|India: Offshore Companies under SEBI Lens|
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Even as foreign institutional investors (FIIs) continue to show their preference for Indian equities and have flooded our stock market with about $5.9 billion since this March, the stock market regulator, the Securities and Exchange Board of India, is unable to rest easy.
The multi-layered organisation of some of these investors makes them opaque, enabling funds from questionable sources to be routed through this conduit into domestic stocks and their derivatives.
The Indian stock market regulator had taken the strong step of banning Barclays Bank and Societe Generale from issuing offshore derivative instruments early this year, for misrepresenting facts. It has now taken the next step in controlling round-tripping by asking all FIIs to divulge the structure of their offshore entities.
FIIs seeking to register with SEBI will henceforth have to give an undertaking that they are not Protected Cell Companies (PCCs) and Segregated Portfolio Companies (SPCs) and if they are Multiclass Share Vehicles (MCVs), then they have an adequate number of shareholders. Existing foreign investors are required to give similar undertakings by the end of this September.
Protected Cell Company
The PCC structure has evolved over the past five years in tax havens to impart anonymity/privacy to investors to enable them shield their assets from ‘prying eyes'. A PCC contains a number of segregated parts known as ‘cells'.
Each cell is legally independent from other cells as well as from the main company (core).
The assets, liabilities and activities of each cell are separated from each other. The creditor of one cell does not have recourse to the assets of other cells or the core in the event of bankruptcy.
While this structure ensures that each cell can continue to survive even if one of the others gets defunct, there is a large degree of opacity surrounding this structure. The most important being that the ownership of each of the individual cells is questionable as the PCC is registered as a single entity only at the core level with SEBI. The company can also continue to add new cells without seeking permission from our market regulator.
Thus the real owner of the funds that are routed into our equities remains unknown.
According to Mr Suresh N. Swamy, ED, PwC, “PCCs have never been a favoured lot with SEBI and it has been reluctant to grant registrations to them. All FII/sub-account have to now declare that they are not a PCC or SPC. If they are, they may have to unwind their structure or amend it to something which may be more acceptable to SEBI.”
Multiclass Share Vehicle
The other structure that the circular talks about is MCV. This is a more conventional entity that is permitted by its memorandum of association/charter to issue multiple classes of shares so that each class of share owns assets catering to a certain set of investors. MCVs act like a mutual fund managing various mutual fund schemes.
There are two structures of MCVs that SEBI has recognised in its circular. One in which there is a common portfolio of assets that is to be distributed across all the classes of shares, and in the second structure each class of share holds a different portfolio.
In the first instance, SEBI requires the foreign company to be broad-based (have a minimum of 20 shareholders at the company level with no single individual investor holding more than 10 per cent shares or units) at the core level.
When each class of shares has a different portfolio, then each class of shares should have minimum of 20 shareholders. In case of change in structure or addition of new classes of shares, permission needs to be taken from SEBI.
To put the SEBI directive in simple terms, only FIIs that are structured as MCVs and suitably broad-based would be allowed to register with SEBI in future.
FIIs structured as PCCs would not be allowed to register. Existing MCVs can broad-base their shareholding and continue to function while the existing PCCs would have to change their structure to something acceptable to SEBI.
The principal consequence of this move is that it can curtail overseas fund-flows into equity markets albeit temporarily.
It is obvious that investors that are part of cells in PCCs are those that are neither registered with any regulatory authority nor want to register directly with the Indian regulator. Anonymity is the main reason why this route is used.
Since such entities cannot invest through the participatory notes either, as these instruments can only be issued to regulated entities, such funds could move away from the Indian stock market.
According to Mr Swamy, “overseas exchanges such as the Singapore Stock Exchange allow funds to bet on the Indian market via the SGX S&P CNX Nifty Future. In addition, there are ETFs linked to Indian equity indices traded on various global exchanges. If investing in India is increasingly made difficult, overseas funds will flock to other jurisdictions where investing is easier.”
While temporary reduction in overseas fund-flow would not impact the structural trend in our stock market, funds from dubious sources moving away from our shores would be welcomed by both SEBI and the RBI. Reduction in the copious overseas flows witnessed since March this year will also ease the pressure on the rupee that has strengthened 4 per cent against the dollar so far this year.
Some quarters are, however, of the view that frequent changes in regulation are not good for the image of the Indian equity market.
“The financial services world is very innovative and regulation often plays catch up. It would also not be surprising if overseas funds come up with something new in the near future,” added Mr Swamy.
The opinions expressed do not constitute investment advice and specialist advice should be sought about your specific circumstances.
Published on our website on May 5, 2010