P-Notes

Participatory Notes or P-Notes or PNs are instruments issued by registered foreign

institutional investors to overseas investors, who wish to invest in the Indian stock
markets without registering themselves with the market regulator, the Securities and
Exchange Board of India.

Financial instruments used by hedge funds that are not registered with SEBI to invest in
Indian securities. Indian-based brokerages to buy India-based securities / stocks and then
issue participatory notes to foreign investors. Any dividends or capital gains collected
from the underlying securities go back to the investors.

History of P notes

Since 1992, when FIIs were allowed to invest in Indian equity markets after the balance
of payments crisis, an offshore market for PNs developed as a primary conduit for
foreign investors to invest in India.

The origins of such flows stems from the bilateral tax treaty that India has had with
Mauritius. The main provision of the 1983 treaty was that no resident of Mauritius would
be taxed in India on capital gains arising from the sale of securities in India. The treaty
therefore gave capital gains exemption for investments routed via Mauritius. Despite the
uniform reduction in capital gains tax arbitrage that existed from the early 1990s through
July 2004, it is interesting to note that there has been a rapid growth in the market for
PNs in the last six to seven years.

Need of P-Notes

Since international access to the Indian capital market is limited to FIIs. The market has
found a way to circumvent this by creating the device called participatory notes, which
are said to account for half the $80 billion that stands to the credit of FIIs. Investing
through P-Notes is very simple and hence very popular.

Why investors prefer P-Notes

1. It keeps the investor anonymous

2. Investors can avoid tax. Presently, the tax authorities can open the files of FII’s
even after a period of 5 years after the date on which the actual transaction took
place and penalize them. However, in the case of P-Notes, this is not possible.
 3. It saves cost of record keeping, transaction cost, and regulatory compliance
overseas especially for small investors.

Thus investor use PNs to enter the Indian market in a small way and then when they are
established, they shift to full-fledged FII structure.

Problem with the P Notes

1. It is tough to establish the beneficial ownership or the identity of original investor.
The investor may sell the PN to others, and thus further layers.

2. PN is also becoming favorite with many Indian Money Launderers, who use it to
first ship out money of country through Hawala and then get it back using PNs.

3. SEBI suspects that certain institutions use the Participatory Notes way to
artificially rig the share prices.

Who can invest in P-Notes?

1. Any entity incorporated in a jurisdiction that requires filing of constitutional

and/or other documents with a registrar of companies or comparable regulatory
agency or body under the applicable companies legislation in that jurisdiction;

2. Any entity that is regulated, authorised or supervised by a central bank, such as

the Bank of England, the Monetary Authority of Singapore or any other similar
body provided that the entity must not only be authorised but also be regulated by
the aforesaid regulatory bodies;

3. Any entity that is regulated, authorised or supervised by a securities or futures

commission, such as the Financial Services Authority (UK), the Securities and
Exchange Commission, the Commodities Futures Trading Commission, the
Securities and Futures Commission (Hong Kong or Taiwan), or other securities or
futures authority or commission in any country , state or territory;

4. Any entity that is a member of securities or futures exchanges such as the New
York Stock Exchange (Sub-account), London Stock Exchange (UK), or other
similar self-regulatory securities or futures authority or commission within any
country, state or territory provided that the aforesaid organizations which are in
the nature of self regulatory organizations are ultimately accountable to the
respective securities / financial market regulators.
5. Any individual or entity (such as fund, trust, collective investment scheme,
Investment Company or limited partnership) whose investment advisory function
is managed by an entity satisfying the criteria of (1), (2), (3) or (4) above
The extent of P-Notes usage

There has been continuous increase in the no. of players issuing P-notes. It was just 17 in
2005, the number increased to 28 in 2007.

At present, there are 35 SEBI-registered FIIs in India, who issue PNs to investors in the overseas
market

According to govt. top 5 FIIs control 60% of P-Notes issued. The top P-Notes issuing FIIs are Morgan
Stanley, Merill Lynch, Citigroup, Goldman Sachs and CLSA.

Participatory Notes Crisis of 2007

On the 16th of October, 2007, SEBI (Securities & Exchange Board of India) proposed
curbs on participatory notes which accounted for roughly 50% of FII investment in 2007.
SEBI was not happy with P-Notes because it is not possible to know who owns the
underlying securities and hedge funds acting through PNs might therefore cause volatility
in the Indian markets.

Govt. imposed following restrictions:

1. No more issuing of P-Notes by sub-accounts. (a big chunk of P Notes was via

sub account- exact figure is not available)

2. No more issuing of derivative based P-Notes. (30% of P Notes were were

derivative based)

3. Existing positions with above conditions should be squared off in next 18 months.
(This meant that Rs 390 crore of positions were to be squared off per day over the
next 18 months which was definitely not a small amount)

4. No fresh P-notes to be issued by any FII having more than 40% of its investments
in P notes.

5. If derivative based P-note positions are less than 40% of total investments, then
fresh P-note based investments to be made only at an incremental rate of 5 %.

Due to these restrictions on PNs, the following day, the Sensex crashed by 1744 points or
about 9% of its value - the biggest intra-day fall in Indian stock-markets in absolute
terms. This led to automatic suspension of trade for 1 hour. Finance Minister
P.Chidambaram issued clarifications, in the meantime, that the government was not
against FIIs and was not immediately banning PNs. After the markets opened at 10:55
am, they staged a remarkable comeback and ended the day at 18715.82, down just 336.04
from Tuesday’s close after tumbling to a day’s low of 17307.90.

This was, however not the end of the volatility. The next day (October 18, 2007), the
Sensex tumbled by 717.43 points — 3.83 per cent — to 17998.39, its second biggest fall.
The slide continued the next day when the Sensex fell 438.41 points to settle at 17559.98
at the end of the week, after touching the lowest level of that week at 17226.18 during the
day.

The SEBI chief, M.Damodaran held an hour long conference on the 22nd of October to
clear the air on the proposals to curb PNs where he announced that funds investing
through PNs were most welcome to register as FIIs, whose registration process would be
made faster and more streamlined. The markets welcomed the clarifications with an 879-
point gain — its biggest single-day surge — on October23, thus signaling the end of the
PN crisis. SEBI issued the fresh rules regarding PNs on the 25th of October, 2007 which
said that FIIs cannot issue fresh P-Notes and existing exposures were to be wound up
within 18 months. The Sensex gave a thumbs up the next day - Friday, 26 October by re-
crossing the 19,000 barrier with a 428 point surge. On October 29, 2007

history was created when the Sensex leaped 734.5 points to cross the hallowed 20,000
mark

Important Events related to P-Notes

1992: P-Notes first made their appearance in 1992 when regulations were relaxed
permitting foreign institutional investors (FIIs) to invest in India

May 1998: Sensex crashed 162 points, The fall in the pivotals like IDBI, ITC, ICICI,
Larsen, and Reliance was attributed to the selling of participatory notes.

June 2001: SEBI reported that FIIs have done transaction for entities that are not allowed
to invest in India. The government decided to plug the misuse of participatory notes by
foreign institutional investors and took necessary corrective steps, including changes in
the sub-account policy for Mauritius-based FIIs operating in the Indian bourses.

20 November 2001: SEBI made it mandatory for FIIs to disclose details of issue of PNs.
Under the disclosure norms, FIIs had to report to SEBI on monthly basis on issuance,
renewal, cancellation or redemption of these instruments. In addition, they also had to
give details of the name of the investor of the PNs along with the face value, maturity
value and maturity date of these notes.

May 2003: Even though, FIIs were sending reports from time to time whenever they
were issuing PNs, SEBI was still not satisfied. SEBI decided that the disclosures in the
reports submitted by FIIs should be enhanced.

17 May 2004 : The Sensex, the Bombay Stock Exchange's 30-share sensitive index,
crashed by 842.37 points, the biggest intra-day crash in its 129-year history, and the
Nifty, the National Stock Exchange's index, shed 193.65 points. Experts blamed it on
PNs.

May 2004: SEBI banned UBS Securities Asia Ltd (UBS) from issuing participatory notes
for a year following its investigations into the market crash on Black Monday, May 17,
2004.

September 2007: $7 billion of foreign investment in a single month. The point to be

noted was that the market shed points in august 2007 owing to withdrawl of foreign
investments.

October 2007: SEBI imposed several restrictions on PNs, stock market plummeted.

6 Oct 2008 : SEBI removed restrictions on P-Notes. Pre October conditions were
restored.

17 June 2009 : SEBI planned P-Notes route less attractive.. SEBI has proposed that the
registration fee for FIIs be cut to $5,000 (Rs 2.35 lakh) for a five-year licence, as against
the present level of $10,000 (Rs 4.70 lakh) for three years. Similarly, in case of sub-
accounts, the registration fee is expected to be lowered to $1,000 (Rs 47,000) for five
years from $2,000 (Rs 94,000) for three years, said informed sources.
 FINANCIAL MANAGEMENT
ASSIGNMENT- 1

REPORT
ON
PARTICIPATORY NOTES

SUBMITTED TO : Ms. SHIVI KHANNA

SUBMITTED BY : SAPAN TYAGI
DATE : JULY 29, 2009