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Mr. Varun Chikhale is a Fourth Year law student at Symbiosis Law School, Nagpur.
On December 17th, 2024, the Securities and Exchange Board of India (SEBI) released a circular which aims at regulating Offshore Derivative Instruments (ODIs), more popularly known as Participatory Note / P-Notes (the “Circular”). Up until now the regulatory space for ODIs have been found in the SEBI (Foreign Portfolio Investors) Regulations 2019 which lays down certain conditions and restrictions on the issuance of ODIs in India. The article will take a look at the existing framework for ODIs, the amendments made in the circular and will address the issue of disclosure requirements in relation to the Ultimate Beneficiary Owner (UBO) of the ODIs.
It can be seen that SEBI has taken a transparency approach to regulate ODIs which is a must for an instrument like ODI, but the question still remains that are these reporting norms enough? For this we will have to understand how ODI as a financial instrument functions.
Structure of ODIs / P-Notes
ODIs are generally executed through a Total Return Swap (TRS) contract which are traded Over The Counter (OTC). In a hypothetical situation let’s say a Swiss Ultra High Net Worth Individual (UHNWI) named Mr. A wants to gain exposure in the Indian stock market. However Mr. A finds the exchange fees, SEBI charges, brokerage charges, Securities Transaction Tax (STT) , Long Term Capital Gains (LTCG) tax and Short Term Capital Gains tax (STCG) to be a hurdle in gaining a full exposure. Mr. A will approach a hedge fund (who are eligible to be a category I FPI in India) to facilitate a TRS between the hedge fund and any of the SEBI registered FPI in India. The hedge fund on behalf of Mr. A will ask the FPI to buy securities either in the form of equity or debt. Mr A. in return will receive only the total return on the portfolio whereas the hedge fund will pay a fixed interest rate to the FPI (which can be Secured Overnight Finance Rate (SOFR)). The FPI can also include a clause in the TRS that if the portfolio suffers a loss, the hedge fund will have to pay an additional interest rate. The FPI will receive the dividends arising out of the securities and will also be entitled to voting rights in the companies. The hedge fund for facilitating this transaction will receive an investment fee and the ODI holder will receive the returns as well as a note (P-note) certifying that he/she is the holder of the following underlying assets. This P-note can further be sold and can change hands.
The Foreign Portfolio Investors (FPI) Regulations
Under the SEBI (Foreign Portfolio Investors) Regulations, 2019 (“FPI regs”), ODIs are defined as any instrument which is issued overseas by a FPI having Indian securities as its underlying asset. Regulation 21 of the FPI regs further lays down 4 conditions on the issuance of ODIs, which are: a) Category I FPIs can only issue ODIs and similarly can only sell them to persons who are eligible to become category I FPIs, b) Issuance of ODIs can be done only after complying with ‘Know Your Customer’ (“KYC”) norms of SEBI, c) FPIs must disclose any information related to the terms of and the parties in the ODI pertaining to the securities held by it, d) FPIs will have to collect a regulatory fee (800 USD) from the offshore investor in the ODI.
Amendments by the Circular
SEBI in the circular has proposed to ban ODIs which have derivatives as its underlying assets. Earlier in 2017, SEBI restricted the use of derivatives as underlying assets only for the purpose of hedging. However this circular completely bans the issuance of ODIs with derivatives. The circular also mandates a granular disclosure requirement for FPIs which fulfill certain criteria. Under the granular disclosure norms SEBI mandates reporting of beneficiary owners who have 1) any ownership, 2) economic interest, 3) exercising control, in the ODIs which are subscribed. This disclosure should be carried out on a full look through basis upto the level of natural persons.
These disclosure requirements are however only applicable to FPIs which fulfill the following criteria which are a) ODI holder having more than 50% of its equity position in India in a single corporate entity (example; Mr. A has 50% of its portfolio invested in ITC Ltd via the ODI route)
b) ODI holder having more than INR 25,000 Crore worth of equity position in the Indian stock market.
The circular also exempts certain FPIs from the granular disclosure regime these include a) Government and Government related investors who are registered as FPIs in India, b) Public Retail Funds as governed under the FPI Regs, c) Exchange Traded Funds (ETFs) which less than 50% exposure to Indian securities, d) Government regulated pooled investment vehicles, e) University funds and university related endowments who are either registered or are eligible to register as Category I FPIs.
The Anonymity of the P-note Holder
The amendments proposed by SEBI are simply not enough to reveal the identity of the Beneficiary Owner (BO) or the P-note holder. Currently the BO’s KYC framework in India is governed by the Prevention of Money Laundering (Maintenance of Records) Rules 2005 (“PML (Maintenance of Records) Rules”). Rule 9 of the PML (Maintenance of Records) Rules give thresholds for persons who will be considered to be the BOs, for example in case of a company BOs will be any natural person who has more than 10% of controlling ownership interest. However the rules provide for an exception that if no natural person is identified the details of the senior managing official should be provided. Since the ODI holder only receives the returns on his portfolio he/she cannot be called to have a controlling interest as voting rights and dividends are vested with the SEBI registered FPI.
In the case of ODIs it is very difficult to identify the natural person. As seen in the above Mr. A’s example, the SEBI registered FPI can simply provide the details of the hedge fund manager who is handling his/her portfolio. Further if the P-note is sold the hedge fund manager will remain the same but the Ultimate Beneficiary Owner (UBO) will no longer be Mr. A. This anonymity of the offshore investor still remains a mystery even after the amendments are applied.
Conclusion The amendments introduced by SEBI reflect its intent to enhance transparency and accountability in the regulation of ODIs. However, the framework still leaves room for improvement as the challenges for fully uncovering the identity of P-note holder persists. Moving forward, SEBI may need to further refine its approach to ensure that the spirit of the reforms – greater oversight and
