SEBI Restricts The Ability Of Certain FPIs To Issue Offshore Derivative Instruments

Foreign portfolio investors were a brainchild of the KM Chandrasekhar committee and were legitimised by the Securities and Exchange Board of India in 2013 by merging foreign institutional investors, sub-accounts and qualified foreign investors into a new investor class. Since then, FPIs have had to deal with umpteen circulars and complex operational guidelines. This prompted the market regulator to set up a committee, led by former deputy governor of RBI HR Khan, to rationalise the FPI regime.

The exercise has now culminated with SEBI notifying a new set of regulations for FPIs which mark a philosophical shift in how this investor class is viewed, their ability to attract participation in the Indian market, instruments they can invest in, and transfer securities.

SEBI has done so by:

• Dividing FPIs into two buckets as opposed to three categories that exist today.
• Limiting the category of FPIs which can issue Overseas Derivative Instruments.
• Allowing FPIs to invest in REITs, InvITs and units of Category III Alternative Investment Funds, RBI-approved debt securities as additional instruments.
• Permitting multi-investment manager structures to do off-market transfer of securities.

Rejigging FPI Categories: Impact

So far, FPIs were bucketed under three categories. Category I included government entities. Category II included regulated broad-based funds. And endowments, charitable societies, foundations, family offices fell under Category III.

Category I FPIs were subject to lighter Know-Your-Customer norms, that progressively tightened for the second and third categories. Categories I and II also enjoyed some tax advantages.

The new regulations have brought these categories into two:

Category I

• Investment entities owned by governments or government-related investors such as central banks, sovereign wealth funds.
• Pension and university funds, regulated entities such as insurance entities, banks
• All entities from Financial Action Task Force member countries which are appropriately regulated.
• Entities 75 percent owned by any of the above type of funds or where the investment manager is based in a FATF-compliant jurisidction

Category II

• All entities that don’t meet the criteria of a Category I FPI, now fall into Category II.
• This includes corporate bodies, individuals, unregulated funds in the form of limited partnerships and trusts etc…

The new KYC requirements and tax treatment for these two categories has yet to be detailed or notified. But there is concern, that those FPIs, say from Mauritius or Cayman or any other non-FATF jurisdiction, that may have qualified as the old Category II and availed of a relatively lighter KYC regime, would now fall into the new Category II bucket that may not have these advantages.

Earlier, to qualify for lighter KYC and tax advantages, many funds located in such non-FATF jurisidictions had designed themselves as broad-based to meet the old Category II criteria. But now that broad-based eligibility criteria are gone. Hence most of these funds could stand to lose those advantages, said Richie Sancheti, head of the funds practice at law firm Nishith Desai Associates.

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.

Some of these broad-based funds may still qualify for the new Category I, if they have an investment manager based in an FATF-compliant jurisdiction. But that creates its own impracticality, Divaspati Singh, partner at law firm Khaitan & Co. said.

‘From a fund’s perspective, it’s imperative that a manager is also set up in the jurisdiction where the fund is. So, if you are looking at setting up a structure in Mauritius, most likely you’ll also have the manager based out of Mauritius,’ he said.

FPIs Ability To Issue ODIs Restricted

Offshore Derivative Instruments are issued by FPIs overseas against securities held by them that are listed or proposed to be listed, as its underlying. So far, only Category I and certain Category II FPIs—regulated broad-based funds—were permitted to issue ODIs.

The new regulations specify that only Category I FPIs can issue or subscribe to ODIs. An entity whose investment manager is from FATF member country can also subscribe to ODIs.

It may impact some of the existing funds a negative way because a lot of ODI subscriptions have been through Cayman Island-based fund structures, Sancheti said. Further, issuances have largely been through Mauritius, Singapore or France-based FPIs who hold the underlying hedge but issue the ODI to Cayman-based structures or Mauritius-based structures, he explained.

More Investment Options For FPIs

So far, FPIs have been allowed to invest in listed or to-be-listed shares, listed derivatives, mutual fund units, Indian depository receipts etc. Now, the list of eligible instruments has been expanded to include Real Estate Investment Trusts, Infrastructure Investment Trusts and units of Category III Alternative Investment Funds. Debt securities, permitted by the Reserve Bank of India, can also attract FPI investment.

FPIs, according to Sancheti, would be eager to see the list of debt securities they’ll be allowed to invest in. There is some conversation around allowing them not only in NPAs directly but secondary purchases of a portfolio of loans from banks, which could be NPAs or even standard loans, Sancheti said.

‘A lot of asset classes are expecting cash flows to come from the FPI regime, and I think this opening up is absolutely in line with the broader policy approach of attracting investment,’ he added.

Easing Transfer Of Securities

All FPI transactions have to be carried out through registered stock brokers. Only certain off-market transactions were permitted. That’s been expanded now. Under the new regulations, FPIs who operate under multi-investment manager structures and have the same beneficial owner and common PAN can now do off-market transfer of securities.

This is an extremely welcome step, Singh said, adding that earlier FPIs would have to go through a lengthy process to do such transfers on the market and specific regulatory exemptions were hard to come by. Now, for instance, a university fund using multiple managers—A, B and C—can transfer securities among them off-market, if for some reason it wants to terminate the services of any of them, Singh said.

Watch the full discussion with Richie Sancheti and Divaspati Singh here...