposals to curb participatory notes trickled in, Sensex lost 9% of its value in intra-day trading, leading to automatic suspension of trades for one hour.

Finance Minister Arun Jaitley issued a clarification stating that the government was not against FIIs and was not banning participatory notes. SEBI issued fresh rules regarding participatory notes on 25th Oct '07. It said FIIs cannot issue fresh participatory notes (P-Notes) and existing exposures were to be wound up within 18 months. The Sensex bounced back following this announcement by SEBI.

The Sensex galloped 734.5 points to pass the much sought after 20,000-mark. This shows the extent of influence investments through participatory notes have on the Indian markets. The regulators have time and again found certain questionable intentions behind this route of investing in Indian markets.


The reason why participatory notes have become the potential route for investments in Indian stock markets is that they can evade regulatory and disclosure norms of regulators. It is a well-known fact that foreign investments have to meet certain criteria of regulators. So, by choosing the participatory notes route, foreign investors have been investing in the Indian markets for a fairly large number of years.

This seems unfair to registered investors in India who follow disclosure norms laid down by the regulators. These disclosures include filling up the Know Your Customer(KYC) form to presenting PAN card and other personal details such as proof of address. Besides evading regulatory norms and approvals, there are various categories of investors that regulators are wary of and are, therefore, keeping a close eye on these categories. There are largely four categories of foreign investors, which use P-Notes to invest in India.

Firstly, there are regular funds which invest with the sole aim of making as much returns as possible in Indian markets. These funds are invested in the Indian markets and in comparison with developed markets find returns from the Indian markets more attractive and sustainable. Secondly, there are investors who have immense money outside India and want to bring it back into India.

This money could belong to politicians, bureaucrats, celebrities and/or businessmen and other powerful and influential people in the society. These people would have made huge sums through or by way of gifts or under-invoicing.

Thirdly, there are foreign governments/entities who would like to acquire/control Indian entities by taking them over. And lastly, there are terror financiers who could find this route attractive and simple. Naturally, the first category of investors aims to earn returns/repatriate and benefit out of interest rate and currency value arbitrage. They enter and exit according to calculations. These investors pay applicable taxes and follow a large part of disclosure norms as laid down by the authorities.

The second category of investors too is not much detrimental to the Indian markets. Investors like bureaucrats, celebrities and other influential and powerful people, largely, bring back money to the Indian markets as KYC norms in so-called safe havens such as Switzerland, which have now become quite stringent. Also, when money arrives in the Indian markets, it is declared by following KYC norms in India. It is the third category, which regulators are closely watching. These investors buy into shares of local Indian companies without its knowledge.

According to experts, these investors try to wield their strength with the owners of companies in which they invest. In worst cases, they try to take over companies in which they have invested. Experts point out that several sovereign funds based in China use private equities to invest in Indian companies. The intention here could be to acquire companies or indirectly hold stake in Indian companies. Experts point out that such investors have held stakes or bought shares of companies in software or oil or telecom, which are critical sectors.

Lastly, it is the fourth category, which experts point out that regulators and the public are concerned about. These terror financiers could use participatory notes to invest in India as they serve them well. One, it is the anonymity involved in P-Notes, which makes them more attractive. Two, domestic regulations on gifting of shares could also serve the purpose of achieving ulterior motives.

It is estimated that more than 50% of funds, which are flowing into India are through P-Notes. This needs close examination. Because in this globalized world where markets are interlinked, allowing unknown investors can be risky for a growing economy like India. These unknown investors could also have political motive apart from gaining astronomical returns by investing in the country.

It is believed that recently the National Security Advisor had sounded the bugle against such investors, who were financing terror activities through banks and stock markets. Hence, P-Notes are on the close radar of the regulators.

About the Author:

Nirmal Bang Securities Pvt. Ltd. is an online share & stock trading company in India. This one of the best trading company where you will see online share trading tips, NSE live news, Indian currency trading market, depository services, mutual fund investment, equity share market, IPO and live commodity market prices in India for stock and share trading.