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Participatory Notes - When will we cleanse the system?

Recent reports of a huge financial scam originating from Pune running into several thousands of crore rupees has brought into sharp focus the role of Foreign Institutional Investment flows, particularly Participatory Notes (PNs), in the Indian financial sector. PNs were also in the eye of the storm over their use in stock markets.

What added fuel to the fire is the recent statement of the National Security Advisor (NSA), Mr M. K. Narayanan, that terrorists could be manipulating the stock market in India. Speaking in Munich last month, he said: "Isolated instances of terrorist outfits manipulating the stock markets to raise funds for their operations have been reported. Stock exchanges in Mumbai and Chennai have, on occasions, reported that fictitious or notional companies were engaging in stock market operations."

Role of PNs
PNs are attracting attention now because they are derivative instruments issued by the FIIs to foreign investors who want exposure to Indian equities but do not want to register with the Securities and Exchange Board of India and adhere to the regulatory framework. In a way it is a contract between a foreign investor registered in India, and another who is not. The underlying securities of PNs are Indian stocks. Crucially, it has to be noted that under the existing framework, the FIIs are not bound to reveal the names of the PN holders. That makes PNs completely opaque, which goes against the well-established concepts of `Know Your Customer' (KYC) norms practised world over.

Consequently, the names of these investors are not known to Indian regulators. Further, the FIIs are not allowed to issue PNs to Indian nationals, Persons of Indian Origin or Overseas Corporate Bodies (a majority of which are controlled by NRIs).

Obviously, suspicions about terrorists operating from some tax haven and routing their investments and wrecking havoc on the Indian stock market remain. The irony is that if such investment is routed through Mauritius, the Indo-Mauritius DTAA ensures that the gains are tax free — both in India and Mauritius.

With the criticisms against PNs growing, some people have alleged thatthese notes are mainly round-tripping of Indian capital, moved out and routed back through the Hawala route, taking advantage of the tax-breaks provided by the Indo-Mauritius DTAA. It is precisely this angle that the investigators are reportedly investigating in the Pune case.

Finance Ministry report
The Finance Ministry had constituted a high-power committee comprising senior officials and experts from the Ministry as well as from SEBI and the RBI in 2005 to look into these issues. The `Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative flows' was submitted in November 2005.

The concern
The report had listed out concerns arising from the anonymity afforded by the PN route. The first concern was that "some of the money coming into the market via PNs could be the unaccounted wealth of some rich Indians camouflaged under the guise of FII investment." Associated with this concern was that the capital flows might even be tainted and linked with illegal activities. Interestingly, despite such apprehensions, the conclusion of the expert group was to allow investments through the PN route.

However, the RBI, which was a part of this Committee, held a contrary view. In a dissenting note to the expert group, it had stated, "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."

Obviously, the RBI was concerned about the entry of dirty money and its impact on the markets. More crucially, it was concerned about enhancing the reputation of the market by keeping away such dirty money which, in turn, could lead to improved and healthy capital flows into the Indian markets.

Tarapore panel
Subsequently, the Tarapore Committee, set up by the RBI in 2006 to recommend steps to usher in Full Capital Account Convertibility, reiterated the above recommendation of banning PNs. In this connection, the report stated, "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."

It may be recalled that after the stock market crash of May 17, 2004, SEBI had asked UBS Securities, an FII that had issued PNs, to name the end beneficiaries who had sold such shares in large quantities on that day. Queried by SEBI, UBS said that Caxton International was the end beneficiary, an answer that did not "satisfy" SEBI.

SEBI banned UBS from issuing PNs for the next one year. This order is under an appeal by UBS before the Securities Appellate Tribunal (SAT). Obviously, the RBI and SEBI are uncomfortable with the current practice of allowing PNs.

Invoke the Benami Act
It was widely expected that the latest Budget would address this issue, particularly in the context of the observation of Mr Narayanan. That the Budget remained silent on the crucial issue is indeed intriguing. Obviously, we seem to be completely fixated to the stock market indices and are loath to upset the apple cart. As a result we seem to implicitly abet money laundering and reduce the stock markets to being a mere facilitator in the pass-through process. Surely, the stock markets are too important to be exposed to such extraneous influences.

With the Finance Ministry mum on this issue, it is crucial that the debate on the present policy on PNs is revisited. One policy option available is to invoke the benami laws and ensure that the Government expropriates investments in cases where the investors do not come forward to own their investment to the complete satisfaction of the regulators. Needless to say, the entire process has to be carried out with appropriate checks and balances so that genuine investors who have opted for the PN route are not impacted.

It is indeed inconceivable in these times of transparency that a class of investors is allowed to operate behind the veil of secrecy. This cannot and should not be permitted. Using the ambit of the Benami Act, the Government should seek necessary information about identity of the investors holding PNs.

The benami and the money-laundering laws must not be reduced to mere ornamental pieces of legislation. It may be pertinent to note that this route in examining PNs would clear the two doubts that linger in the minds of analysts: (1) Whether the money invested in the markets is clean, and (2) whether the money invested though PNs is not unaccounted wealth of rich Indians routed back into India. In the process, we could also break the terror-finance nexus.

Alternatively, if the expropriation route seems too drastic, the PNs must be, as suggested by the Tarapore Committee, phased out within the next year or so. Either way, continuation of the PNs has become untenable and must be discontinued at the earliest.

It does not require a seer to say that the stock markets will fluctuate violently and there could be a downturn as and when the government acts to unwind the PNs. But that would be only in the short run. In the medium-to-long-run, the markets would tend to bounce back. To ensure a healthy functioning of the stock market, it is important that we prevent the bad circulating with the good. And precisely for that reason, we need to ban PNs at the earliest. Otherwise Else, the Pune-type hawala scams will occur with regular frequency.

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Last modified on Sunday, 07 July 2013 07:36