Why Participatory Notes are dangerous

R. VAIDYANATHAN
Participatory Notes are a slap on the face of every citizen who is an investor. To invest in shares
one has to fill up umpteen forms and provide proof of residence, PAN number, and so on. But
for PN investors, the system is totally silent, even on basic information. Why not have confidence
in the India story and realise that we can get funds with addresses without offering such
anonymity, asks R. VAIDYANATHAN.

The PN system is discriminatory and seems to favour ghost investors.

Participatory Notes (PN) — a general name used for the investment by Foreign Institutional
Investors (FIIs) through Offshore Derivative Instruments (ODIs) such as Participatory Notes,
Equity-Linked Notes, Capped Return Notes and Participating Return Notes — have created a
storm in the stock market, with SEBI coming out with a draft for discussion to regulate them, the
RBI suggesting that they be phased out, and the Finance Minister assuring that the Government
is not going to phase them out.

First things first. Let us clearly understand the fundamental issues. The PNs are a slap on the face
of every citizen who is an investor. For a person to invest even in one share, several KYC (know
your customer) forms have to be filled up, and PAN numbers and proof of address, etc.,
provided. For the PN investor the system is totally silent on even elementary information. The
FIIs issue PNs to funds/companies whose identity is not known to the Indian authorities.

Hence, the PN system is blatantly discriminatory and seems to favour ghost investors. Any self-
respecting market, if it discriminates at all, does so against outsiders. But we have done the
unthinkable.

We should recognise and internalise the fact that funds are in search of markets, and not the other
way. Given the demographic shift in the developed markets (where pension funds have to locate
markets to get returns for longer periods) and the lack of huge opportunities in long-term
projects, it is natural that global funds are in search of markets.

The PN route, through which a section of investors is participating in our markets, is a mystery
wrapped in a puzzle, crammed inside a conundrum and delivered through a riddle. These are
address-less funds that could be from dubious sources and the clamour for it is intriguing, if not
outright suspicious.

Current Scenario

According to the SEBI Web site, the current position of these instruments is as follows:
“Currently, 34 FIIs / Sub-accounts issue ODIs. This number was 14 in March 2004. The notional
value of PNs outstanding, which was at Rs 31, 875 crore (20 per cent of Assets Under Custody
of all FIIs/Sub-Accounts) in March 2004, increased to Rs 3,53,484 crore (51.6 per cent of AUC)
by August 2007.

The value of outstanding ODIs, with underlying as derivatives, currently stands at Rs 1,17,071
crores, which is approximately 30 per cent of total PNs outstanding. The notional value of
outstanding PNs, excluding derivatives as underlying as a percentage of AUC is 34.5 per cent at
the end of August 2007.” (SEBI – Paper for Discussion on ODIs).

This implies that more than 50 per cent of the funds are flowing through this anonymous route
which needs a re-think on this entire issue. This brings us to the question about who are the
investors interested in Indian Papers.

Who uses the PN route?

The first category is the regular funds whose twin objectives are returns and more returns on a
21*7*365 basis. They are interested in India since the India story is very good and returns are
attractive compared to developed markets. The second category is prodigal money returning. It is
not a secret that a large number of politicians/bureaucrats/business-persons have accumulated
wealth abroad. This has been accumulated by under-invoicing/over-invoicing, by corruption in
contracts and gifts from abroad; and by not bringing in legitimate receipts.

The third category is those foreign governments/entities who would like to acquire/control Indian
entities by taking them over.

The fourth category is the terror financiers who could find this route attractive and simple. The
first category does not have any reason to use the “anonymous” route since the aim is to earn
returns /repatriate and benefit out of interest rate and currency value arbitrage. They enter and
exit as per these calculations and are not shy about the greed for maximum returns. They pay the
taxes applicable and laugh all the way to the bank with bonus incentives.

The only issue is that currently the stock market is the only route for investing while several
other “unlisted” sectors, such as trade, transport, restaurants and other services are starved of
funds. Maybe methods should be evolved to get these regular global funds to invest not just in
the top ten shares of the stock market but in the needs of the large non-corporate or “ unlisted”
segments of the economy, through NBFCs. That would ease the volatility in the market since
currently large funds are chasing too few shares of the Sensex or Nifty.

No more ‘safe havens’

The second category will be enthusiastic in bringing the money back into India since the KYC
(Know your Customer) norms in many so-called “safe” territories like Switzerland are becoming
tougher — particularly after 9/11— and the India story is very interesting and the returns and
growth prospects are very good. The Government can always think of an “Amnesty Scheme” for
such “prodigal funds” in the form of “no questions asked” about the source. But, once the funds
are brought in, then all the KYC norms must be followed, with minimum legal and tax hassles.
After all, such amnesty schemes for the domestic black-money holders in the past have met with
reasonable success. Otherwise, a Special Purpose Vehicle (SPV) can be created which can be
dollar-denominated to hold these funds at attractive rates and which are converted over a period
of time to minimise the flow impact.

Harmful for companies

The third category spells danger for domestic companies since the unknown entity may be
targeting the local company without its knowledge. With reasonable control they can pressure
the current owners to settle with them or even try taking over.

This becomes more ominous in the context of several sovereign funds, like that of China, using
the private equity companies to manage their funds which are non-transparent.

These PEs could use other vehicles to acquire on behalf of these sovereign funds and it may be
possible that Chinese or West Asian sovereign funds may hold indirectly shares in Indian
companies, particularly in software or oil or telecom, which are critical sectors.

The fourth category is the one to be worried about. The terror financier will be happy on two
counts, namely the anonymity provided by these instruments and the domestic regulations on
gifting the shares.

Also important is the issue of the sale of these PNs to entities that could be inter-connected to the
original buyers.

In other words, the original buyer and to whom he sells could belong to inter-connected terror
entitities, in which case the global entity could have succeeded in transferring funds to India with
ease and anonymity.

It is not without basis that the National Security Advisor (NSA) has cautioned against terror-
financing through the banking and stock market channels.
That is a cause for concern. Why are we insisting on the anonymity of the investor and the
sources? Why not have confidence in the India story and realise that we can get funds with
addresses since we have arrived on the global arena?

We should distinguish between clean global flows and dubious flows as a responsible country
with a remarkable growth story.

(The author is Professor of Finance and Control, IIM-Bangalore. His views are personal and do
not reflect those of his organisation.)