No To Participatory Notes

The refusal of the Securities and Exchange Board of India (SEBI) to place stringent curbs on the use of participatory notes (PNs) by Foreign Institutional Investors (FIIs) is truly inexplicable. The government claims - the use of PNs enables higher inflows, adds to liquidity & trading volumes, leads to better price discovery and lowers transaction costs. However, the negative features of these opaque offshore derivative instruments far outweigh possible benefits of their continuance. The only explanation for their use is that PNs have become means to launder black money and bring these funds into the country in the run-up to the elections.

In recent months, well over half the foreign funds that have come into Indian bourses have been through PNs. These notes are issued by FIIs against underlying shares and securities that can be traded by individuals or firms who are not legally entitled to buy or sell shares in Indian stock markets. These persons or entities remain anonymous and operate through FIIs registered with SEBI. The fact is that SEBI can lift the 'corporate veil' only up to a point to identify the true beneficiaries of transactions using PNs.
The problem is one of identifying the 'real' beneficiaries of transactions using PNs.

Company A could be controlled by Company B, which in turn, could be controlled by Company C in a country over which the Indian government has no jurisdiction. The regulator has no way of ascertaining whether Company C is controlled by the notorious D Company? Theoretically, SEBI can establish an 'audit trail' up to three layers of beneficiaries. But this is easier said than done. The final beneficiaries of these transactions have engaged smart accountants and lawyers who 'slice' and 'splice' these complex derivatives in ways that conceal their identities.

Many believe that some of this money actually belongs to persons of Indian origin who had stashed their money abroad at a time when the government used to have strict restrictions on hard currency movements. Such 'round-tripping' funds are now returning to Indian through tax havens like Mauritius.

In October 2007, SEBI imposed curbs on the use of PNs. Markets collapsed but the regulator stood its ground and placed a cap on the issuance of fresh PNs with a view to phasing out their use altogether by the end of 2008. In October 2008, however, as the international financial crisis deepened, SEBI reversed its decision to restrict the use of PNs ostensibly on the ground that FIIs needed encouragement to continue to invest in India.

In recent months, FIIs had been using existing PNs to indulge in 'short-selling' of shares, that is, lending shares that did not belong to them and buying them back by obtaining loans from third parties. On October 31, SEBI released historical data on short-sales by FIIs that indicated that on October 09, there had been short-selling in 224 specific stocks worth around Rs 6,500 crore. If the historical value of these shares are considered at the then prevailing rupee-dollar exchange rate, the total amount would be many times higher, perhaps $3 billion (Rs 15,000 crore). Among the entities whose shares were 'short-sold' are HDFC, ICICI Bank, Axis Bank, Reliance Industries, Bharti-Airtel, Infosys, Reliance Capital and Reliance Communications.

On October 23, Finance Minister P. Chidambaram told journalists: “SEBI has told them (meaning, FIIs) now that it disapproves of lending to offshore entities and asked them to reverse such transactions. I am told that those transactions are likely to be reversed over the next few days.” But nothing much seems to have happened.

The Reserve Bank of India had argued for a ban on the use of these instruments, not once or twice but at least thrice in the recent past. But North Block is reticent, Why?