"PARTICIPATORY Notes are derivative instruments issued against underlying security of investments in shares. Primarily, the Participatory Notes are one of the methods to raise funds by large investors. An investor wishing to raise resources may collect funds from various investors (retail investors) to pool in the funds against security of underlying investments in shares. Normally, the return of the retail investors are linked to an equity index. PN is issued outside India and represents transaction between two non-residents, who are not subject to the Indian laws. PNs are extra territorial instruments and SEBI has no regulatory jurisdiction over them." (Para 8.67 of the JPC report)

This was in the year 2001. Much water has flown down the Ganges ever since but the unease over SEBI's ability to discipline the FIIs that have been issuing this derivative instrument ever since they were allowed to invest in India still continues. Similarly, the apprehension about the use of the PNs for the purpose of round tripping of black money into the Indian financial market has been voiced on many occasions and there have been calls for a complete ban on the practice of issuing these notes. Dr. Subramaniam Swamy of the BJP has been at the vanguard of the anti PN movement for quite some time. The issue now gets added attention because of the present government's tough talk against black money, particularly of the variety ‘stashed abroad'. If the suspicion of round tripping is well founded, such stashed money can easily acquire legitimacy.

The Special Investigation team (SIT) constituted by the present government and working under the supervision of the Supreme Court is mandated to look into every aspect of the generation and circulation of black money. On the 23rd of July 2015 the SIT submitted its third report to the Court. The report deliberated on issues relating to black money and suggested some measures. The issues discussed related to market manipulation, use of p-notes for money laundering, shell companies and beneficial ownership, action under PMLA for trade based money laundering, use of cash in black economy, generation of black money in education sector, additional courts for trying offences under the IT Act, establishment of a central KYC registry, generation of black money through cricket betting, and empowerment of DRI for certain purpose of SEZ Act.

Of all the suggested measures, maximum noise has been created over the suggestion about controlling the use of PNs. No sooner had the recommendation been uploaded, than there started the familiar refrain that such a measure will be against the flow of foreign investment in India, particularly at this juncture when such investment is badly needed in the country to kick start the growth story. Predictably, the market tanked and the Sensex fell by more than 500 points. The Finance Minister, the Revenue Secretary and the SEBI Chairman gave enough broad hints that the government had no desire to disturb the status quo. Considering the heat generated by the suggestion, it may be worthwhile to look into the details of the recommendation of the committee in this regard.

The SIT referred to the report of 2012 committee headed by the Chairman CBDT "Measures to tackle Black Money in India and Abroad" wherein concern was raised that some of the money coming into the market via PNs could be the unaccounted wealth of Indian taxpayers camouflaged under the guise of FII investment. The CBDT report also noted that the reporting requirements mandated by SEBI at that time did not capture details of ultimate beneficial owners of these instruments.

The SIT took note of the fact that as per SEBI, the top locations of end beneficial owner of PNs were Cayman Islands, USA, UK, Mauritius and Bermuda contributing to 31.31%, 14.20%, 13.49%, 9.91 % and 9.10 % respectively of total outstanding notes. The SIT wondered how the ultimate beneficial owners of these notes could be from Cayman Islands that have a population of less than 55000 when the value of such investments amounted to INR 85000 crores. The obvious conclusion is that the ultimate beneficial owners of the PNs were certainly not from the sandy islands.

While the SIT made a specific reference to the Caymans, perhaps by way of example, the same phenomenon is true even for investment coming through Mauritius and Bermuda. Mauritius with a population of 13 lakh people could not possibly be the largest investor in India. In fact, as has been pointed out on a number of occasions in this column, its GBC-1 companies are in fact foreign companies that are allowed to be formed in Mauritius to do business outside Mauritius. By law they are not allowed to do business in Mauritius. Yet, these are considered residents of Mauritius and allowed to avail of treaty benefits. These are well known secrets and perhaps require a comprehensive policy response particularly if one is serious about the need to check and arrest the growth of black money in India.

Coming back to the PNs, although it is not mentioned in the SIT report, it is possible that SEBI might have pointed out that it has tightened the rules relating to P-notes since the CBDT report of 2012. In fact the SIT noted that SEBI had changed its regulations and came up with SEBI (Foreign Portfolio Investor) Regulations, 2014 in terms of which Foreign Portfolio Investors (FPIs) can issue ODIs to only those entities that are regulated by an appropriate foreign regulatory authority subject to compliance with ‘Know Your Client' norms. SEBI, vide its circular dated November 24, 2014 has further listed set of criteria for the subscribers of P-notes or Offshore Derivative Instruments (ODIs).

Notwithstanding such change in the regulations, it is obvious that the SIT was not convinced that SEBI has the knowledge of the real beneficial owners of these instruments. Secrecy jurisdictions like the Caymans thrive by allowing paper companies and trusts to be formed there. If SEBI's records show that the ultimate beneficial owners (most probably companies) were from these jurisdictions, the SIT must have rightly deduced that SEBI actually did not have the information about the real beneficial owners. Accordingly, the SIT made the following recommendations in the context of the issue and regulation of P-Notes.

- SEBI needs to examine the issue and come up with regulations where the "final beneficial owner" of P notes/ODIs is known.

- The information of "beneficial owner" with SEBI should be in form of individual whose KYC information is known to SEBI.

- In no case should the KYC information end with name of a company.

- In case a company is the holder of P notes/ODIs, SEBI should have information of its promoters/directors who exercise effective control over the company.

- In case of Companies/Trusts represented by service providers like lawyers/accountants SEBI should have information on the real owners/effective controllers of those Companies/Trusts.

The SIT noted that P notes are transferable in nature thereby making the tracing of the "true beneficial owner" of such notes is even more difficult since layering of transactions can be made so complex as to make it impossible to track the "true beneficial owner". Finally, the SIT also questioned the need for having such a facility and doubted if the same was in in any way necessary for foreign investments.

At this stage, it may be interesting to note as to how the issue of P- notes came to be authorized. According to an article [(Is India better off without participatory notes? ET Nov 15,2005], L.C.Gupta, former member SEBI stated that the Indian market regulatory authorities knew nothing about participatory notes issued outside India till the joint parliamentary committee stumbled upon them while investigating the Ketan Parekh-led stock market scam of 2002. This seems to be corroborated by the JPC report itself.

Asked when SEBI became aware about FIIs issuing participatory notes, the Chairman SEBI stated: "There was some vague idea about this, but they were not under our control. There were no means of knowing it. They are not issued in India. They are extra-territorial documents. We do not have any control over that." (Para 8.68 of the JPC report)

The JPC found that four Sub accounts of FIIs Coral Reef Investments Co. Ltd. (Sub-account of RP&C International), CAL FP (Mauritius) Ltd. (Sub-account of Credit Agricol Lazard Finance Prod.), DBMG of Mauritius Ltd. (Sub-account of Deutsche International Trust Corpn. CI Ltd.), Kallar Kahar Investment Ltd, (Sub-account of Credit Suisse First Boston) had transacted in scrips associated with Ketan Parekh in a substantial way.

The SIT observed. "Through PNs, various layers are created which make it easier for the holders to keep their identities undisclosed and at the same time purchase shares in Indian market. It is suspected that some of the Indian promoters have purchased shares of their own companies in this way. It appears that shares purchased through this route were shifted to Ketan Parekh entities through OCBs."

It is only thereafter that SEBI issued Circular No FITTC/CUST/14/2001 on October 31, 2001 asking FIIs to file reports about the PNs issued by them. " It has come to the notice of SEBI that some FIIs are issuing derivative/financial instruments against underlying Indian securities. (…) With a view to monitoring the investment by FIIs through these derivative/financial instruments, it has been decided that FIIs may report issuance/renewal/cancellation/redemption of the aforesaid instruments to SEBI with immediate effect as per the format enclosed as Annexure." FIIs were asked to submit the report on monthly basis.

In 2004, finally, the SEBI amended the SEBI (FII) Regulations, 1995 and inserted Regulation 15A to regulate the issue of PNs as follows:

"15A. (1) A Foreign Institutional Investor or sub account may issue, deal in or hold , off-shore derivative instruments such as Participatory Notes, Equity Linked Notes or any other similar instruments against underlying securities, listed or proposed to be listed on any stock exchange in India, only in favour of those 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: Provided that if any such instrument has already been issued, prior to 3rd February 2004, to a person other than a regulated entity, contract for such transaction shall expire on maturity of the instrument or within a period of five years from 3rd February, 2004 , whichever is earlier.

(2) A Foreign Institutional Investor or sub account shall ensure that no further down stream issue or transfer of any instrument referred to in sub regulation (1) is made to any person other than a regulated entity."

The common minimum programme of the UPA apparently envisaged a policy of continued encouragement of FII flows but at the same time wanted to reduce the vulnerability of the financial system to speculative capital. Accordingly, in 2005, the Government appointed the Lahiri committee to provide an action plan for time bound implementation.

The Lahiri committee acknowledged that PNs raise concerns about the nature of entities to whom such notes are issued but noted that while the regulatory structure would like to have information about the end-investors, there are innate limits to regulate such products and cited the examples of Hong Kong, Singapore, Korea and Taiwan noting that Taiwan Securities and Futures Commission had in December 1999, amended its FII regulations to require periodic disclosure by FIIs of all offshore derivative activities linked to local shares, but this requirement was subsequently removed in June 2000.(Para 151). The Committee therefore recommended that the extant dispensation for PNs might continue. However, the committee recommended that SEBI should have full 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. FIIs should be obliged to provide the information to SEBI (Para 153).

However, the RBI representative on the committee submitted a dissent note as follows:

"The Reserve Bank's stance has been that the issue of Participatory Notes should not be permitted. In this context we would like to point out that the main concerns regarding issue of PNs are that the nature of the beneficial ownership or the identity of the investor will not be known, unlike in the case of FIIs registered with a financial regulator. Trading of these PNs will lead to multi-layering which will make it difficult to identify the ultimate holder of PNs. Both conceptually and in practice, restriction on suspicious flows enhance the reputation of markets and lead to healthy flows. We, therefore, reiterate that issuance of Participatory Notes should not be permitted."

In 2006, the Tarapore committee set up by the RBI to examine further liberalization of the capital account convertibility, continued with the opposition of the RBI to the use of p-notes. The majority observed: "(vi) In the case of Participatory Notes (PNs), the nature of the beneficial ownership or the identity is not known unlike in the case of FIIs. These PNs are freely transferable and trading of these instruments makes it all the more difficult to know the identity of the owner. It is also not possible to prevent trading in PNs as the entities subscribing to the PNs cannot be restrained from issuing securities on the strength of the PNs held by them. The Committee is, therefore, of the view that FIIs should be prohibited from investing fresh money raised through PNs. Existing PN-holders may be provided an exit route and phased out completely within one year." In their dissenting notes, A.V.Rajwade and Surjit Bhalla pointed out that the committee's report was diametrically opposite to that of the Lahiri Committee's report submitted just a year back.

Nevertheless, subsequent events indicate that even SEBI was not fully convinced of the utility of PNs and had in fact proposed a ban on the same in the wake of increasing flow of dollar and hardening of the rupee. In 2007, it issued a discussion paper titled: "Paper for discussion on Offshore Derivative Instruments (Participatory Notes)" wherein it proposed, inter-alia, as follows:

"FIIs and their sub-accounts shall not issue/renew ODIs with underlying as derivatives with immediate effect. They are required to wind up the current position over 18 months, during which period SEBI will review the position from time to time."

Predictably, there was a sell off in the market and the then Finance Minister Mr. Chidambaram had to soothe the nerves. Ultimately, the financial crisis of 2008 meant that this could not be followed through.

In 2009, the capital markets division of the Ministry of Finance constituted a working group on foreign investment in India and one of the terms of reference of this committee headed by U.K.Sinha, then head of the UTI Asset Management Company was "to study the arrangements relating to the use of Participatory Notes and suggest any change in the policy if required from KYC and other point of view. This committee after a lot of humming and hawing concluded that "with regard to participatory notes, SEBI should have the final right to demand details about the end investor in cases of needed investigations" In other words, SEBI could call for information in case of any investigation and not on a systematic basis.

Thus there is no dearth of committees that have examined the issue of P-Notes but a satisfactory resolution of the problem still eludes. In terms of the recommendations of the K.M. Chandrasekhar committee on ‘Rationalisation of Investment routes and monitoring of foreign portfolio Investments' submitted in 2013, all the routes of portfolio investments are now merged and SEBI has issued guidelines for FPI investments that have already been mentioned earlier. The process of registration has been made simpler. The KYC requirement has been made risk based so that a genuine investor need not have to take recourse to p-notes.

In the light of the checkered history of P-notes as mentioned above, the most recent recommendation of the SIT has either been welcomed or criticized by commentators depending on their personal predilections. Those believing in foreign investment at any cost have trashed the report with some accusing the SIT to trespass in the area of policy making (ET 14/8/2015). But, a large majority of people, worried about the ill effects of black money power in India has welcomed the suggestion.

In fact, during last year's G-20 summit in Brisbane, Australia, the G-20 nations agreed to certain high level principles on Beneficial Ownership Transparency. The very first principle that has been agreed upon by all is as follows: "1. Countries should have a definition of ‘beneficial owner' that captures the natural person(s) who ultimately owns or controls the legal person or legal arrangement."

Much of the malaise of the present financial system is because of the widespread use of anonymous company structures. In fact, an OECD study: "Behind the corporate veil: using corporate entities for illicit purposes" (2011) mentions that:" almost every economic crime involves the misuse of corporate vehicles." This may be controlled somewhat if countries agree to put in place a registry of beneficial owners as has been mandated in the UK and will come into force from 2016.

Explaining the British initiative in a speech delivered on the 28 th of July, 2015 at the Lee Kwan Yew School of Public Policy, David Cameron, the British PM stated: "(…) As the economist Professor Paul Collier has noted, lack of transparency over who owns companies "not only assists tax avoidance, it is the key vehicle for corruption."

Why? Because when you have companies whose ownership isn't known you allow a shroud of secrecy behind which people can do bad things, sometimes terrible things, with no accountability."

He was brave enough to admit that there is a lot of flow of corrupt money in the UK: "Now with £122 billion of property in England and Wales owned by offshore companies we know that some high-value properties – particularly in London – are being bought by people overseas through anonymous shell companies, some of them with plundered or laundered cash. Just last week, there were allegations of links between a former Kazakh secret police chief and a London property portfolio worth nearly £150 million.

I'm determined that the UK must not become a safe haven for corrupt money from around the world. We need to stop corrupt officials or organised criminals using anonymous shell companies to invest their Ill-gotten gains in London property, without being tracked down."

(Source: https://www.gov.uk/government/speeches/tackling-corruption-pm-speech-in-singapore)

But a P-note like structure puts the international efforts at transparency at risk. There is a lot of drug money, corrupt money available in the world. In the name of facilitating foreign investment, there should not be an open door policy for such money.The SIT having examined the use of P-notes and the problem of circulation of black money, has not recommended banning of P-notes completely but has merely insisted, in the light of the global trend that the real persons behind such instruments should be known to the regulators. This is an eminently sensible recommendation. There fore panic reaction to the stock market manipulations by interested parties should not derail the good work started by the SIT.