SEBI (Foreign Portfolio Investors) Regulations, 2019

What this chapter covers

This chapter carries 3 per cent of the III-A examination.

LEARNING OBJECTIVES: After studying this chapter, you should know about: Eligibility Criteria of Foreign Portfolio Investors · Approval to act as designated depository participant · Investment Conditions and Restrictions

SEBI (Foreign Portfolio Investors) Regulations were formed to provide the framework for registration and procedures with regard to foreign investors who propose to make portfolio investment in India.

And the definition: the Foreign Portfolio Investor means a person who satisfies the eligibility criteria as provided under Regulation 4 of the said SEBI regulations and shall be deemed to be an intermediary in terms of provision of Act.

Deemed an intermediary — which is why the fit and proper criteria and Chapter V of the Intermediaries Regulations apply.

11.1 Eligibility

The designated depository participant shall not consider an application for grant of certificate of registration as a foreign portfolio investor unless the applicant satisfies the following conditions:

a) the applicant is not a resident Indian.

b) the applicant is not a non-resident Indian or an overseas citizen of India.

An FPI must be a foreign entity, not an individual Indian abroad.

c) non-resident Indians or overseas citizens of India or resident Indian individuals may be constituents of the applicant subject to following conditions:

(i) the contribution of a single non-resident Indian (NRI) or overseas citizen of India (OCIs) or resident Indian (RI) individual should be below 25 percent of the total contribution in the corpus of the applicant.

(ii) the aggregate contribution of NRIs, OCIs and RI individuals in the corpus of the applicant shall be below 50 percent of the total contribution — this should not be applicable to an applicant, regulated by the International Financial Services Centres Authority and based in the International Financial Services Centres in India.

Below 25 per cent individually; below 50 per cent in aggregate.

(iii) the contribution of RI individuals should be made through the Liberalised Remittance Scheme notified by the Reserve Bank of India and should be in global funds whose Indian exposure is less than 50 percent.

(iv) the NRIs, OCI and RI individuals should not be in control (right to appoint majority of directors, management decisions etc.) of the applicant.

(v) any other conditions as may be specified by SEBI from time to time.

Two exemptions from (i), (ii) and (iv): they shall not be applicable to foreign portfolio investor who invests only in Government Securities; and sub-clause (ii) does not apply to an IFSC-based applicant or to a SWAGAT-FI.

SWAGAT-FI — Single Window Automatic and Generalised Access for Trusted Foreign Investor — includes Government and Government related investors and Public retail funds.

Other permitted constituents. A mutual fund registered under the Securities and Exchange Board of India (Mutual Funds) Regulations, 1996 may also be constituent of the applicant.

Resident Indians other than individuals may be constituents where such resident Indian, other than individuals, is an eligible fund manager of the applicant, as provided under sub-section (4) of section 9A of the Income Tax Act, 1961 and the applicant is an eligible investment fund as provided under sub-section (3) of section 9A.

Or, in the IFSC context. Here the applicant is an Alternative Investment Fund or a Retail Scheme set up in the International Financial Services Centres and regulated by the International Financial Services Centres Authority. The resident must be a fund management entity or its associate. Its contribution may be up to:

• 10% of the corpus of the applicant in case the applicant is an Alternative Investment Fund; or
• 10% of the Assets under Management in case the applicant is a Retail scheme.

Jurisdiction and integrity conditions

The applicant is a resident of a country whose securities market regulator is a signatory to the International Organisation of Securities Commission's Multilateral Memorandum of Understanding or a signatory to a bilateral MoU with SEBI.

There is a special rule for governments. An applicant being a Government or Government related investor shall be considered as eligible for registration if such applicant is a resident in the country as may be approved by the Government of India.

The applicant, being a bank, is a resident of a country whose central bank is a member of the Bank for International Settlements. Provided that a central bank applicant need not be a member of the Bank for International Settlements.

Sanctions and FATF. This test covers the applicant, its underlying investors above the PMLA threshold, and those identified by control. They:

• Shall not be the person(s) mentioned in the Sanctions List notified from time to time by the United Nations Security Council.
• Must not be resident in a country that the FATF public statement identifies as a jurisdiction having a strategic Anti-Money Laundering or Combating the Financing of Terrorism deficiencies to which counter measures apply.
• Must not be resident in a jurisdiction that has not made sufficient progress in addressing the deficiencies or has not committed to an action plan developed with the Financial Action Task Force (FATF).

The applicant is a fit and proper person based on the criteria specified in Schedule II of the SEBI (Intermediaries) Regulations, 2008, plus any other criteria specified by SEBI.

And an IFSC exemption: clause (a), (d) and (e) shall not apply to an applicant incorporated or established in an International Financial Services Centre.

11.2 Categories

Note the responsibility condition on the fifth Category-I limb: such an investment manager or eligible entity undertakes the responsibility of all the acts of commission or omission of the applicants seeking registration under this sub-clause.

And a helpful deeming rule: an applicant incorporated or established in an International Financial Services Centre shall be deemed to be appropriately regulated.

11.3 The designated depository participant

No person shall act as a designated depository participant (DDP) unless it has obtained the approval of the SEBI.

How: the application shall be made to SEBI through the depository in which the applicant has an agreement to act as a participant and shall be accompanied by the application fee.

And the depository must move promptly: it shall forward the application to SEBI, as early as possible, but no later than 30 days from the date of receipt by the depository, along with its recommendations and after certifying that the participant complies with the eligibility criteria.

Thirty days, with a recommendation and a certification.

Eligibility of a DDP

(a) the applicant is a registered depository participant under the SEBI (Depositories and Participants) Regulations, 1996.

(b) the applicant is a registered Custodian under the SEBI (Custodian) Regulations, 1996.

(c) the applicant is an Authorised Dealer Category-1 bank authorised by the Reserve Bank of India under the Foreign Exchange Management Act, 1999.

(d) the applicant has a multinational presence, either through its branches or through agency relationships with overseas intermediaries regulated in their respective home jurisdictions.

(e) the applicant has systems and procedures to comply with the requirements of the Financial Action Task Force Standards, PMLA, 2002, Rules prescribed thereunder and the circulars issued from time to time by the Board.

(f) the applicant is a fit and proper person based on the criteria specified in Schedule II of the SEBI (Intermediaries) Regulations, 2008.

(g) any other criteria as may be specified by the SEBI.

Three registrations, a global footprint, AML systems and fitness — a demanding set, because the DDP registers FPIs on SEBI's behalf.

An alternative route exists. SEBI may consider an application from an entity, regulated in India or in its home jurisdiction. It must be satisfied that the applicant has sufficient experience in providing custodial services and that the grant of such approval is in the interest of the development of the securities market. Such an entity must be registered with the SEBI as a participant and custodian and shall have a tie-up with an Authorised Dealer Category-1 bank.

11.4 Investment conditions

Permitted securities — Regulation 20(1):

(a) shares, debentures and warrants issued by a body corporate; listed or to be listed on a recognised stock exchange in India.

(b) units of schemes launched by mutual funds under Chapter V, VI-A and VI-B of the Securities and Exchange Board of India (Mutual Fund) Regulations, 1996.

(c) units of schemes floated by a Collective Investment Scheme.

(d) derivatives traded on a recognised stock exchange.

(e) units of Real Estate Investment Trusts, Infrastructure Investment Trusts and units of Category III Alternative Investment Funds registered with the Board.

(f) Indian Depository Receipts.

(g) any debt securities or other instruments as permitted by the Reserve Bank of India.

(h) such other instruments as specified by the Board.

The first review question follows — mutual fund schemes, exchange-traded derivatives and REIT units are all permitted.

Pre-existing unlisted holdings that continue after an IPO shall be subject to lock-in for the same period, if any, as is applicable to shares held by a foreign direct investor placed in similar position.

Secondary market conditions

A foreign portfolio investor shall transact in the securities in India only on the basis of taking and giving delivery of securities purchased or sold.

So trading is delivery-based. The exceptions are:

• Any transactions in derivatives on a recognized stock exchange.
• Short-selling transactions in accordance with the framework specified by the Board.
• Transactions pursuant to an agreement entered into with the merchant banker in the process of market making or subscribing to an unsubscribed portion of the issue.
• Any other specified transaction.

Through registered brokers: the transaction involving dealing in securities by a foreign portfolio investor shall be only through stockbrokers registered with the Board.

There are fourteen exceptions. They include:

• Transactions in Government securities and such other securities falling under the purview of the Reserve Bank of India.
• Sales into a letter of offer under the takeover regulations, and delisting and buy-back offers.
• ADR/GDR disinvestment, and government disinvestment offers.
• Market making.
• Transactions in corporate bonds, and the electronic book provider platform.
• Unlisted securities received through involuntary corporate actions including a scheme of a merger or demerger, or under the Insolvency and Bankruptcy Code, 2016. Such holdings are treated as Foreign Direct Investment.
• Transfer of right entitlements.
• Purchase or sale transactions of illiquid or suspended or delisted securities.
• Transactions between registered foreign portfolio investors, who are multi-investment manager structure of the same beneficial owner and have common Permanent Account Number.

Illiquid securities shall mean those securities that are not frequently traded in terms of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018.

Dematerialised holding: a foreign portfolio investor shall hold, deliver or cause to be delivered securities only in the dematerialized form. There are two exceptions. Physical shares held before these regulations are allowed if such shares cannot be dematerialised. And all the Rights Entitlements may be held or transferred in non-dematerialized form.

Debt investments: FPIs shall also comply with terms, conditions or directions, specified or issued by SEBI or Reserve Bank of India, from time to time, in addition to other conditions specified in these regulations.

The second review question is therefore False — RBI's conditions apply as well as SEBI's.

Beneficial ownership: unless otherwise approved by SEBI, securities shall be registered in the name of the foreign portfolio investor as a beneficial owner as defined under the Depositories Act, 1996.

The ten per cent limit

The purchase of equity shares of each company by a single foreign portfolio investor including its investor group shall be below ten per cent of the total paid-up equity capital on a fully diluted basis of the company.

The third review question — 10 per cent.

Where it is breached: the FPI shall divest the excess holding within five trading days from the date of settlement of the trades resulting in the breach.

And the consequence of not divesting: the entire investment in the company by such foreign portfolio investor including its investor group shall be considered as an investment under the Foreign Direct Investment... and the foreign portfolio investor and its investor group shall not make further portfolio investment in that company under these regulations.

Not merely the excess — the entire investment reclassifies.

Two further provisions. An FPI is permitted to invest in Indian securities as a person resident outside India in accordance with provisions of the Foreign Exchange Management Act, 1999. And it may lend or borrow securities in accordance with the framework specified by the SEBI.

11.5 Suspension, cancellation and surrender

Registration granted by the designated depository participant on behalf of SEBI... shall be permanent unless suspended or cancelled by SEBI or surrendered by the foreign portfolio investor.

Permanent by default.

Suspension and Cancellation... shall be dealt with in the manner as provided in chapter V of SEBI Intermediaries Regulation, 2008.

Surrender is requested through the DDP, who shall accept the surrender of the certificate of registration after obtaining approval from SEBI, and DDPs may impose such conditions as may be specified by SEBI.

Before seeking a No objection certificate (NOC), the DDP shall confirm three things:

• Accounts held by the applicant in the capacity of FPI have nil balance and are blocked for further transactions. Further, the CP code of the FPI is also blocked.
• There are no dues /fees pending towards SEBI.
• There are no actions /proceedings pending against the said applicant.

And after the NOC: DDP shall ensure to execute the following within 10 days from the date of receipt of NOC from SEBI: all the accounts (including bank account and securities account) held by the applicant in the capacity of FPI are closed and the Custodial Participant (CP) code is deactivated.

Ten days to close everything.

11.6 Offshore derivative instruments

FPIs shall not be allowed to issue ODIs referencing derivatives. Further, no FPI shall be allowed to hedge their ODIs with derivative positions on stock exchanges in India.

The exception, available through a separate FPI registration of an ODI issuing FPI under Category I:

a. Derivative positions that are taken on stock exchanges by the FPI for 'hedging of equity shares' held by it in India, on a one to one basis; and/or.

b. An ODI issuing FPI may hedge the ODIs referencing equity shares with derivative positions in Indian stock exchanges, subject to a position limit of 5% of market wide position limits for single stock derivatives. The permissible position limit for stock index derivatives is higher of INR 100 crores or 5% open interest; and/or.

c. An ODI issuing FPI, which hedges its ODI only by investing in securities (other than derivatives) held by it in India, cannot undertake proprietary derivative positions through the same FPI registration. Such FPI must segregate its ODI and proprietary derivative investments through separate FPI registrations.

And: no fresh derivative position which are not in compliance with above requirements shall be allowed henceforth.

When is an instrument an ODI? The threshold for trades with non-proprietary indices (e.g. MSCI World or MSCI EM Asia) as underlying shall be taken as 20%, i.e. those trades for which the materiality of Indian underlying is less than 20% of the index would not be regarded as ODIs, even if such exposure is hedged onshore in India. However, trades with custom baskets as underlying if hedged onshore would always be regarded as ODIs regardless of percentage of Indian component that is hedged onshore in India.

Twenty per cent for a standard index; no threshold at all for a custom basket.

Synthetic short activities, where ODI are issued which has the effect of short sale in the Indian securities, continue to be prohibited for FPIs.

And due diligence: the ODI issuer shall ensure that it has collected documents/ information enough to satisfy itself with regard to the relationship between the ODI subscriber and its Investment Manager from a FATF member country.

Investment restrictions... shall apply to ODI subscribers also.

11.7 Code of conduct

Standards. The FPI must keep:

• High standards of integrity, fairness and professionalism in all dealings in the Indian securities market with intermediaries, regulatory and other government authorities.
• High standards of service, exercise due diligence and independent professional judgment.
• Confidentiality in respect of trades done on its own behalf or on behalf of its clients.

Segregation: clear segregation of its own money and securities and that of its client's money and securities, and an arm's length relationship between its business of fund management/investment and its other business.

Knowledge and compliance: maintain an appropriate level of knowledge and competency and comply with the Act, regulations, circulars and guidelines, and with the award of the Ombudsman and the decision of the Board under Securities and Exchange Board of India (Ombudsman) Regulations, 2003.

Candour: shall not make any untrue statement or suppress any material fact in any documents, reports or information to be furnished to the designated depository participant and/or Board.

Governance: good corporate policies and corporate governance policies are observed by it.

Market conduct:

• No fraudulent and manipulative transactions.
• No insider trading by the FPI or any of its directors or managers... either through its/his own account or through an associate or family members, relatives or friends.
• No part in creation of a false market, price rigging or manipulation of prices, or passing of price-sensitive information to any person or intermediary in the securities market.

The cases

Case 11.1 — HSBC as DDP and Custodian

Pathway Finance Societe had undergone change in name of the FPI, change in ownership and change in jurisdiction, so that the entity to which FPI registration was granted, no longer exists. Nonetheless it was able to make an investment in corporate debt and sent the instructions for funding to the custodian on December 19, 2017 and custodian released the payment on December 20, 2017. Thus, the changed entity was able to transact as an FPI without holding a valid registration in contravention of Section 12(1A) of SEBI Act & Regulation 3(1) of FPI Regulations.

Two allegations were not established — that the DDP failed to ensure only registered FPIs invest and failed to inform SEBI of the delay generally; and that the Custodian failed to restrict participation in the debt limits auction or block accounts.

One was: it is established that DDP failed to intimate SEBI immediately, when there was a more than six-month delay in intimation by Pathway of a material change i.e., Change of domicile.

And the reasoning: function of a DDP in granting registration to FPI is carried out on behalf of SEBI and casts an obligation on the DDP to be prompt in reporting to SEBI where such reporting is called for. The DDP was lax in reporting change of address and domicile of the FPI.

Penalty: Rs 5 lakhs under Section 15A(b).

Case 11.2 — Stock Holding Corporation of India

An inspection observed non-maintenance of records and documents, registration of ineligible FPIs, discrepancies in the DDP manual, non-compliance with KYC and demat forms, non-compliance with fit and proper check, and failure to segregate activities and to maintain necessary infrastructure.

SEBI could not quantify gain or loss — the material available on record does not quantify any disproportionate gains or unfair advantage, if any, made by the DDP and the losses, if any, suffered by the investors — nor establish repetition.

But that did not excuse it: the role of a DDP is crucial as it is primarily responsible for the registration and on boarding of FPIs. Registration is with the objective of protecting the interests of the investors, as it casts accountability and responsibility upon the DDP to comply with all regulatory requirements applicable to the conduct of its business activity so as to promote the best interests of clients and the integrity of the market.

And the finding: the irregularities, including delay in forwarding audit report on internal controls, does not absolve it from penalty. The irregularities on the part of SHCIL clearly shows that it has failed in its fiduciary duties owed to its clients.

Penalty: Rs. 16 lakh.

The chapter's review questions confirm that an FPI may invest in domestic mutual fund schemes, exchange-traded derivatives and REIT units alike; that it is False that an FPI investing in debt need not comply with RBI's conditions — it must comply with SEBI's and the RBI's; that a single FPI including its investor group must stay below 10 per cent of a company's fully diluted paid-up equity capital; and that it is False that a DDP may consider an FPI application previously rejected by another DDP, since a DDP acts on behalf of SEBI and its rejection binds the applicant across DDPs.