Dissecting the FPI Regulations 2019
[Soham Goswami and Dibya Prakash Behera are Editors at IRCCL.]
On 23 September 2019, the Securities and Exchange Board of India (SEBI) issued the SEBI (Foreign Portfolio Investors) Regulations 2019 (2019 Regulations). The 2019 Regulations repeal the regulations of 2014 by the same name (except in the circumstances explained later in the summary) and are based on the findings of a report (FPI Report) prepared by a committee chaired by Harun Khan, former deputy Governor of the Reserve Bank of India dealing with foreign portfolio investors (FPIs).
The FPI Report deals with the consolidation of the existing regulations and circulars issued by the regulatory authorities with respect to foreign portfolio investments; it highlights the necessity of simplifying the FPI registration process through fast-track applications and expansion of the categories of broad-based entities.
Of particular importance is the streamlining of the categories of FPIs; the 2019 Regulations brings down the number of categories from three to two. Category-I FPIs will include pension and university funds and appropriately regulated entities in addition to the existing sub-categories. The FPI Report had deemed pension funds low-risk and therefore deserving of the Category-I status (university funds were deemed worthy of the Category-II status in the FPI Report). Other than the said entities, Category-I will include government and government-related investors such as central banks, sovereign wealth funds, international or multilateral organisations or agencies including entities controlled or at least 75% directly or indirectly owned by such government and government-related investors.
The 2019 Regulations inter alia stipulate that a fund can seek registration as a Category-I FPI if it falls under any of the following categories:
appropriately regulated funds from FATF countries;
unregulated funds where the investment managers are registered under Category-I;
entities which are at least 75% owned by eligible entities from FATF member countries; and
university-related endowments for universities in existence for more than 5 years.
Category II is the residual category; the 2019 Regulations provide that such category will "include all the investors not eligible under Category-I foreign portfolio investors...”. Also, of significance in the redefined categories is the Know Your Customer (KYC) requirements; it is likely that the SEBI (Issue of Capital and Disclosure Requirements) Regulations 2009 (ICDR) can cause different entities under Category-II to be subject to different levels of KYC compliances. No guidance on the same is available yet.
The SEBI has now simplified the issuance of offshore derivatives so long as they are issued by registered Category-I FPIs and to persons eligible to register as a Category-I FPI. In a rather welcoming move, the SEBI has provided a relaxation in that it has done away with the ‘broad-basing criteria’ pursuant to which at least 20 investors were required to establish a fund. Relaxing the norms, the SEBI has also widened the eligibility net to the central banks that are not members of the Bank for International Settlements which would now be allowed to register as FPIs. In an addition, Indian mutual funds floating offshore funds are now permitted to invest in the domestic markets under the FPI route.
The rollback of surcharge applicable on FPIs and the new set of relaxations provided in the form of 2019 Regulations are intended towards regaining the faith and trust of foreign investors in the Indian market. Notably, post the surcharge, India had witnessed a record outflow of FPIs with over INR 11,000 crores. Per the surcharge, individuals earning more than INR 5 crore per annum were subjected to an effective tax rate of 42.5%. The move did more harm than good compelling the government to ultimately roll back the decision to impose a surcharge. Amidst the Indian market facing severe slowdown, the 2019 Regulations are intended to be a shot in the arm for the foreign investors that may make India a more investor-friendly market.
However, the SEBI has seemed to miss a trick or two while revising rather revamping the regulations. The addition of the condition that foreign funds that only belong to the 39-member club of FATF are eligible to be categorised as Category-I FPIs will definitely come as a major blow to foreign funds from jurisdictions such as Mauritius, Cayman Islands and Cyprus. Mauritius has been the top contributor of Indian outward investments into Africa. Not surprisingly, it has remained the top source of foreign direct investment in India in the last fiscal year, only to be toppled by Singapore this fiscal year courtesy the Walmart-Flipkart deal. Mauritius and Cayman Islands, although members of regional bodies seeking top curb money laundering, are only considered as associate FATF members. The new restriction might be a boon for the foreign funds registered in Singapore, which has turned into a hotbed for investors owing to its liberalization policy and higher tax incentives.
Also, the SEBI has reflected its dicey stand on the issuance of participatory notes (P-Notes). It is noteworthy here that SEBI in 2017 had mandated that FPIs cannot issue offshore derivative instruments which had derivatives as their underlying security, unless and until they were being used for the purpose of hedging the equity shares. In essence, it had then given clear indications of phasing out P-Notes in the future. However, with the 2019 Regulations aiming to rationalize the restrictions on P-Notes, it seems to have reversed its position. P-Notes have often been resorted to by foreign investors hiding behind the veil and anonymously investing into the Indian market. The mode of investing had its own concerns as it had always been accompanied with risks of finance terrorism, black money channelization, multi-layering and market volatility. In a bid to rationalize the same, the SEBI has restricted the issuance of the same only by Category-I FPIs and only to entities fulfilling the stricter norms of eligibility for Category-I FPIs. The inclusion of FATF requirements within the norms are aimed at addressing the risks factors often associated with the issuance of such instruments.
The KYC norms are aimed at ensuring better compliance and reporting of the FPIs in India. However, the stricter requirements might act as a setback for foreign investors. It remains to be seen if the operating guidelines soon to be issued by the SEBI address the concerns arising from the 2019 Regulations. It is expected that the operating guidelines would inter alia provide for other restrictions as well on funds from non-FATF nations. It also remains to be seen how the KYC norms are to be implemented for the FPIs. The SEBI may take a leaf out of its previous KYC norms which were rigid enough to dissuade foreign investors from investing in India. The regulator has often grappled with the issue of striking a balance between the safety of investors and keeping the investments clock ticking enough. With the 2019 Regulations, it seems to be finding some ground for itself in this highly regulated space.