Participatory Notes
Why finmin is ignoring the crime paper trail

As money-launderers, FII stock market manipulators—and perhaps even those inimical to our national security—laugh all the way to the bank, Finance Minister
P Chidambaram staunchly defends the seriously problematic Participatory Notes.

By Paranjoy Guha Thakurta

Participatory notes, or P-notes (PNs), are financial instruments preferred by stock market players in India to conceal the real beneficiaries of illegal flows of money and speculative transactions. For more than six years now, government authorities and regulatory bodies have been aware of how P-notes have been misused to launder funds—that is, convert black money into legal tender. More recently, there have been indications that the country’s share markets are being manipulated for the benefit of terrorist organisations.

In fact, reports a financial daily, PN issuance has spiked over the past couple of months using the route of the 'proprietary sub-accounts' of foreign portfolio investors. PNs as a share of total foreign portfolio inflows ratcheted up from 32 per cent towards the end of 2006 to 42 per cent at the end of March 2007.

Obviously, the intent of the proprietary sub-accounts is to avoid fingering by the country’s regulatory bodies, which are, in any case, riddled with operational inconsistencies. The rise in PNs is said to be largely through these proprietary sub-accounts.

The modus operandi is simple, and because of its simplicity, amenable to cloaking. ‘A’ routes money—primarily hawala—into an offshore firm that exists solely on paper. This firm goes to bank ‘B’ and opens an account with the dubious money. The bank approaches ‘C’, a foreign institutional investor (FII) registered with the Securities and Exchange Board of India (SEBI).

This FII opens up a sub-account in a tax haven to handle the funds the bank gave it, and more often than not invests in Indian equities, issuing PNs to the bank. The FII, therefore, technically fulfils SEBI’s norms that it be informed of the identity of the sub-account investor. On paper, it is the bank that benefits, even though it is no more than a conduit for ‘A’, which is the prime beneficiary, with the bank taking a good cut from all transactions.

The Union Ministry of Finance has, however, inexplicably chosen to turn a blind eye to the blatant abuse of P-notes. North Block has obstinately ignored suggestions made not only by independent experts but by members of official committees whose very views it should have heeded long ago. These panels have included senior executives of the Reserve Bank of India (RBI), the country’s central bank and apex monetary authority, and SEBI, the regulator of the stock exchanges and financial markets.

There is enough indication of the intrinsic problems that attends P-notes that Finance Minister Palaniappan Chidambaram should not be turning a deaf ear to those who been calling for the imposition of an outright ban on their use. The rampant use of these instruments has not merely eroded the confidence of ordinary investors, but might also have adversely impacted the security of the nation. If there is a reason behind the finance minister’s immobility on the issue, it’s not clear to anyone.

On February 11 this year, while speaking at the 43rd Conference on Security Policy in Munich, Germany, the Government of India’s National Security Adviser (NSA) M K Narayanan stated: “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.”

Chidambaram begged to differ. On May 15, replying to a question in the Rajya Sabha on the role of FIIs that were allegedly acting as conduits for terrorist money coming into India, Chidambaram said, “The NSA had stated that there could be isolated incidents of terrorist organisations manipulating the stock market. My ministry then sent a formal query to the National Security Council [NSC] and asked them to inform the government of any specific instances that may have come to their notice. The NSC secretariat replied that they had no specific information.”

Trinamool Congress Member of Parliament Dinesh Trivedi then wondered if all the talk about terrorists investing in the country’s stock markets was just “a piece of garbage”. The finance minister shot back, “There is a system in place which is monitoring money laundering. I can’t recall of any instance of terrorists’ money being laundered in the Indian stock market.”

Sushma Swaraj of the Bharatiya Janata Party (BJP) wondered whether terrorists could be using
FIIs to smuggle in money because “they are faceless entities”. To the apprehension she expressed, Chidambaram replied, “All FIIs are regulated entities in their respective jurisdictions. When an FII applies for investment, SEBI examines the application carefully and sometimes the permission for allowing them to invest in the stock market is held back for several months.” Then he emphasised, “Nobody—and I repeat, nobody—who is not a regulated entity, can and has applied for investment.” He added that he was “confident that these laws are adequate, though I am open to any suggestions…”

Is Chidambaram really open to suggestions? This is, indeed, a crucial enough question for a finance minister at the best of times. During rocky periods, the question becomes critical to national security. The facts indicate that on a number of occasions, the finance ministry has, in its infinite wisdom, ignored advice given by experts about the need to stop the use of P-notes. On the contrary, certain mandarins in North Block have argued against banning PNs on the ground that this could lead to a sudden fall in share market indices, and have reportedly called for a “cautious approach” in this regard, saying that it would be wrong to assume that “all” transactions using PNs involve “hot money”—funds that have either been illegally obtained or, as in the case of hedge funds, money that could rapidly flow in and out of the country.

What indeed are P-notes? A participatory note is an offshore ‘derivative’ financial instrument, or a contract note that has been issued by an FII registered with SEBI or one of its sub-account holders to another entity that wishes to invest in Indian stock markets but is not registered (or does not wish to register itself) with SEBI. In other words, a P-note is a contract between a legal entity registered in India with one that is not. P-notes are generally issued overseas by the associates of India-based foreign brokerages or even domestic institutional brokerages against underlying shares or securities that are listed on Indian stock exchanges. Brokers buy or sell these shares or securities on behalf of their clients on their proprietory accounts, and issue P-notes in favour of such foreign investors.

Such is the nature of international terrorist operations that they will utilise any and every loophole in financial regulations they can dig up. It’s in the nature of the game. It would be extremely optimistic to assume—even despite beagle-eyed monitoring—that P-notes have escaped the notice of interests inimical to India. In fact, in recent years, P-notes have attracted attention because the ultimate beneficiaries of the transactions using such notes are often not known to any government authority in India, be they the RBI, SEBI or the Income Tax Department. This implies that P-notes facilitate tax avoidance and money laundering. Since P-notes do not attract the attention of market regulators in the countries where they are issued, the entities holding such instruments go virtually unregulated.

It may be recalled that during the securities scam of 2001 involving brokers like Ketan Parekh, a SEBI investigation had revealed that transactions worth around US$ 2 billion had taken place through overseas corporate bodies (OCBs) controlled by non-resident Indians registered in Mauritius, a tax haven with which India has a Double Taxation Avoidance Treaty (DTAT), whose real beneficiaries were resident Indians. The transactions of these unregulated OCBs caused considerable market volatility. SEBI provided the finance ministry with a list of names of 30 OCBs that were banned from investing in the markets after the scam—it was found that six of the most reputed FIIs had issued P-notes to these OCBs.

In early-2004, SEBI and the RBI found that as much as a quarter of the total inflow of FII funds—or roughly Rs 24,000 crore out of a total of Rs 90,000 crore—had entered the country’s stock markets through P-notes. The RBI feared that quite a substantial proportion of the transactions that had used P-notes involved illegal money that had first been taken out of India and then brought back into the country in a ‘clean’ form, most of it through Mauritius. As soon as rumours started doing the rounds that SEBI might ban P-notes, market indices nosedived. But SEBI, ostensibly an ‘autonomous’ regulator, did nothing of the sort. The BJP-led NDA government had by then embarked on its ‘India Shining’ campaign; the markets had to remain buoyant.

Earlier, on December 19, 2002, the Joint Parliamentary Committee led by Sri Prakash Mani Tripathi submitted a voluminous report on the 2001 stock market scandal that stated: “SEBI has expressed suspicion that some Indian promoters have purchased shares of their own companies through PNs (participatory notes) issued through the sub-accounts of FIIs. This mechanism enables the holders to hide their identities and enables them to transact in the Indian capital market. The Committee notes that SEBI has since directed FIIs to report about the details of the PNs as and when issued by them. The Committee suggests that failure on the part of FIIs to report issue of PNs should be viewed seriously and should entail stringent punitive action. It should also be ensured that this instrument is not misused in any way to manipulate the Indian securities market.”

Over the past few years, the rules pertaining to the use of P-notes have ostensibly been tightened. With effect from February 3, 2004, P-notes can be issued only to regulated entities, and further transfers, if any, can be issued only to other regulated entities. Moreover, the FIIs issuing P-notes are bound by ‘know your client/customer’ (KYC) norms. In addition, FIIs cannot issue such notes to Indian nationals, persons of Indian origin, or OCBs controlled by NRIs. FIIs are required to submit quarterly reports to SEBI about investments made through P-notes and each month, they have to report details of PNs issued, renewed, cancelled or redeemed to SEBI.

But these are rules, and meant to be broken: market players have found ways to circumvent these rules and continue with impunity to use P-notes to help the process of “round-tripping” of illegal funds held by Indians. It is believed that the Pune-based horsetrader, Hassan Ali Khan, used precisely this method to launder huge amounts, a vast majority of it well under SEBI’s radar.
In May 2004, the national common minimum programme (NCMP) of the United Progressive Alliance (UPA) government had talked of encouraging FII inflows, but also of simultaneously reducing the vulnerability of the country’s financial systems to speculative flows. In November 2005, a report prepared by a committee of experts headed by the Chief Economic Adviser to the Government of India in the finance ministry, Dr Ashok K Lahiri, had listed various concerns about the use of P-notes, the first of which 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”.

Although the report of the committee—called the “expert group on encouraging FII inflows and checking the vulnerability of capital markets to speculative flows” —cautioned against the “potential abuse” of P-notes and the need for their “appropriate regulation”, it did not suggest that the use of PNs be stopped. While stating that the current dispensation for P-notes might continue, the Lahiri group report said: “SEBI should have full powers to obtain information regarding the final holder/beneficiaries or of any holder at any point of time in case of any investigation or surveillance action. FIIs should be obliged to provide the information to SEBI.”

The report pointed out that market integrity concerns could get heightened when funds from unknown sources or laundered money were involved, adding that a “negative list” of tax havens should be prepared and entities registered in these jurisdictions should be prevented from attaining the status of registered FIIs.

But, in a most unusual development, Vinay Baijal, Chief General Manager of the RBI, submitted a dissenting note that stated: “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, restrictions on suspicious flows enhance the reputation of markets and lead to healthy flows.

We, therefore, reiterate that the issuance of participatory notes should not be permitted.” He called for a closer look at hedge funds that had applied for registration with SEBI and suggested the formation of a special group to study measures to contain large volatility in FII inflows.

The Lahiri group was supposed to prepare an “action plan” for “time bound implementation”. The committee of experts (including the representative of the RBI) took another tack altogether, suggesting, instead, that one more research programme be initiated in the finance ministry’s Department of Economic Affairs on the issue of building a consensus on future policies on
capital account.

This is what K Subramanian, a former official in the finance ministry, wrote in the Hindu Business Line on December 12, 2005:
“In short, the group has remitted the burden back to the Ministry! In part, it is a sop to the RBI, which, while dissenting with the group, wished that all material be placed in the public domain for a wider debate. The debate is not new. The RBI Governor (Y V Reddy) voiced his misgivings and, in January had said, ‘The magnitudes of FDI (foreign direct investment) and FII flows are tending to be large and volatility has perhaps increased. The impact of such flows on the stock markets is discernible.’ He went on to add, ‘There is scope for enhancing the quality of flows through a review of policies relating to eligibility for registration as FIIs, and an assessment of the risks involved in flow through hedge funds, participatory notes, sub-accounts, etc.’

“In a later speech, he (Reddy) suggested imposition of a tax, on the lines of (James) Tobin (the 1981 Nobel Laureate in economics), to moderate inflows. In no time, the Finance Minister (Chidambaram) countered the suggestion and said that the government had no intention of curbing inflows through taxes. The differences seem to run deep. It is clear that the group could not iron out the differences with the RBI and has given a ‘divided’ report. It is unclear how such a report will help formulate policies visualized in the NCMP.”

Subramanian criticised the Lahiri group report for the selective use of research data to conclude that the volatility of the Indian stock markets was not a matter of concern. He wrote that an issue “on which there is serious disagreement is over the treatment to be accorded to P-notes”. “The RBI wants P-notes banned. Its concerns 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. The group recommends continuance of the current policy of allowing P-notes and sub- accounts…Unfortunately, hedge funds, which are hiding behind P-notes, are not registered in any country or with any regulator. Their ownership is opaque and location shifty.”

He argued that the Lahiri group mistakenly believed that other countries would cooperate with India in checking money-laundering through P-notes. “There are 33 (countries) in the ‘cooperative list’ (of the Organization of Economic Cooperation and Development or the association of the wealthiest countries in the world). These countries are unlikely to help SEBI in any investigation. They are mostly principalities of OECD countries and have power over them. None of those countries nor the OECD will come to our rescue, as they might not view such security dealings as violations under their laws. Even Mauritius, a friendly country, did not permit ‘fishing’ while grappling with the Ketan Parekh stock scandal. Thus, any due diligence suggested in the report is on paper. We have been living with this legal fiction for long.”

What Subramanian described as ‘fishing’ is also called ‘lifting the corporate veil’ or ‘establishing an audit trail’. At present, theoretically speaking, SEBI can ask an FII to identify up to three layers of beneficial owners of an entity that has been transacting in Indian securities using P-notes—that is, identify the owners of firms A, B and C in a situation in which Firm A is controlled by Firm B which, in turn, is controlled by Firm C. In actual practice, however, as financial columnist Sucheta Dalal points out (see interview), this is rarely done.

As Subramanian states: “The problem with hedge funds is that they operate in unregulated realms; their dealings are secret and operational methods opaque. Many of them could be…(OCBs) which have been banned after the… (JPC) report on (the 2001) stock scam. Much of it is ‘round tripping’. The RBI’s concerns are real.” Chennai-based chartered accountant M R Venkatesh pointed out (Hindu Business Line, March 16, 2007) that since FIIs are not bound to reveal the names of the holders of PNs, the instrument is “completely opaque” and against well-established ‘know your customer’ norms followed the world over. “It is inconceivable in these times of transparency that a class of investors is allowed to operate behind (a) veil of secrecy,” he wrote. “This cannot and should not be permitted…The benami and the money-laundering laws must not be reduced to mere ornamental pieces of legislation.”

Not that the story ends here with this sort of contrariety between the authorities and experts. Soon after a visit by Prime Minister Manmohan Singh in March 2006, the RBI appointed a high-level committee on full capital account convertibility headed by its former deputy governor, S S Tarapore. This panel questioned the authorship of PNs, unequivocally stating in its September 2006 report that since the “beneficial ownership or the identity” of the holder of a PN is not known, and since these notes are freely transferable, “FIIs should be prohibited from investing fresh money raised through PNs”, adding that existing holders of PNs “may be provided an exit route and phased out completely within one year”.

For reasons best known to government, the blizzard of warnings by independent experts and panels of the government’s own making have changed not a single thing: P-notes continue to be used. It has been officially estimated that the value of P-notes in the country’s stock markets grew by as much as 70 per cent between January 2006 and January 2007, accounting for roughly one-third of the total volume of foreign portfolio investments—which amounted to US$ 8.5 billion in 2004, US$ 10.7 billion in 2005, and US$ 8 billion in 2006. So far in the current calendar year, approximately US$ 3 billion has already made its way into the Indian stock exchanges through FIIs.

According to Business Standard newspaper, between 10 and 15 of the 1,000-plus FIIs registered with SEBI are active players that use P-notes. These FIIs include some of the biggest names in the business: firms affiliated to financial services bigwigs like Merrill Lynch, Morgan Stanley, and Goldman Sachs. Subramanian remarks that as far as ‘know your customer’ requirements are concerned, “the problem is that reputed institutions such as Citigroup, JP Morgan, HSBC, and Goldman Sachs, operating through their subsidiaries in Mauritius, stonewalled supply of information and took cover behind confidentiality”. The finance ministry is hardly unaware of the financial clout of these institutions, nor of their facility in finding ways to beat any system. So, the question remains: Is the finance ministry, led by the sometimes bellicose and always self-assured P Chidambaram, afraid of antagonising these well-known international financial behemoths? Does he apprehend that if the use of Participatory Notes is banned, stock market indices might implode, as they did on May 17, 2004, soon after the UPA government came to power? (See box on the UBS Securities case) Or does he entirely identify a bullish stock market with the country’s economic development, as some analysts like L C Gupta believe? (See interview) However they might sound, these questions are not merely rhetorical: if the authorities give us the wrong answers, or make the wrong decisions, the repercussions could be calamitous for the country for a long time to come.