Despite the concerns of terrorist and black money alleged to be invested through p-notes as a result of the anonymity surrounding this route, steps have not been taken to ban it. A Sebi proposal on October 16, 2007, to substantially restrict such investments resulted in Black Wednesday. Interestingly, RBI has been an opponent of this route, but its views do not find support from the finance ministry.
The major thrust of the p-notes regulatory regime is to ensure that p-notes are issued by FIIs (sub-accounts are not permitted to issue the instruments) only to regulated persons/entities after compliance with KYC norms. Sometimes, the p-note purchaser re-issues the p-note to another entity and there may be subsequent re-issuances down the line (downward issuance). Sebi requires FIIs to do KYC on such subsequent purchasers who are also required to be regulated entities. In some instances, Sebi has found FIIs unable to conduct such KYC on subsequent purchasers (which turn out to be unregulated entities) and consequently unable to disclose the final purchasers name to Sebi, as required per the monthly ODI reporting norms. Sebis earlier actions against UBS Securities, Socit Gnrale and Barclays were based on such non-compliances. As a result, Sebi, in its recent circular of January 2011, has required FIIs to give an undertaking that the beneficial owner and purchaser of ODIs are regulated entities and KYC norms have been followed for the ultimate owner (in legal jargon, beneficial owner).
Sebis actions have mostly been reactive and tend to overregulate rather than practically address the issues. There are three key issues surrounding the regulations on p-notes, which cause unpredictable non-compliances. First, Sebi KYC requirements are ambiguous, as noted by the Securities Appellate Tribunal (SAT) in the case concerning UBS Securities. UBS was unable to provide information on top five shareholders of the p-notes purchaser last in the chain of downward issuances. SAT commented that KYC requirements are vague and if the intent was to make it unambiguous, Sebi could have easily added the words ultimate beneficiaries.
Interestingly, the observation in the September 2005 SAT order has been implemented more than five years later in January 2011 by the recent Sebi circular notifying the undertaking. This was a result of such issues raised in matters concerning Socit Gnrale and Barclays that were banned from issuing p-notes, the restriction being removed recently. Both the FIIs failed to disclose the name of the last purchaser in a series of downward issuances and were accused of not conducting KYC on ultimate beneficiaries.
Second, Sebi should provide clarity regarding KYC of the beneficial owner. It appears that the Sebi circular would require FIIs to conduct diligence not only on the p-note purchaser (including purchaser in downward issuances) but also on their beneficiaries, for example, individuals/entities in a fund and shareholders of a company. It would be impractical for FIIs to conduct such diligence because this changes on a frequent basis. In any event, recent issues concerning Socit Gnrale and Barclays suggest that FIIs cannot, other than by contract, ensure that KYC is done for purchasers under downward issuances. FIIs, by obtaining undertakings from the first p-note purchaser, ensure that any downward issuance would be subject to similar compliances that were applicable on the original issuance, but have no tool to ensure compliance on a continuing basis.
Third, Sebi, in view of its past experiences, should understand that FIIs may not be able to track downward issuances that are in control of the first and subsequent p-note purchasers. Sebi should either disallow downward issuances under FII regulations or otherwise not hold FIIs responsible for somebody elses wrong. This would avoid what happened with UBS, Socit Gnrale and Barclays.
Although Sebi has curbed downward investments through p-notes, much is to be done to streamline this route. The KYC norms should be prescribed with both clarity and practicality. Punishing a gun seller for his inability to stop murders done by his licensed client may not be the best of ideas.
The authors are with Finsec Law Advisors