India’s New Regulatory Regime for Foreign Portfolio Investors

The Securities and Exchange Board of India (SEBI) notified the SEBI (Foreign Portfolio Investors) Regulations, 2014 (FPI Regulations) on Jan. 7, 2014.

The notification comes pursuant to the SEBI board meeting on Oct. 5, 2013, wherein the draft FPI Regulations were approved based on the proposals of the Committee on Rationalisation of Investment Routes and Monitoring of Foreign Portfolio Investments constituted under the chairmanship of Mr. K.M. Chandrasekhar (Committee) to merge the existing legal regimes for Foreign Institutional Investors (FIIs) and sub-accounts and Qualified Foreign Investors (QFIs) into a single class of investors, i.e., Foreign Portfolio Investors (FPIs).¹

This article analyses the salient features of the newly introduced FPI framework.

Background

SEBI set up the Committee on Dec. 6, 2012, inter alia, to prepare the draft guidelines and regulatory framework for an integrated policy on foreign investments, keeping the recommendations of the Working Group on Foreign Investment in India² as a starting point. The Committee analysed various portfolio investment routes currently available to foreign investors, and recommended, in its report dated June 12, 2013 (Report), the development of draft guidelines and a regulatory framework for FPI by merging FIIs and QFIs into a single investor class to be termed “FPI” so as to develop a harmonised model of investment routes. The Committee also recommended simplification of entry norms for FPIs by substituting the current requirement of direct registration with SEBI by registration with Designated Depository Participants (DDPs),³ subject to compliance with the applicable know your client (KYC) requirements.

SEBI, in its meeting on Oct. 5, 2013, accepted the recommendations of the Committee, and approved the draft FPI Regulations. On Jan. 7, 2014, SEBI notified the FPI Regulations, which in turn repeal the SEBI (Foreign Institutional Investors) Regulations, 1995.

Salient Features

Registration of FPIs

The FPI Regulations shift the onus of registering an FPI with SEBI to DDPs. The key conditions to be satisfied by an entity to be granted registration as an FPI, inter alia, include the following:

• the applicant is a resident of a country whose securities regulator is a signatory to the International Organisation of Securities Commission’s (IOSCO) Multilateral Memorandum of Understanding (Appendix A Signatories) or a signatory to a bilateral memorandum of understanding with SEBI;

• if the applicant is a bank, it is a resident of a country whose central bank is a member of the Bank for International Settlements;

• the applicant is resident in a country not identified in the public statement of the Financial Action Task Force (FATF) as having strategic Anti-Money Laundering/Combating the Financing of Terrorism deficiencies to which countermeasures apply, a jurisdiction that has not made sufficient progress or not committed to an action plan developed with the FATF to address the deficiencies;

• the applicant is a person not resident in India, but not a Non-Resident Indian;

• the applicant is legally permitted in its jurisdiction to invest in securities outside the country of its incorporation;

• the applicant (if it is a company) is permitted by its memorandum of association and articles of association or equivalent documents to invest on its own or on its clients’ behalf;

• the applicant has sufficient experience with a good track record, is professionally competent and financially sound and has a generally good reputation of fairness and integrity;

• the grant of certificate to the applicant is in the interest of the development of the securities market; and

• the applicant satisfies the “fit and proper” person test laid down by SEBI under Schedule II of SEBI (Intermediaries) Regulations, 2008.

Comment: The FPI Regulations introduce certain additional eligibility criteria that entities seeking registration will need to fulfil as compared to the FII Regulations. Thus, an entity from a jurisdiction which is not featuring in Appendix A of the IOSCO Multilateral MOU (e.g., Indonesia, Russia, etc.) will be unable to register as an FPI and make investments, whereas it would otherwise have been eligible under the FII Regulations to participate as a “sub-account” relying on its relevant FIIs, being regulated and registered.

Secondly, shifting the onus onto DDPs to determine whether the grant of registration to an applicant will be in the interest of the securities market could be burdensome and may result in DDPs seeking excessive information to satisfy themselves of such subjective conditions, thereby defeating the purpose of simplification and expediency. We do hope that some guidance from SEBI will emerge for DDPs on such criteria over a period of time.

Additionally, Non-Resident Indians (NRIs) may again feel short-changed considering that now they are specifically prohibited from investing as FPIs and will now only need to contend with the Portfolio Investment Scheme regime for investments in Indian securities. Further, it is unclear how entities with substantial NRI interests (e.g., general partners owned by NRIs, funds/investment vehicles with NRI beneficiaries) will be treated for the purpose of FPI registration by DDPs.

Migration to the FPI Regime

The FPI Regulations provide that all existing FIIs and sub-accounts may continue to buy, sell or otherwise deal in securities under the FPI regime upon the payment of a conversion fee until their current registration period has expired, thus ensuring a smooth transition of FIIs/sub-accounts to the FPI platform. However, there appears to be some confusion from the language in the FPI Regulations and the fees schedule as to 1) whether existing FIIs can simply continue to trade under the FPI regime during the subsisting period as long as they continue to pay a conversion fee at any time on or prior to expiry of the current registration period, or 2) whether all of them are required to pay this fee immediately before they can undertake any trade under the FPI regime. A clarification from SEBI in this regard will be useful and even necessary.

Further, the FPI Regulations also provide that existing QFIs may continue to buy, sell or otherwise deal in securities upon the payment of a conversion fee for a period of one year from the date of notification of the FPI Regulations, within which period they can obtain registration as FPIs through DDPs.

Any pending applications for FII/sub-account registration with SEBI shall be dealt with in accordance with the extant FII Regulations, and SEBI may continue to grant registration certificates in such cases until March 31, 2014, which period may be extended until June 30, 2014. However, all new applications will have to be made under the FPI Regulations, with immediate effect.

Categorisation of FPIs

FPIs are classified into three categories:

• Category I, which includes government and government-related foreign investors (which may include foreign central banks, sovereign wealth funds, multilateral organisations, etc.);

• Category II, which includes appropriately regulated entities (which may include banks and asset management companies), broad-based funds (such as mutual funds, investment trusts, insurance and reinsurance companies), university funds, university-related endowments and pension funds, and unregulated broad-based funds with regulated investment managers; and

• Category III, which includes all others FPIs not eligible to register as Category I or Category II FPIs.

For the purposes of being registered as a Category II FPI, “appropriately regulated” is defined to mean any entity which is regulated or supervised by the securities market regulator or the banking regulator of the entity’s home jurisdiction.

Comment: It is interesting to note that the definition provides for “regulated” and “supervised” instead of “registered”, which could provide flexibility for a lot of funds structured in jurisdictions such as Singapore and the United States, where, though the funds are regulated under the ambit of the local regulatory regime, they are not specifically registered. However, please note that other entities which are not regulated by a “securities market regulator” or the “banking regulator” (e.g., the U.S. Commodity Futures Trading Commission, etc.) will also be eligible to register under Category III.

The FPI Regulations provide that a fund will be classified as a broad-based fund only if it has a minimum of 20 direct or underlying investors, with no investor holding more than 49 percent of the fund. In the event that an institutional investor holds more than 49 percent of the fund, the institutional investor is required to be broad-based for the fund to be considered as a broad-based fund. Only pooling vehicles will be considered for the purpose of determining the underlying investors.

Comment: The differences that arise in the definition of “broad-based” in the FPI Regulations as compared to the FII Regulations are: 1) dispensation of having to satisfy the “20” investor test in case of one institutional investor; 2) for determining the number of investors at an applicant level, aggregation of the direct and indirect investors is now recognised; and 3) the look-through test for determining the number of investors will apply only in the case of “pooling” vehicles and not for any other institutional investors (e.g., insurance companies, banks, etc.).

Registration and Fees

Pursuant to satisfying all conditions under the FPI Regulations, the DDP is obligated to dispose of the application, either by granting a certificate of registration or rejecting the application within 30 days from receipt of the application or from the date of receiving the request/inquiry for any additional information. In the event of any dispute or interpretational issue, the applicant or the DDP may approach SEBI. Further, the applicant may also apply to SEBI for reconsideration within 30 days from the date of rejection of the application by the DDP.

It is to be noted that SEBI has removed the proposal in the draft FPI Regulations to institute a one-time registration fee for FPIs, and has retained the extant practice of obtaining registration and subsequently renewing the same every three years for Category II (U.S.$3,000) and Category III (U.S.$300) FPIs. Category I FPIs are not required to pay any registration fees.

Registration of DDPs

The FPI Regulations provide that all entities registered with SEBI as custodians or qualified depository participants are deemed to be registered as DDPs, subject to payment of the specified fees. With respect to the appointment of new DDPs, the FPI Regulations restrict the applicants to Authorised Dealers Category-1 banks authorised by the Reserve Bank of India (RBI) apart from other conditions. However, an exception is made for global banks that have tie-ups with an Authorised Dealers Category-1 bank.

Investment-Related Conditions

Investment Restrictions and Limits

The FPI Regulations limit the investments to be made by FPIs to only such securities that are listed and proposed to be listed. FPI Regulations restrict investments by any single investor or investor group (in case the same set of ultimate beneficial owners invest through multiple entities, such entities shall be treated as part of the same investor group) to not more than 10 percent of the equity share capital of an Indian company.

Broadly, the FPI Regulations allow all categories of FPIs to invest in various asset classes and those securities where FIIs are allowed to invest, including:

• securities in primary and secondary markets, including shares, debentures and warrants of companies, listed/unlisted/to be listed on recognised stock exchanges;

• units of schemes floated by domestic mutual funds (listed or unlisted);

• units of collective investment schemes;

• listed derivatives;

• treasury bills and dated government securities;

• commercial papers;

• rupee-denominated credit-enhanced bonds, perpetual debt and debt capital instruments, rupee-denominated bonds or units of infrastructure debt funds;

• security receipts issued by asset reconstruction companies;

• listed and unlisted bonds issued by infrastructure companies, bonds issued by infrastructure finance companies; and

• Indian depository receipts.

Comment: By removing “unlisted” securities from the eligible investments (as existed in the FII Regulations), SEBI has put to bed the controversy around whether an FII entity can make portfolio investments in unlisted entities under the FII route. Secondly, it also seems that, going forward, an FPI entity will not be able to make foreign direct investments (FDI) in unlisted entities. Additionally, since the FPI Regulations propose an aggregate cap of 10 percent amongst all investor group entities, it could pose a challenge for private equity funds and other large institutional groups that may also have FDI interests in the same company under a different vehicle. For example, if a private equity investor has invested in an entity under the FDI route and, following the listing of such entity, the investor wants to further consolidate its position through market purchases, the above restriction could pose a challenge. It may well be important for SEBI to clarify that the above aggregation would apply only to shares which may have been acquired by the investor group under the FPI route.

Further, QFIs were not permitted to invest in more than 5 percent of the equity of an Indian company. However, it is now feasible for entities investing as QFIs to increase their investments up to the 10 percent limit for equity share capital upon migration to the FPI regime. A similar benefit will also arise to foreign corporate/foreign individual sub-accounts registered with SEBI, pursuant to registration as FPIs.

Additionally, SEBI has increased the threshold limit for all categories of foreign investors (except NRIs) to 10 percent. However, NRIs who are now compelled to come through the Portfolio Investment Scheme route can invest only up to 5 percent. There may be a need for RBI to reconsider the above cap for NRIs in light of these new regulations to bring about parity between NRIs and other non-residents investing in Indian listed securities.

Moreover, clarity is awaited on the debt investment limits that will be allowed for FPIs and whether it will be the same as the current limits applicable to FIIs and QFIs.

Certain Key Investment Considerations

• All transactions should be only on the basis of taking and giving delivery of securities;

• Short selling and securities lending and borrowing are allowed for all categories of FPIs in accordance with the extant framework specified by SEBI;

• FPIs shall trade in only dematerialised securities; and

• Transactions by an FPI shall be routed only through registered stock brokers.

Comment: QFIs will also now be allowed to engage in the borrowing and lending of securities, which previously was not permissible.

Offshore Derivative Instruments (ODIs)

The FPI Regulations provide that, other than Category III FPIs, both Category I and Category II FPIs will be allowed to issue, subscribe or otherwise deal in ODIs⁴ directly or indirectly. However, broad-based funds registered as Category II FPIs, on the basis of their investment manager being appropriately regulated, are not allowed to issue, subscribe or deal in ODIs.

Further, an obligation has been cast upon the issuer/subscriber FPI to satisfy itself that such ODIs are issued/being issued only by/to persons who are regulated by an “appropriate foreign regulatory authority” after ensuring compliance with the KYC norms.

Comment: By covering even “subscription” to ODIs under the ambit of this provision and expanding the reach by using the terms “directly” or “indirectly”, there could be a potential challenge for large institutional investors and prime broking entities where one arm could be registered as an FPI and the other independently managed arm is subscribing to ODIs. Unlike under the FII Regulations, the term “appropriate foreign regulatory authority” has not been defined by SEBI in the FPI Regulations. However, the FII Regulations provide for a broad definition, including 1) regulated/supervised and licensed/regulated by a foreign central bank; 2) registered and regulated by a securities or futures regulator; and 3) any broad-based fund whose investments are managed by persons regulated as 1) or 2). Under the current FPI Regulations, drawing an inference from the definition of “appropriately regulated” under Explanation 1 of Regulation 5 (if it is regulated or supervised by a securities market regulator or the banking regulator), it is possible that many of the entities currently utilising ODIs under the FII framework will be prevented from doing so.

Another significant diversion is disallowing unregulated broad-based funds whose investment manager is regulated from subscribing to or dealing in ODIs. This could clearly have a significant impact on investors, especially hedge funds which could have relied on the regulated status of their manager to subscribe to ODIs.

The FPI Regulations provide for grandfathering of ODIs that have been issued under the FII Regulations. While it appears that the intent may have been to grandfather all ODIs issued prior to the date of the entry into effect of the FPI Regulations, the language appears to create some ambiguity, as it refers to validating such ODIs under the “corresponding” provisions for the FPI Regulations. Considering that unregulated broad-based sub-accounts are no longer eligible to subscribe to ODIs (as stated above), in the absence of any corresponding provision under the FPI Regulations, there is some ambiguity which remains. It would be wise and important for SEBI to clarify its position to avoid any unnecessary panic on this count, if the intent was to fully grandfather all existing ODIs.

Restriction on Providing Investment Advice

The FPI Regulations restrict FPIs or their employees from providing investment advice in publicly accessible media directly or indirectly without providing disclosure of their interest in the securities being discussed. The wide nature of the provision might result in regulatory issues for large multinational entities which provide investment advice in multiple jurisdictions.

General Obligations

Amongst a plethora of general obligations on an FPI, including reporting, compliance, appointment of a custodian, bank, compliance officer, etc., an FPI is also obligated to inform the DDP forthwith of any “direct” or “indirect” change in structure or beneficial ownership of the FPI. This could be an onerous obligation for open-ended structures such as hedge funds and mutual funds whose investor base may change on a daily/weekly/monthly basis.

Tax Insight

Under the extant tax provisions, FIIs are taxed under a special tax regime, whereby various streams of income earned by FIIs, including capital gains and interest, are taxed at a concessional rate of tax. Needless to say, the concessional tax regime is a significant incentive enjoyed by FIIs and makes investment into India a more attractive proposition.

With the FII regime now being subsumed in the FPI Regulations, it is imperative that the tax laws keep pace and are amended at the earliest possible opportunity to provide for a similar concessional tax regime for FPIs and to avoid any confusion on tax treatment during the transitional period. In fact, it may have been prudent for SEBI to make the FPI Regulations effective concurrent with the corresponding changes being carried out in the tax laws to avoid any confusion.

In the past, tax laws on occasion have not kept up with the changes made by regulatory authorities like SEBI. There has been confusion even when the beneficial tax incentives are extended as to whether these will encompass all categories of FPIs or they will be restricted to only Category I and Category II FPIs.

While SEBI in its public statement has clarified, based on assurance from the Ministry of Economic Affairs, that the beneficial tax regime will be extended to all categories of FPI, in the current environment there will always remain discomfort in an investor’s mind on this count, which could hamper the flow of investments through this regime until clarity is provided.

Conclusion

For the reasons of relaxed registration norms and potential expansion of the investment horizon for a wider class of investors, introduction of the FPI regime is a progressive move and a part of the structural reform phase that India seems to have embarked upon. The SEBI FII Regulations, which proved to be a backbone for the flow of foreign capital into Indian capital markets since 1995, served their purpose, but over time, with the multiplicity of regimes, a need was felt to consolidate these under an omnibus regime for all portfolio investors and also to ease entry into the Indian capital markets.

While SEBI’s vigilance is much-admired, for the FPI regime to be effective, corresponding revision of the applicable foreign exchange regulations needs to be undertaken by RBI. Currently, FIIs enjoy certain tax benefits on their income from dealing in Indian securities, and, for the FPI regime to be attractive, such benefits should also be extended to investors registered as FPIs.

As an overall assessment, this is a commendable exercise undertaken by SEBI to efficiently and effectively replace the long-established FII regime with the new FPI regime with minimal disruption. However, as often is the case with any such exercise, some hurdles may surely be encountered, and how maturely SEBI and other relevant regulators deal with them will be important and crucial to maintain continuity.

Siddharth Shah is a Partner and Divaspati Singh is a Senior Associate in the Funds and Corporate Practice Group of Khaitan & Co., Mumbai. They may be contacted at siddharth.shah@khaitanco.com and divaspati.singh@khaitanco.com.