ROLE OF FOREIGN INSTITUTIONAL INVESTORS IN THE INDIAN ECONOMY

Subject: Corporate Law - II.

Submitted to: Prof. Harpreet Kaur Submitted by: Aman Singh Poras Roll No: 2008-07 Sai Teja Vangala. Roll No: 2008-53 IV Year- VIII Semester. B.A, LL.B (Hons.) .

National Law University, Delhi.

TABLE OF CONTENTS LIST OF CASES..................................................................................................................................i LIST OF STATUTES........................................................................................................................ii LIST OF ABBREVIATION.............................................................................................................iii CHAPTER-I........................................................................................................................................1 INTRODUCTION..............................................................................................................................1 1.1 Introduction:...............................................................................................................................1 1.2 Research Methodology:..............................................................................................................3 CHAPTER-II......................................................................................................................................4 THE IMPORTANCE OF FIIS IN AN ECONOMY......................................................................4 2.1 Advantages of Foreign Institutional Investment........................................................................9 2.2 Disadvantages: Risk of Hot Money Flows..............................................................................10 CHAPTER-III...................................................................................................................................11 THE LAW GOVERNING FOREIGN INSTITUTIONAL INVESTMENT IN INDIA...........11 3.1 CASE STUDY..........................................................................................................................14 3.1.1 Goldman Sachs Investments (Mauritius) Limited v. The Adjudicating Officer, SEBI...14 3.1.2 HSBC Investment Securities (Netherlands) NV v. Adjudicating Officer, SEBI.............14 3.2 Foreign Exchange Management Act Regulations: .................................................................16 3.3 Sectoral Caps............................................................................................................................17 3.4 MNCs Delisting.......................................................................................................................18 Major reasons for delisting:............................................................................................................19 Consolidated FDI Policy 2012:......................................................................................................20 CHAPTER-IV...................................................................................................................................21 CONCLUSION.................................................................................................................................21 Bibliography.......................................................................................................................................iv

LIST OF CASES Goldman Sachs Investments (Mauritius) Limited v. The Adjudicating Officer, SEBI HSBC Investment Securities (Netherlands) NV v. Adjudicating Officer, SEBI

ii

LIST OF STATUTES Securities and Exchange Board of India Act, 1992 Foreign Exchange Regulation Act, 1973 Foreign Exchange Management Act, 1999 SEBI (Foreign Institutional Investors) Regulations 1995 Securities and Exchange Board of India (Criteria for Fit and Proper Person) Regulations, 2004 Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations, 2002 Foreign Exchange Management Act Regulation Notification 20/2000-RB

iii LIST OF ABBREVIATION Ed. P. Pp. e.g i.e. Art. Ed. Cl. Amend. v. AIR S.C H.C Ibid. Edited page pages exempli gratia that is Article Edition Clause Amendment verses All India Reporter Supreme Court High Court Paragraph Ibidium

CHAPTER-I INTRODUCTION

1.1 Introduction: Foreign Investment refers to investments made by residents of a country in financial assets and production process of another country. After the opening up of the borders for capital movement, these investments have grown in leaps and bounds. However, it had varied effects across the countries. It can affect the factor productivity of the recipient country and can affect the balance of payments. In developing countries there was a great need of foreign capital, not only to increase their productivity of labor but also helps to build the foreign exchange reserves to meet the trade deficit.1 Foreign investment provides a channel through which these countries can have access to foreign capital. It can come in two forms: foreign direct investment (FDI) and foreign portfolio investment (FPI). Foreign institutional investors such as mutual funds are regulated by the Securities and Exchange Board of India Act as well as under FEMA. While foreign nationals are not allowed to invest directly in the Indian stock market, foreign institutions that are regulated in their home country are allowed to invest, subject to certain rules, according to the Indian government. For example, no single foreign institutional investor can acquire more than 10 percent of an Indian company, and all foreign institutional investment cannot exceed 24 percent of the capital of the Indian company. Foreign institutional investors must also receive approval from the Reserve Bank in some instances, such as non-stock exchange sales and purchases. According to a law firm familiar with foreign investment policies in India, the Securities and Exchange Board of India regulations are much less demanding than those under the FIPB approval process. In 2006, India amended the Securities and Exchange Board of India regulations, expanding the list of entities considered foreign institutional investors, which are allowed to invest in the Indian stock market, to include governmental agencies such as sovereign wealth funds. Foreign direct investment involves in the direct production activity and of medium to long-term nature. But the foreign portfolio investment is a short-term investment mostly in the financial
1

Suchismita Bose and Dipankar Coondoo, The Impact of FII Regulations in India, Money and Finance, JulyDecember

2 markets and it consists of Foreign Institutional Investment (FII). The FII, given its short-term nature, might have bi-directional causation with the returns of other domestic financial markets like money market, stock market, foreign exchange market, etc. Hence, understanding the determinants of FII is very important for any emerging economy as it would have larger impact on the domestic financial markets in the short run and real impact in the end. The present study examines the determinants of foreign portfolio investment in the Indian context as the country after experiencing the foreign exchange crisis opened up the economy for foreign capital. India, being a capital scarce country, has taken lot of measures to attract foreign investment since the beginning of reforms in 1991. Until the end of January 2003 it could attract a total foreign investment of around US$ 48 billions out of which US$ 23 billions in the form of FPI. FII consists of around US$ 12 billions in the total foreign investments.2 This shows the importance of FII in the overall foreign investment program.3 As India is in the process of liberalizing the capital account, it would have significant impact on the foreign investments and particularly on the FII, as this would affect short-term stability in the financial markets. Hence, there is a need to determine the push and pull factors behind any change in the FII, so that we can frame our policies to influence the variables which drive-in foreign investment. In addition, FII has been subject of intense discussion, as it is held responsible for intensifying currency crisis in 1990s. The project will also highlight the role played by the SEBI by making regulations which regulate the foreign institutional investment in India. The Securities and Exchange Board of India was established on April 12, 1992 in accordance with the provisions of the Securities and Exchange Board of India Act, 1992. The Preamble of the Securities and Exchange Board of India describes the basic functions of the Securities and Exchange Board of India as ..to protect the interests of investors in securities and to promote the development of, and to regulate the securities market and for matters connected therewith or incidental thereto FEMA is an Act to consolidate and amend the law relating to foreign exchange with the objective of facilitating external trade and payments and for promoting the orderly development and
2

Rajesh Chakraborty, FII Flows to India: Nature and Causes in Money and Finance, October-December. Ibid

3 maintenance of foreign exchange market in India. The law relating to exchange control in India has undergone a substantial change in scope, content and approach by the substitution of the Foreign Exchange Regulation Act, 1973 ( FERA ) by the Foreign Exchange Management Act, 1999 ( FEMA ). The most noticeable aspect of FEMA is that there is no imprisonment prescribed for contraventions of the law, not even as an alternative punishment and for the blatant and deliberate of violations. The provisions of FEMA displays so much change that one could almost delink FEMA from FERA and concludes that FEMA is a new law altogether which needs an independent reading and interpretation divorced from the earlier law and decisions rendered there under.

1.2 Research Methodology: The researcher has utilized the non-doctrinal method of research to supplement the field work done for this project. The books and journals available in the NLU, Delhi Library has been utilized for the purposes of this project. The Internet has also been made use of. A brief analysis of latest case laws has also been included. Furthermore, the latest trends with respect to foreign institutional investment in India have been discussed.

CHAPTER-II THE IMPORTANCE OF FIIS IN AN ECONOMY

In 2004-05 portfolio investments in India accounted for about 62% of total foreign investment in the country and at about 1.29% of GDP well exceeded the current account deficit (0.95% of GDP). Foreign Institutional Investors (FIIs) investments accounted for about 97.5% of this.4 Ever since the opening of the Indian equity markets to foreigners, FII investments have steadily grown from about Rs. 2,600 crores in 1993 to over Rs.48,000 crores in 2005. At the end of June 2006, the cumulative FII flows to India accounted for a little over 9% of the Bombay Stock Exchange market capitalization.5 While it is believed that portfolio flows benefit the economies of recipient countries, policy-makers worldwide have been more than a little uneasy about such investments. Often referred to as hot money, they are known to stampede out at the slightest hint of trouble in the host country leaving an economic wreck in their wake, like Mexico in 1994. They have been blamed for exacerbating small economic problems in a country by making large and concerted withdrawals at the first sign of economic weakness. They have also been held responsible for spreading financial crises causing contagion in international financial markets. International capital flows and capital controls have emerged as important policy issues in the Indian context as well. The danger of abrupt reversals and their destabilizing consequences on equity and foreign exchange markets are always a concern. Nevertheless, in recent years, the government has been making strong efforts to increase FII flows in India. Others have argued that, far from being healthy for the economy, FII inflows have actually imposed certain burdens on the Indian economy. Understanding the determinants and effects of FII flows and devising appropriate regulation therefore constitute an important part of economic policy making in India.6 Entities covered by the term FII include Overseas pension funds, mutual funds, investment trust, asset management company, nominee company, bank, institutional portfolio manager, university
4

Coondoo, Dipankar and Paramita Mukherjee (2004): Volatility of FII in India, Money and Finance, OctoberMarch. 5 Ibid. 6 Gordon, James and Poonam Gupta (2003): Portfolio Flows into India: Do Domestic Fundamentals Matter?, IMF working paper No 03/20.

5 funds, endowments, foundations, charitable trusts, charitable societies, a trustee or power of attorney holder incorporated or established outside India proposing to make proprietary investments or investments on behalf of abroad-based fund (i.e., fund having more than 20 investors with no single investor holding more than 10 per cent of the shares or units of the fund).7 FIIs can invest their own funds as well as invest on behalf of their overseas clients registered as such with SEBI. These client accounts that the FII manages are known as subaccounts. A domestic portfolio manager can also register itself as an FII to manage the funds of sub-accounts. A few large FIIs (less than 3% of all registered ones, issue derivative instruments called participatory notes that are registered and traded overseas, backed by the FIIs holdings of Indian securities. This arrangement has raised some concerns in regulatory circles since it makes it difficult to trace the ultimate beneficiary in the funds and may be used to bring in unclean funds (funds generated out of illegal activities) into the Indian markets. 8 As of mid-July 2006, there were 932 FIIs registered with SEBI, of which 115 were registered in the first half of 2006 itself. US-based funds accounted for 39% of all registered FIIs, followed by UK-based ones (16%), Luxembourg (7%) and Singapore (5%). In terms of net cumulative investment, US based funds accounted for 29% at the end of October 2005 followed by UK (17%).
9

Though initially restricted to investing only in listed company stocks, FIIs are now allowed to invest in equity, bonds and derivative instruments in India subject to limits of foreign ownership for various sectors as well as ceilings on total investment per FII. Regular FIIs follow what has come to be known as the 70:30 rule, i.e. they must invest no less than 70% of their funds in equity-related instruments and may invest the remainder in debt-related instruments. There are also some FIIs that are registered as 100 per cent debt-fund FIIs that are permitted to invest exclusively in debt instruments. Although equity holdings of FIIs have received maximum
7

Government of India, Ministry of Finance (2005): Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows, New Delhi, November. 8 Id. 9 Id.

6 attention from the press, researchers and policymakers alike, the debt holdings of FIIs are not wholly insignificant. As of July 21, 2006, the regular FIIs held USD 224.25 million (about Rs. 1,009 crores) in government securities/Treasury Bills and USD 82.02 million (about Rs. 369 crores) in corporate debt. At the end of June 2006, the open interest of FIIs in stock and index futures and options exceeded Rs 22,000 crores.10 A number of studies in the past have observed that investments by FIIs and the movements of Sensex are quite closely correlated in India and FIIs wield significant influence on the movement of Sensex. It has been observed that in the Indian stock markets FIIs have a disproportionately high level of influence on the market sentiments and price trends. This is so because other market participants perceive the FIIs to be infallible in their assessment of the market and tend to follow the decisions taken by FIIs. This herd instinct displayed by other market participants amplifies the importance of FIIs in the domestic stock market in India. 11 FIIs are the major players in the domestic stock market in India, but their influence on the domestic markets is also growing. Data on trading activity of FIIs and domestic stock market turnover suggest that FIIs are becoming more important at the margin as an increasingly higher share of stock market turnover is accounted for by FII trading. Moreover, the findings of this study also indicate that Foreign Institutional Investors have emerged as the most dominant investor group in the domestic stock market in India.12 Particularly, in the companies that constitute the Bombay Stock Market Sensitivity Index (Sensex), their level of control is very high. Data on shareholding pattern show that the FIIs are currently the most dominant non-promoter shareholder in most of the Sensex companies and they also control more tradable shares of Sensex companies than any other investor groups. In most of the Sensex companies, FII holding is more than the RBI prescribed ceiling limit of 24 percent. According to shareholding data of this year, more than 36 percent of non-promoters share in Sensex companies are owned by FIIs. It notable here that whereas 500 odd FIIs control more than 36 percent of all non-promoters share of the Sensex companies, the 20
10

Rakshit, Mihir (2006): On Liberalising Foreign Institutional Investments, Economic and Political Weekly, March 18. 11 Ibid. 12 Id.

7 million odd Indian retail investors control only about 20 percent of these shares. In comparison, Indian financial institutions, which used to be the largest market movers in India, control only about 16 percent of non-promoters shares in Sensex companies. Given the perception about FIIs as market leaders in the domestic stock market, the increasing importance of FII trading at the margin and the dominant position of FIIs in the Sensex companies, it is not surprising that FIIs are in a position to influence the movement of Sensex in a significant way. The influence of FIIs on the movement of Sensex became apparent after the general election in India when the sudden reversal of FII flows triggered a panic reaction which resulted in very high volatility in the Indian stock market. During this period, the Sensex experienced its worst single-day decline in its history and in the three month period between April to June 2004, it declined by about 17 percent. And it all started because of the selling pressure exerted by the FIIs after the post election phase when they became less confident about the continuation of reform process in India. However, when we look at the shareholding pattern of FIIs in the Sensex companies, we see that the shareholding pattern of FIIs have remained relatively unchanged between March and June 2004.13 To explain the anomaly, one can argue that after the elections FIIs were concerned about the continuation of reform process in India and started withdrawing their investments. This led to the stock market crash and prices of shares tumbled. However, once the assurance about the continuation of reform process was given, FIIs started buying back the shares they sold earlier. Taking advantage of the stock market crash, they managed to regain their portfolio at a much cheaper price. If this chain of events is true then it shows that the FIIs have come out as the clear winner in the post-election turmoil of the stock market. Not only have they gained financially out of the situation, but they have also managed to influence policy making in this country. The pressure exerted by FIIs also allowed them to get some fiscal sops in the recent budget. It needs to be reiterated here that there has been no change in the macroeconomic fundamentals faced by the country before and after the volatile period in the stock market.

13

Mukherjee, Paramita, Suchismita Bose and Dipankar Coondoo (2002): Foreign Institutional Investment in the Indian Equity Market, Money and Finance, April-September.

8 It needs to be remembered that in India, almost all previous experiences with high phases of stock market volatility have been associated with some form of irregularities and corruption. Given the frequent occurrences of scams and irregularities in the Indian stock market, the likelihood of market manipulation cannot be totally ruled out. The manner in which record FII investments build up the stock market during the first quarter of the year and the way the stock market was brought down, strengthens this apprehension. It also needs to be considered here that FIIs have emerged as the major market drivers of Sensex companies and, in the past, there have been instances where the nexus between FIIs and big brokers of the BSE was found to be involved in price manipulations in the BSE.14 The whole process also highlights another disturbing feature. During the post election period, the sudden volatility in the stock market and the subsequent decline of Sensex was almost treated as a national emergency in India by the financial media and to a certain extent, by the incoming UPA government. It is very difficult to understand why the government feels so concerned about speculative investors and the movements in Sensex. Most studies have shown that Sensex is neither a good barometer of economic fundamentals it is nor an indicator of future growth prospects of the economy. Moreover, this study also shows that even sharp changes in Sensex do not necessarily indicate a significant alteration of actual shareholding pattern of different investor groups even in the Sensex companies. As far as the real economy is concerned, the stock market has a very limited role to play. In India, for the year 2002-03, new capital issues by nongovernment public limited companies raised a combined capital of Rs 1,878 crores from ordinary shares, preference share and debentures. This amount is only 0.33 percent of gross domestic capital formation of the economy and about 1.6 percent of gross domestic capital formation by private corporate sector for that year. This is not surprising because even in developed stock markets like USA, the stock market has not been a significant source of finance for new investments. Also, stock markets mobilize a very small fraction of household financial saving in India. As the recent RBI Handbook of Statistics shows, investment in shares and debentures and units of UTI account for only 1.37 percent of total household financial savings for the year 2003-04.15 In
14 15

Ibid. Supra nt. 13.

9 comparison, bank deposits account for about 42.8 percent of household financial savings for the same year. Under these circumstances, it is not clear why so much importance is given to the stock market and portfolio investors by policymakers in India. It is high time to realize that in spite of the impression given by the financial media, movements of stock markets and Sensex do not necessarily imply any fundamental changes in the economy and these movements affect a very small minority of the countrys population. It will be unfortunate if movements of speculative capital and the resultant stock market gyrations are allowed to influence macro-economic policymaking in India.

2.1 Advantages of Foreign Institutional Investment 2.1.1 Enhanced flows of Equity Capital FIIs are well known for a greater appetite for equity than debt in their asset structure. For example pension funds in the United Kingdom and United States had 68 per cent and 64 per cent respectively of their portfolios in equity in 1998. Thus opening up the economy to FIIs is in line with the accepted preference for non-debt creating foreign inflows over foreign Debt. Furthermore because of these preferences for equities over bonds, FIIs can help in compressing the yield differential between equity and bonds and improve corporate capital structures. Further, given the existing savings investment gap of around 1.6 per cent, FII inflows can also contribute in bridging the investment gap so that sustained high GDP growth rate of around 8 per cent targeted under the 10th Five year Plan can materialize. 2.1.2 Managing Uncertainty and Controlling Risks Institutional investors promote financial innovation and development of hedging instruments. Institutions for example, because of their interest in hedging risks are known to have contributed to the development of Zero coupon bonds and index futures. FIIs, as professional bodies of asset managers and financial analysts just not only enhance competition in financial markets but also improve the alignment of asset prices to fundamentals. Institutions in general and FIIs in particular are known to have good information and low transaction costs. By aligning asset prices closer to fundamentals, they stabilize markets. Fundamentals are known to be sluggish in their movements. Thus, if prices are aligned to fundamentals, they should be as stable as the

10 fundamentals themselves. Furthermore a variety of FIIs with a variety of risk return references also help in dampening volatility. 2.1.3 Improving Capital Markets FIIs as professional bodies of asset managers and financial analysis, enhance competition and efficiency of financial markets. Equity market development aids economic development by increasing the availability of riskier long term capital for projects and increasing firm incentives to supply more information about themselves, FIIs can help in the process of economic development. 2.1.4 Improved Corporate Governance Good Corporate Governance is essential to overcome the principal agent problem between Shareholder and Management. Information asymmetries and incomplete contracts between share holders and management are at the root of the agency costs. Dividend payment, for example is discretionary. Bad corporate governance makes equity finance a costly option. The large shareholders with leverage to complement their legal rights and overcome the free rider problems but shareholding beyond say 5 per cent also lead to exploitation of minority Shareholders. FIIs constitute professional bodies of asset managers and financial analysts, who by contributing to better understanding of firms operations improve corporate governance. Among the four models of corporate control - takeover or market control via equity, leveraged control or market control via debt, direct control via equity and direct control via debt or relationship banking. The third model which is known as corporate governance movement has institutional investors at its core. In this third model, Board Representation is supplemented by direct contacts by institutional investors. Institutions are known for challenging excessive executive compensation and remove under performing managers. There is more evidence that institutionalization increases dividend payouts and enhances productivity growth.

2.2 Disadvantages: Risk of Hot Money Flows The two common apprehensions about FII inflows are the fear of management take over and potential capital outflows.

11 2.2.1 Management Control There are domestic laws that effectively prohibit institutional investors form taking management control. For example, US Law prevents mutual funds from owning more than 5 per cent of a Companys stock. According to the International Monetary Funds Balance of Payments Manual 5, FDI is that category of international investment that reflects the objective of obtaining a lasting interest by a resident of other economy. The lasting interest implies the existence of a long term relationship between the direct investor and the enterprise. 2.2.2 Potential Capital Outflows FII inflows are popularly described as hot money because of the herding behavior and potential for large capital outflows. All the FIIs tries to either only buy or only sell at the same time particularly at times of market stress (Parthapratim, 1998). Value at Risk models followed by FIIs may destabilize markets by leading to simultaneous sale by various FIIs as observed in Russia and Long Term Capital Management 1998 (LTCM) crisis. Extrapolative expectations or trend chasing rather than focusing on fundamentals can lead to destabilization. Movements in the weight age attached to a country by indices such as Morgan Stanley Country Index (MSCI) or International Finance Corporation (W) (IFC) also leads to mass shift in FII portfolios.

CHAPTER-III THE LAW GOVERNING FOREIGN INSTITUTIONAL INVESTMENT IN INDIA

The SEBI is the principal regulatory authority formed to take appropriate measures to protect the interests of investors in securities, promote the development of the market, and regulate the market. To fulfil its responsibility, the SEBI makes regulations from time to time and is endowed

12 with wide powers to enforce the same. With a view to regulating investment in Indian Securities market by foreigners, the SEBI framed the SEBI (Foreign Institutional Investors) Regulations 1995.16 In exercise of the powers conferred by Section 30 of the Securities and Exchange Board of India Act, 1992 (15 of 1992) made the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995. In terms of the Regulations, a foreign institutional investor means: .............an institution established or incorporated outside India which proposes to make investment in India in securities;17 Provided that a domestic asset management company or domestic portfolio manager who manages funds raised or collected or brought from outside India for investment in India on behalf of a subaccount, shall be deemed to be a Foreign Institutional Investor. Regulation 2 (f) of the 1995 Regulations defines a Foreign Institutional Investor as an institution established or incorporated outside India which proposes to make investment in India in securities. Regulation 3 (1) specifies that no person shall buy, sell or otherwise deal in securities as a Foreign Institutional Investor unless he holds a certificate granted by the Board.18 Under Regulation 4 (2), the Board can signify the applicant to appear before the Board personally in connection with the grant of a certificate.19 The Board is mandated under Regulation 6 to consider, inter alia, applicants track record, professional competence, financial soundness, experience, general reputation of fairness and integrity.20 Furthermore, Regulation 6 A clarifies that the provisions of the Securities and Exchange Board of India (Criteria for Fit and Proper Person) Regulations, 2004 shall, as far as may be, apply to all applicants or the foreign institutional investors under these regulations. Regulation 7 governs the procedure and the grant of certificate and states that where an application is made for grant of certificate under these regulations, the Board shall, as soon as possible but not later than three months after information called for by it is furnished, if satisfied that the application is complete in all respects, all particulars sought have been furnished and the applicant is found to be eligible for the grant of certificate, grant a certificate in form B, subject to

16 17

Dennis Campbell, International Securities Law and Regulation 2006, Vol. I, p. 487. Regulation 2(f), SEBI (FII) Regulations, 1995 18 Regulation 3(1), SEBI (FII) Regulations, 1995. 19 Regulation 4(2), SEBI (FII) Regulations, 1995 20 Regulation 6, SEBI (FII) Regulations, 1995

13 payment of fees in accordance with the Second Schedule. 21 Regulation 8 states that the certificate and each renewal shall be valid for a period of three years from the date of its grant or renewal, as the case may be.22 The Chapter III of the Regulations discusses the investment conditions and restrictions on the foreign institutional investors. Regulation 14 states that a foreign institutional investor shall not make any investments in securities in India without complying with the provisions of Chapter III. The investment restrictions are prescribed by Regulation 15 and Regulation 20 requires that every Foreign Institutional Investor shall, as and when required by the Board or the Reserve Bank of India, submit to the Board or the Reserve Bank of India, as the case may be, any information, record or documents in relation to his activities as a Foreign Institutional Investor as the Board or as the Reserve Bank of India may require. Regulation 21 states that any foreign institutional investor who fails to comply with any provisions of the Act, rules or regulations, shall be dealt with in the manner provided under the Securities and Exchange Board of India (Procedure for Holding Enquiry by Enquiry Officer and Imposing Penalty) Regulations, 2002.23 The SEBI continually comes up with amendments to these regulations in order to respond to the requirements of the times.

21 22

Regulation 7, SEBI (FII) Regulations, 1995 Regulation 8, SEBI (FII) Regulations, 1995 23 Regulation 21, SEBI (FII) Regulations, 1995

14

3.1 CASE STUDY 3.1.1 Goldman Sachs Investments (Mauritius) Limited v. The Adjudicating Officer, SEBI24 In Goldman Sachs Investments (Mauritius) Limited v. The Adjudicating Officer, SEBI , the primary question question that arose before the Securities Appellate Tribunal, Mumbai for consideration in the Appeal was whether the Securities and Exchange Board of India could ask the Foreign Institutional Investors (FIIs) to furnish an undertaking that they had not dealt in respect of off-shore derivative instruments with Indian residents, non-resident Indians (NRIs), persons of Indian origin (PIOs) or overseas corporate bodies (OCBs) in the absence of a bar on such deals. With a view to regulate the activities of FIIs and their sub-accounts, the Board framed the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995 (for short the Regulations). These provide that no person shall buy, sell or otherwise deal in securities as an FII unless he holds a certificate granted by the Board under the Regulations. An FII is also required to seek from the Board registration of each sub-account on whose behalf he proposes to make investments in India. Regulation 20 enjoins that every FII shall, as and when required by the Board or the Reserve Bank of India, submit to the Board or the Reserve Bank of India, as the case may be, any information, record or documents in relation to its activities as an FII. The Securities Appellate Tribunal held that the requirement of an undertaking is opposed to all norms of reason and totally devoid of logic since when the FIIs and their sub accounts have not been debarred from dealing in ODIs with Indian residents/ NRIs/ PIOs/ OCBs and many of them would have dealt with the latter, they could not be asked to furnish the undertaking. It was stressed that the requirement of the undertaking by FIIs and their sub-accounts could have been appreciated if they had first been debarred from dealing with the aforesaid persons or in other words, the bar must necessarily precede the undertaking demanded from the FIIs and their sub-accounts.

3.1.2 HSBC Investment Securities (Netherlands) NV v. Adjudicating Officer, SEBI25 In HSBC Investment Securities (Netherlands) NV v. Adjudicating Officer, SEBI, the question for decision in the appeal was whether in terms of regulation 20 of the Securities and Exchange Board of India (Foreign Institutional Investors) Regulations, 1995 (FII Regulations, for short), read with the Securities and Exchange Board of India (the Board, for short) circular No.
24 25

Goldman Sachs Investments (Mauritius) Limited v. The Adjudicating Officer, SEBI , 2008 BusLR 611 (NULL). HSBC Investment Securities (Netherlands) NV v. Adjudicating Officer, SEBI, 2007 Bus LR 345 (NULL)

15 FITTC/CUST/14/2001 of 31.10.2001, an FII is required to report to the Board the issuance of participatory notes against the purchase or sale of Indian securities. The appellant was a banking corporation registered in the Netherlands and was granted a certificate of registration as an FII by the Board on 9.5.2000. In response to its application dated 14.7.2003, the Board cancelled its registration as FII on 17.11.2003. With effect from 7.3.2006, the appellant stands liquidated under the laws of the Netherlands. In August-September 2000, the appellant issued participatory notes (a derivative instrument) against the purchase/sale of shares of Bharat Petroleum Corporation Ltd (BPCL for short), an Indian company, to Union Global Management and Union Investment in the U. K. Admittedly, this was not reported to the Board. However, the Board, having been informed of the issuance of these participatory notes by HSBC Securities, the appellant's broker in India, wrote to the appellant on 1.9.2003 seeking detailed information on the subject. In response, the appellant furnished the details of the participatory notes on 12.9.2003. Thereafter, on 16.7.2004, the Board issued a show cause notice to the appellant under the Securities and Exchange Board of India (Procedure for Holding enquiry and imposing penalties by Adjudicating Officer) Rules, 1995 alleging breach of regulation 20 of the FII Regulations, 1995 read with the Board's circular of 31.10.2001. The adjudication proceedings that followed the reply given by the appellant culminated in the Board's order dated 22.12.2006 imposing on the former a penalty of Rs. 10 lacs under Section 15A of the Securities and Exchange Board of India Act, 1992 (the Act, for short). It is this order that is under challenge in this appeal Now Regulation 20 of the FII Regulations states: Every FII shall, as and when required by the Board or the Reserve Bank of India, submit to the Board or the Reserve Bank of India, as the case may be, any information, record or documents in relation to his activities as a FII as the Board or as the Reserve Bank of India may require. An FII is defined under regulation 2 (f) of the FII Regulations as "an institution established or incorporated outside India which proposes to make investment in India in securities...." Hence, it was argued by the respondents that , the information desired by the Board in its circular of 31.10.2001 has necessarily to be restricted to the activities of an FII in India and not outside. It was stressed a foreign institution that issues derivatives, outside India, on underlying Indian securities is not required to be registered with the Board as an FII. The appellant's action of issuing participatory notes abroad was not an action as an FII registered with the Board but as a banker in a

16 jurisdiction outside India. The fact that the underlying security in the present case was Indian was only incidental. The respondent argued that the stand taken by the appellant that regulation 20 of the FII Regulations can relate only to an FIIs activity in India to be a totally incorrect proposition. It was argued by the respondent that any issuance of derivative instruments abroad by an FII against an Indian security has to count as an activity in relation to his activity as an FII within the meaning of regulation 20. Furthermore, it was argued that regulation 20A is only clarificatory in nature and all activities of an FII in relation to Indian securities, whether in India or abroad, is covered within the ambit of regulation 20. The SAT agreed with arguments of the respondent. This is so because a registered FII can issue derivative instruments abroad against an Indian security and is at liberty to trade and invest in the same security in the Indian market at the same time. The Sat clarified that the appellant was trading in BPCL shares in the Indian market during the same time when it was issuing participatory notes against these shares abroad. A foreign operator who is not a registered FII can not do this. Clearly, in order to get a complete picture of the operations of an FII in Indian securities, it is essential to have full information regarding his activities involving derivative instruments against Indian securities abroad. Thus, the obligation cast upon FIIs by the Board in its circular of 31.10.2001 under regulation 20 of the FII Regulations was considered to be a legitimate one. Finally. SAT dismissed the appeal and reduced the quantum of penalty to be paid by the appellant to a sum Rs. 10000 only. 3.2 Foreign Exchange Management Act Regulations: Under Section 6(3)(b) of the Foreign Exchange Management Act,1999, the Reserve Bank of India has been granted authority to set guidelines to determine if and when persons resident outside India may purchase shares of an Indian company. Notifications like FEMA 20/2000-RB and FEMA 21/2000-RB are the sum and substance of the various mechanisms devised by RBI to give effect to Section 6(3) of the Act to regulate the transfer or issue of any security by a person resident outside India. FEMA 20/2000-RB is an important notification dealing with foreign investment in India and FEMA 120/2004-RB deals with overseas investment made by persons resident in India. For the purpose of the FEMA 20/2000-RB, investment in India by a non-resident has been divided into 6 categories and the regulations applicable have been specified in respective schedules as

17 Investment under the FDI scheme, Investment by FIIs under the Portfolio Investment Scheme, Investment by NRIs under the Portfolio Investment Scheme, Investment by NRIs on Nonrepatriation or/and repatriation basis, purchase and sale of securities like government securities, treasury bills etc by FIIs and NRIs and Investments made by Foreign Venture Capital Funds. Portfolio Investment Scheme for FIIs FIIs registered with SEBI are eligible to purchase shares and convertible debentures issued by Indian companies under the Portfolio Investment scheme. A SEBI registered FII/sub-account is permitted to open a Foreign Currency denominated Account or a Special Non-Resident Rupee Account for making genuine investments in the securities. In the case of FIIs, the total holding of each FII/SEBI approved sub account shall not exceed 10 percent of the total paid up capital and the total holdings of all FIIs/Sub-accounts of FIIs put together shall not exceed 24 percent of the paid up capital. The limit of 24 per cent can be increased to the sectoral cap/statutory limit as applicable to the Indian company concerned, by passing a resolution of its Board of Directors followed by a special resolution to that effect by its General Body. FIIs are not permitted to invest in equity issued by an Asset Reconstruction Company, chit funds, nidhi companies, real estate etc.

3.3 Sectoral Caps Quite apart from the ceilings on FII investment, there were and are ceilings on FDI, and in some cases, unified ceilings for nonresident investments. There are two types of ceilings on FII investment: statutory and administrative. Currently non-resident investments in public sector banks and insurance sector are capped under Acts at 20 per cent and 26 per cent respectively. Accordingly, FDI plus portfolio investments by FIIs and NRIs are capped at 20 per cent and 26 per cent under the above statutes. There are also sectors where administrative caps for non-resident investments have been prescribed. In these sectors (viz. telecom services, media, private sector banks) FDI plus portfolio investments by FIIs and NRIs cannot exceed the administrative caps fixed.

18 Caps can be of three types: i) A separate cap on FDI, ii) A separate cap on FII, and iii) A composite caps on FDI and FII combined together. Separate caps on FDI and FII, in turn, can be of five types: I) Ban on both FDI and FII (e.g. lottery business, gambling and betting), II) Non-zero separate caps on both FDI and FII ([e.g., DTH-broadcasting]), [DTH has composite ceiling with a sub-ceiling for FDI at 20 per cent] III) A composite non-zero cap on FDI and FII (banking, insurance, telecom) IV) Ban on FDI with a non-zero cap on FII (e.g., Terrestrial broadcasting FM, retail trading), and V) Ban on FII with a non-zero cap on FDI (e.g. print media). For example, for private sector banks falling within the purview of the RBIs regulatory jurisdiction, no distinction is made either between different categories of non resident investors or the nature of foreign investment, whether portfolio or FDI. Similarly, no distinction is made either between different categories of sub-sectors of FM radio broadcasting and satellite uplinking, cable network and Direct-to-home.

3.4 MNCs Delisting In the last decade, we have seen numerous cases where listed subsidiaries of multinational companies (MNCs) got delisted from Indian stock markets. Companies such as Reckitt Benckiser, Cadbury, Philips, Panasonic, Ray Ban, Otis and Carrier were once listed on the Indian bourses.26 Analysts and investment bankers are concerned that a sharp rally in shares of many multinational companies, or MNCs, over expectations of delisting offers is building up a bubble which could eventually burst.

26

http://www.equitymaster.com/detail.asp?date=04/13/2011&story=4&title=Why-do-MNCs-want-to-delist-fromIndia.

19 They feel share prices of many MNCs have surged beyond levels justified by their fundamentals with more and more investors betting that parent organisations of MNCs may opt for delisting following the government diktat on a minimum 25% public holding in all listed companies. There is a potential risk of share prices correcting sharply if the government extends the deadline for complying with the minimum public holding norm beyond June 3, 2013. This, however, has been ruled out by the regulator. Investors can also lose in the short-term if MNCs opt for equity dilution to stay listed.27 Major reasons for delisting: 1. Lenient FDI norms and removal of sector caps: In the first place it is important to understand the reason behind MNCs getting listed in the Indian stock markets. Two decades back, foreign companies eager to set up their shops in India had restrictions to operate alone. They had to adhere to the foreign direct investment (FDI) policy that had an upper cap on the maximum ownership by a foreign entity. They could not have owned 100% of the business entity in India. This requirement led many foreign companies to list their subsidiary in India.

But the last few years have seen the Indian economy changing its FDI policy in many sectors. There are now no caps on ownership except in a few critical sectors. MNCs can own full 100% in their subsidiaries if they want to. So the compulsion of FDI policy that made the MNCs list in the markets is no more applicable. This has been one of the biggest reasons for the MNCs to delist now. 2. Strategic move for greater independence and lower costs: For a company to stay listed, the company has to adhere to a lot of rules and regulations. There are various forms of compliance to be met with BSE, NSE, SEBI and other regulatory bodies. Timely information is to be disclosed to the shareholders (e.g.: annual report, quarterly results, etc). Approvals are mandatory for taking significant investment decisions like M&A, raising funds among others. All these aspects not just increase the time but also increase the cost of operations. So if the MNCs have enough financing support from their parent company and do not require financing from the Indian capital market, it makes sense for them to delist.
27

http://articles.economictimes.indiatimes.com/2012-05-02/news/31538652_1_mncs-ineos-abs-foreign-parents.

20

3. Depressed Market Conditions: Whenever we see the stock markets falling due to various reasons, almost all the stocks get beaten down. These suppressed stock market conditions lead to pessimism among investors who just want to get out of equities. Most investors do not differentiate between the good and the bad in that kind of pessimistic environment. Promoters of MNCs use this kind of undervaluation to their advantage. They acquire the remaining shares at lower valuations and apply for delisting. So we have seen that there is no single reason why MNCs opt to delist their stocks. Now you may ask: Is delisting by MNCs good or bad for investors? Well, that depends on the price at which the delisting happens. However, if we take a long term view, minority investors definitely stand to lose out on the possible gains that can be made from a few MNCs that are global brands and have amazing businesses. Consolidated FDI Policy 2012: The Department of Industrial Policy and Promotion (DIPP) has issued the new Consolidated FDI Policy Circular 1 of 2012 and some of the key changes relate to sectoral issues: - Relaxation for foreign investment in commodity exchanges whereby FII investment may be brought in through the automatic route; and - Clarification regarding the scope of leasing for investment in non-banking finance companies (NBFCs). Others relate to the imposition of additional restrictions on foreign direct investment (FDI): - Unavailability of share issuance option for purchase of second hand machinery from foreign suppliers; and - the need to make prior intimation to the Reserve Bank of India (RBI) while increasing the limit of 24% foreign institutional investments (FIIs) in a single company. The remaining changes formalize previous announcements that were already made by the Government:

21 - Investments by foreign venture capital investors (FVCI) through private arrangements and purchase on stock exchange; - Investments by qualified financial investors (QFI); - Liberalization of policy on transfer of shares in the financial services sector; and - Changes to sectoral policy in pharmaceuticals and single-brand retail trading. In terms the periodicity of changes to the FDI policy, a decision has been taken to review the policy annually rather than to follow the current practice of bi-annual changes. In the interim, changes will be effected by way of press notes. Although these are only the highlights of the policy, other issues might likely arise based on a detailed reading of the new policy, especially on matters of interpretation. Therefore, an FII28 may invest in the capital of an Indian Company under the Portfolio Investment Scheme which limits the individual holding of an FII to 10% of the capital of the company and the aggregate limit for FII investment to 24% of the capital of the company. This aggregate limit of 24% can be increased to the sectoral cap/statutory ceiling, as applicable, by the Indian Company concerned through a resolution by its Board of Directors followed by a special resolution to that effect by its General Body and subject to prior intimation to RBI. The aggregate FII investment, in the FDI and Portfolio Investment Scheme, should be within the above caps. No person other than registered FII/NRI as per Schedules II and III of Foreign Exchange Management (Transfer or Issue of Security by a Person Resident Outside India) Regulations of FEMA 1999, can invest/trade in capital of Indian Companies in the Indian Stock Exchanges directly i.e. through brokers like a Person Resident in India.

CHAPTER-IV CONCLUSION
Participatory Notes have been a contentious issue but due to the fear of slowing foreign capital inflow consensus had generally eluded the Indian policy makers on the manner of regulation. Timing of the final decision seems to have been prompted by large inflow of foreign capital into India since August 2007, which pushed the stock markets to record levels, thereby creating
See 2.1.15., DIPP defined FII as Foreign Institutional Investor(FII) means an entity established or incorporated outside India which proposes to make investment in India and which is registered as a FII in accordance with the SEBI (FII) Regulations 1995, p.11.
28

22 apprehensions of market volatility. Although, SEBI's conciliatory measures by relaxing FII registration seems to have steadied the Indian stock markets for now, long term impact on foreign capital inflow remains to be seen. It is to be expected that FIIs would seek out the best returns as well as hedge their investments by maintaining a diversified geographical and market portfolio. The difficulty is that when they make their portfolio adjustments, which may imply small shifts in favour of or against a country like India, the effects it has on host markets are substantial. Those effects can then trigger a speculative spiral for the reasons discussed above, resulting in destabilising tendencies. Thus the end of the bull run in January was seen to be the a result of a slowing of FII investments, partly triggered by expectations of an interest rate rise in the US. These aspects of the market are of significance because financial liberalisation has meant that developments in equity markets can have major repercussions elsewhere in the system. With banks allowed to play a greater role in equity markets, any slump in those markets can affect the functioning of parts of the banking system. On the other hand, if FII investments constitute a large share of the equity capital of a financial entity, as seems to the case with HDFC, an FII pullout, even if driven by development outside the country, can have significant implications for the financial health of what is an important institution in the financial sector of this country. Similarly, if any set of developments encourages an unusually high outflow of FII capital from the market, it can impact adversely the value of the rupee and set off speculation in the currency that can, in special circumstances, result in a currency crisis. There are now too many instances of such effects worldwide for them to be dismissed on the ground that India's reserves are adequate to manage the situation. Thus, the volatility being displayed by India's equity markets warrant returning to a set of questions that have been bypassed in the course of neo-liberal reform in India. The most important of those questions is whether India needs FII investment at all. With the current account of the balance of payments recording a surplus in recent years, thanks to large inflows on account of nonresident remittances and earnings from exports of software and IT-enabled services, we dont need those FII flows to finance foreign exchange expenditures. Neither does such capital help finance new investment, focussed as it is on secondary market trading of pre-existing equity. The poor showing of the markets on the IPO front in most years during the 1990s is adequate confirmation of this. And finally, we do not need to shore up the Sensex, since such indices are inevitably

23 volatile and merely help create and destroy paper wealth and generate, in the process, inexplicable bouts of euphoria and anguish in the financial press. In the circumstances the best option for the policymaker is to find ways of reducing substantially the net flows of FII investments into India's markets. This would help focus attention on the creation of real wealth as well as remove barriers to the creation of such wealth, such as the constant pressure to provide tax concessions that erode the tax base and the persisting obsession with curtailing fiscal deficits, both of which are driven by dependence on finance capital. SEBIs amendments to its FII regulations, which were notified on May 22, are in essence meant to discourage sub accounts and tighten conditions for issuance of Offshore Derivative Instruments (ODIs), while encouraging foreign funds to come upfront and register themselves as FIIs. The amendments also lay emphasis on establishing the identity of foreign entities investing in India. Having said that, the amendments have also relaxed conditions for registration as FIIs, throwing the arena open to a whole lot of entities, said an official with a law firm, who tracks regulatory developments. For one, a newly-established fund can now apply to be registered as an FII, provided the track record of the investment manager of the fund, who has promoted it, is taken into consideration. Earlier, the fund itself had to have a track record. The other relaxation is that university funds, endowment funds, charitable trusts and societies may be considered for registration as FIIs, even if they are not regulated by any foreign regulatory authority. KYC norms for registering sub accounts and for ODI issuances are a key feature of the amendments. Also, sub account has now been defined in a more focussed way, rather than in the inclusive way earlier, said legal experts. A sub account is now any person resident outside India, on whose behalf investments are proposed to be made in India by a foreign institutional investor and who is registered as a sub account under these regulations. FIIs can issue ODIs only to persons regulated by an appropriate foreign regulatory authority; and only after compliance with Know Your Client norms. Earlier, these conditions were not explicit, what was a qualification has now become a precondition for issuance of ODIs.

iv

Bibliography Articles Referred: Suchismita Bose and Dipankar Coondoo, The Impact of FII Regulations in India, Money and Finance, July-December Rajesh Chakraborty, FII Flows to India: Nature and Causes in Money and Finance, October-December. Coondoo, Dipankar and Paramita Mukherjee (2004): Volatility of FII in India, Money and Finance, October-March. Gordon, James and Poonam Gupta (2003): Portfolio Flows into India: Do Domestic Fundamentals Matter?, IMF working paper No 03/20. Government of India, Ministry of Finance (2005): Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative Flows, New Delhi, November Rakshit, Mihir (2006): On Liberalising Foreign Institutional Investments, Economic and Political Weekly, March 18 Mukherjee, Paramita, Suchismita Bose and Dipankar Coondoo (2002): Foreign Institutional Investment in the Indian Equity Market, Money and Finance, AprilSeptember. Dennis Campbell, International Securities Law and Regulation 2006, Vol. I, p. 487. New Rules for regulating PNs, The Hindu, Oct. 26, 2007, available at < http://www.hindu.com/2007/10/26/stories/2007102659960100.htm > India Changes Rules for Foreign Institutional http://www.sycr.com/files/India_Change_Rules.pdf> Investors, available at < < <

Only regulated entities can invest through PN route, available at http://www.thehindubusinessline.com/2007/10/26/stories/2007102651860100.htm > Priya Nair, Are KYC norms crossing the limits?, Available at

http://www.thehindubusinessline.com/2006/07/18/stories/2006071800690600.htm >