Cleaning up

After the crackdown on shell companies, time to completely phase out participatory notes

Sebi has restricted trading to once a month in more than 300 listed companies on suspicion of being vehicles for money laundering. Going beyond, the market regulator should examine when and how these companies got listed, the investment bankers who shepherded them and the auditors signing their books. The Insolvency and Bankruptcy Code, passed in May 2016, has blocked crony capitalists with a track record of defaults. The travails of a consumer durables company and a conglomerate with dreams of rivalling RIL are symptomatic of the changed times. Earlier, some helpful bankers would have bailed them out. Now, they are shedding businesses to survive. Ironically, both had interests in oil exploration and telecom, the two sectors with plenty of room for arbitrariness in awarding contracts and licences in the pre-May 2014 era. The recall of high value notes late last year flushed out unaccounted cash. The income tax department got a wealth of data to inspect and pursue. One lakh shell companies have been detected. Banks got low-cost funds. According to a Reserve Bank of India study, most of the deposits were later diverted into mutual funds, a departure from the earlier practice of opting for real estate and gold. Therefore, a major benefit of demonetization is the weaning away of the equity market from foreign investors. The introduction of the goods and services tax from 1 July 2017 will support listed companies to capture the share of the unorganized sector. Companies in the informal sector that have achieved scale but were reluctant to list due to the increased scrutiny will no longer be able to enjoy the edge of tax evasion. Investors should gear up for a booming primary market.

Despite some hiccups, the stock market has been stable during these surgical strikes. Previous attempts to staunch dodgy foreign inflows did not meet with a calm response. In October 2007, Sebi proposed curbs on participatory notes (PNs) issued by registered foreign institutional investors to overseas investors who wished to test the Indian stock market. It is not possible to know who owns the underlying securities. Hedge funds acting through PNs were the cause of much volatility. The instruments accounted for around 50% of investments made by FIIs then. Within a minute of opening for trading on 17 October, the BSE Sensex shed 1,744 points, or about 9% of its value, in the biggest intra-day plunge in absolute terms. Finance Minister P.Chidambaram had to clarify that there were no plans to immediately ban PNs. Stocks staged a remarkable comeback after opening at 10.55 am and ended down just 336.04. The Sensex tumbled 717.43 points, or 3.83%, its second biggest fall, next day. There was a 438.41-point slide the day after. Sebi chairman M Damodaran had to announce simplification of the FII registration process. The market gained 879 points, its biggest single-day surge. The regulator nonetheless banned FIIs from issuing fresh PNs and asked them to wind up their exposure within 18 months. In a couple of days, the benchmark crossed the 20,000 mark for the first time.

Five years ago, Sebi ordered FIIs to report monthly details of PN transactions within 10 days instead of six months after a Union government white paper on black money identified the instruments as one of the routes through which black money transferred outside India comes back. End 2014, new regulations were published to curb illegal fund inflows by tightening know-your-client norms and shutting out entities with opaque structure. A couple of months ago, a fee of US$1,000 was levied on each PN. Issuance for speculative purposes was barred. At the same time, entry was relaxed for FIIs willing to invest directly. In July, the regulator put in place restrictions on FIIs from issuing PNs for derivatives. These were to be used only for hedging. Besides, existing positions on un-hedged PN derivatives had to be liquidated by end December 2020. The market in the meanwhile has become more transparent. Disclosure norms are getting stringent. Companies have to inform the stock exchanges of any defaults within 24 hours. The usage of Aadhaar and KYC removes ambiguity about the identity of domestic investors. FIIs are now choosing the derivatives platform over the cash segment. Despite their falling share, to 6% end April, the opaque nature of PNs does not fit in the concept of New India propounded by Prime Minister Narendra Modi on 15 August. Concerns still remain that PNs are being misused for round-tripping. With mutual funds displaying capability to insulate the market from any external shock, it is time to bury the ghost of PNs once and for all.

Mohan Sule