SEBI Panel’s FPI Proposals: Red Carpet For Some, Plugging Of Mischief By Others

Consolidation, rationalisation, simplification and liberalisation – with these core objectives in mind, the HR Khan committee set up by Securities and Exchange Board of India last year has proposed several changes to regulations that govern foreign portfolio investments. The suggestions will make registration simpler for certain categories, bring in investment restriction by clubbing group entities, and plug the mischief with respect to broad-based criteria, experts told BloombergQuint.

Red Carpet For Some

Public Retail Funds like mutual funds, insurance companies, pension funds, FPIs investing in low-risk government securities may get a fast track on-boarding process. The proposal is to introduce a simplified Abridged Common Application Form for them, which won’t need details relating to broad-based investor details, intermediate material shareholder or owner details, information on authorised signatories or senior management etc.

Pension Funds – that are currently categorised a Category II FPIs- should be treated as Category I FPI since they are less risky investment structures, the committee has said. The SEBI’s regulations divide FPIs into three categories based on their risk profile and the consequent KYC requirements.

A change in category – from Category III to Category II- for all university-related endowments and funds from Financial Action Task Force member countries has also been recommended.

This will give a strong message to institutional FPIs that they are strategically important for India, Siddharth Shah, partner at Khaitan & Co., told BloombergQuint

It will help India position itself as a market that welcomes institutional capital by reducing the Know Your Customer requirements for some of these entities and bucketing them in the low-risk category, he said.

Clubbing Restrictions: Spoiling The Party?

The committee’s suggestion on looking at the FPI and foreign direct investment caps at a group level and recharacterising the investment may create execution issues, experts point out.

Existing Regime

Currently, Foreign Exchange Management Act treats any investment less 10 percent in a listed entity as FPI. Anything above 10 percent becomes a FDI.

To determine the 10 percent cap, two or more FPIs having direct or indirect common ownership of 50 percent or more, or common control, are treated as forming part of an investor group. The investments of all such entities are clubbed for monitoring of the investment limit i.e., below 10 percent of the paid-up capital of the company.

To illustrate—Let’s say X is making a proprietary investment in a particular company in India through three pools—a private equity, a public market and a distressed fund. The three pools are managed by different teams with independent decision making, but the primary investor is X. To determine the 10 percent cap, investment across all these entities will have to be clubbed.

The Change

But there could also be situations where X also has an FDI investment in the same company. The committee has recognised this and suggested that the FDI investment must also be clubbed to determine the investment cap.

In such situations, the committee has said, FPIs need to ensure that holding of all their group entities in shares of a company shall be below 10 percent. In case the limit is breached, either all entities of an investor group will have to be re-categorised as FDI or divestment be made within five trading days from the date of settlement of the trades causing the breach.

If an investor, as a group, already owns 20 percent in listed company Y, and if this investor wants to now acquire any additional stake on the exchanges through the FPI route, it can do so but the latter would then have to be categorised as an FDI investment, Richie Sancheti, head of Investment Funds Practice at Nishith Desai Associates, explained.

This may lead to some execution issues, Shah added.

The status of the entity will not change—it’s the investment that will get re-categorised as FDI. The potential implications for such a re-categorised investment from a tax perspective will need to be clarified because FPIs enjoy certain preferential regime that FDI doesn’t, he added, but it can be argued that if the status of the investor isn’t changing, the tax consequences shouldn’t change either.

Broad-Based Criteria: Plugging The Mischief

The committee has noted that several structures in the market are not keeping with the spirit of the FPI regulations. And that’s in the context of how they are achieving the criteria of a broad-based fund. This criteria needs to be fulfilled if an FPI investor wants to qualify as Category II and deal with less onerous KYC requirements versus Category III where they would be seen as a riskier entity.

A broad-based fund is a fund, incorporated outside India, which has at least 20 investors, with no investor holding more than 49 percent of the shares or units of the fund.

The committee has said that there could be a fund where two investors hold 49 percent each and there’s a fund with 2 percent investment, which in turn may have more than 20 investors.

Under the existing laws itself, SEBI mandates that if an FPI is relying upon another fund (which is a broad-based entity) to fulfil the broad-based criteria, it needs to meet certain eligibility conditions, Sancheti pointed out. When this is the case, should the 25 percent test be applied at all, he asked.

There will be significant push back from the industry on this front, Shah agreed.