Mumbai: A few hundred foreign institutional investors (FIIs) and thousands of so-called sub-accounts they operate for their overseas clients are likely to close after the capital market regulator asked them to have at least one such account that has a wide investor base.
These rules are not driven by the recent turmoil in the stock market, but can cause it to drop further.
The Securities and Exchange Board of India (Sebi), between November and January, issued circulars to FIIs that also serve as investment managers, asking them to have at least one so-called broad-based sub-account. The regulator gave them a year’s deadline.
Out of the 1,741 FIIs registered in India as of November, some 1,200 act as investment managers, operating 5,586 sub-accounts.
Currently, a significant part of trading takes place through proprietary sub-accounts, which have a smaller investor base, with a single or a small group of rich individuals holding a majority in the corpus. Proprietary sub-accounts are shown as FIIs’ own money.
A broad-based sub-account needs to have at least 20 investors, with none holding more than 49% of the funds. Such accounts typically belong to large overseas wealth funds. Money that comes in through them is long-term in nature and the investors’ identities are known, ensuring quality and stability.
Sebi wants investment managers to have a meaningful portion of investments through such pooled accounts, although it has not specified the proportion.
Nearly 40% of FII sub-accounts, however, are proprietary accounts. In addition, 30% of FIIs that are investment managers operate only through proprietary accounts. They are not willing to comply with Sebi’s new guidelines, two persons familiar with the development said on condition of anonymity.
With the one-year deadline approaching fast, these FIIs will not renew their licences and may opt to invest only through participatory notes, the persons said, asking not to be identified citing the sensitivity of the issue.
“Most of them are in the process of closing shop while others may consolidate (reduce their number of sub-accounts),” one of the persons said.
Although the development “has nothing to do with current market turmoil”, he said, FIIs are key drivers of Indian equity markets and their exit may hit the markets hard at a time when they are quite vulnerable.
Indian markets have fallen more than 20% since January. The BSE Sensex has fallen by 6.6% this month alone on the back of weak global markets and heavy selling by foreign investors.
“So far there are three broad categories of FIIs—broad-based, foreign corporate bodies and foreign individuals. Now, Sebi wants all investment managers to have broad-based sub-accounts,” said U.R. Bhat, managing director, Dalton Capital Advisors.
“Foreign investors can close sub-accounts and invest through participatory notes, but then they would not be allowed to participate directly in QIPs (qualified institutional placements), bulk share deals, IPOs (initial public offerings) and so on. Another problem is that many registered entities may have pooled accounts with hundreds of investors, but one investor may be holding more than the permissible limit (49%), which does not comply with the definition of broad-based accounts. It will be difficult for them to continue.”
Licences for FIIs and their sub-accounts are valid for three years. “It is not possible to merge proprietary accounts with broad-based ones. Forty per cent of the sub-accounts and 300-400 FIIs may not renew their registrations with the new rules coming in,” the first person cited above said.
“In late 1990s, FIIs were allowed to have proprietary accounts and that is when corporate bodies and individuals started coming in. Later, the rules were tightened and only those FIIs were being given licences which had broad-based sub-accounts,” he added. “But around 2004-05, Sebi again started clearing applications with non-broad-based sub-accounts. Now, again, they want broad-based accounts.”
This person added that considering the poor performance of domestic markets, “Sebi may hold back its decision for some time”.
For renewal of registrations, FIIs need to inform the regulator at least three months prior to the expiry of their licences, but requests for registrations are not coming in, Sebi data shows.
This year, the net number of registered FIIs has fallen by five, compared with a net addition of 36 last year, 124 additions in 2009 and 408 in 2008.
The new norm is a additional onus on foreign investors, the second person said.
“For the last four months, the number of new registrations has stagnated. Some of the FIIs have been able to comply with new regulations and some are still struggling. While many would refrain from renewing their licences, at least 15% of the FIIs will completely exit on their own,” this person said.
Sebi’s move should not be to the clients’ detriment, a lawyer, who advises a large number of FIIs, said, asking not to be identified. Smaller FIIs will be the hardest hit, especially as they manage their own money through proprietary accounts that are used to generate offshore derivatives using participatory notes.
“Many such sub-accounts may opt to transfer their registrations to those FIIs who have at least one broad-based account,” the second person said.
The government opened the country to foreign investment in 1992. FIIs contribute an estimated 80% of the equity volume in India. In 2007, Sebi sought to arrest the surge of overseas money of uncertain origin being parked in Indian stocks through curbs on participatory notes.
The regulator’s latest attempt at cleaning up such flows comes during a year in which FII money is expected to go the other way. Since January, FIIs bought shares worth a net $774.50 million, having bought a record $29 billion of Indian equity in 2010. In August, FIIs have sold Indian equities worth $1.4 billion.