Mumbai: The Securities and Exchange Board of India (Sebi) on Thursday proposed tighter rules for participatory notes (P-Notes) in an attempt to curb the potential for money laundering through this investment route, popular among rich individuals and hedge funds.

Separately, Sebi also made it easier for companies to settle cases of suspected violations under the so-called consent mechanism if the breaches haven’t had a wide impact on the markets.

The change in rules on P-Notes follow recommendations made by a Supreme Court-appointed Special Investigation Team (SIT), which was set up to address the issue of black money, or unaccounted and untaxed wealth.

The SIT report in July 2015 made some critical observations on P-Notes and suggested increased regulation of fund flows through this route.

Following through on those suggestions, Sebi has proposed an increase in disclosure requirements and restricted transfer of P-Notes. Both these changes will help in keeping track of the beneficial owners of these instruments.

Through its changes, Sebi aims to bring P-Note holders under the ambit of Indian know-your-customer (KYC) and anti-money laundering norms.

P-Notes, or off-shore derivative instruments (ODIs), are instruments issued by registered foreign portfolio investors (FPIs) to overseas investors who wish to invest in Indian stock markets without registering themselves with Sebi.

By their very nature, P-Notes are seen as an opaque route for investment which leave room for round-tripping—the practice of money stashed away overseas by Indians returning home through tax havens in the garb of foreign capital—and money laundering.

One of the more significant changes proposed by Sebi is regarding the transfer of P-Notes—a big draw of the product.

According to a Sebi statement, the transfer of P-Notes will be restricted and allowed only after prior consent of the issuer. This means that for every downstream transfer of a P-Note, prior consent of the issuer would be needed.

Additionally, transfer of a P-Note will be allowed only to a pre-approved list of subscribers.

Any suspicious transaction that comes to the notice of the issuer would need to be reported to the Financial Intelligence Unit, which functions under the department of revenue.

“It is the requirement to keep track of transfers of P-Notes that could be cumbersome and impose transaction costs. One isn’t sure how many abusive P-Notes indeed get transferred. So I’m not sure if this is warranted, going by the potential benefits compared to the costs imposed," said Somasekhar Sundaresan, partner at J. Sagar Associates.

Issuers will need to verify entities that hold more than the predefined thresholds. For companies, the predefined threshold would be 25% of the total P-Note size and for proprietorship and partnership firms and trusts, the limit has been set at 15%.

The issuer will also need to report who controls the management and operations of a P-Note subscriber.

“The new norms are more for ensuring transparency and having checks in place while dealing with P-Notes rather than weaning out potentially abused ODIs. These additional compliance requirements would not impact the quantity of quality money that comes to India through ODIs," said Sandeep Parekh, founder of Finsec Law Advisors. “These steps will increase the onus on the financial institutions that are issuing P-Notes and could impact even the clean money in long term. However, in short, we may not see much of a knee-jerk reaction from the market."

The proposed changes come on the heels of an amended tax treaty with Mauritius under which India will get to tax capital gains on investments made through the island republic—a move aimed at curbing tax evasion, round-tripping and other treaty abuses.

Settlements through consent mechanism

At its board meeting on Thursday, the market watchdog said it will prohibit settlement through consent rules only in the case of offences that had a market-wide impact and hurt investors substantially.

The consent process was introduced in 2007 with the idea of reducing the regulatory time spent on minor violations. It allowed companies suspected of wrongdoing to settle cases without admission or denial of guilt.

However, relatively serious violations, such as insider trading, fraudulent and unfair trade practices, among others, were not allowed to be settled via consent.

These rules have been made less stringent now and a benchmark of “market impact" will used to decide whether a case can be settled through consent or not.

Sebi has defined “market-wide impact" as those cases that have a bearing on the broader securities market and not just on one listed security and its investors. The second criteria listed by the regulator, “substantial impact of default on investors", would depend on the number and quality of complaints.

“As per the initial reading of the press release, ‘market wide impact’ seems subjective and a majority of fraud cases under the Fraudulent and Unfair Trade Practice regulations could now be allowed consent. However, we would need to wait for the fine print for further analysis," said J.N. Gupta, a former executive director at Sebi. “I hope the objective of the new norms for consent is to allow settlement for smaller cases and keep the big cases that impact market adversely out of the ambit," added Gupta, who was not commenting on any specific case.

As per the regulator, this move is aimed at reducing the regulatory and administrative burden.

On 4 May, Mint reported that Sebi’s new line of thinking on the consent process could pave the way for the settlement for some old cases. For instance, they could see the settlement of the nine-year old case involving Reliance Industries Ltd (RIL).

Sebi, under its previous rules, had declined to settle a case of an alleged violation by RIL while dealing in shares of Reliance Petroleum Ltd in 2007. Since Sebi is yet to pass its final order in the case, cases such as RIL’s could become eligible for consent.

In other decisions taken on Thursday, Sebi proposed to reduce the mandatory sponsor holding from the current 25% to 10% to attract infrastructure participants towards Infrastructure Investment Trusts. Additionally, the regulator also decided to increase the number of sponsors to five from three.

The board of the market watchdog also mandated the top 500 listed companies by market capitalization to disclose their dividend distribution policies in their annual reports.

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