[Manas and Smruti are students at Gujarat National Law University.]
The Securities and Exchange Board of India (SEBI) has recently notified an additional steadfast disclosure mandate for foreign portfolio investors (FPIs) to bolster transparency and fairness in the FPI regulation framework. The circular dated 24 August 2023 comes in the offshore of the Adani-Hindenburg controversy, where the report alleged the group for failing to comply with the requirement to disclose detailed information on beneficial owners (BOs). This claim has been substantiated by the Organised Crime and Corruption Reporting Project in its findings, wherein it has accused the conglomerate of breaching the securities rules by obfuscating the true ownership of its significant shareholders behind complex offshore structures.
The SEBI circular highlights that such instances of exploitation of the FPI route to circumvent regulatory oversight have triggered the need to put a check on the investors seeking refuge in loopholes and rectify existing norms. It further establishes various compliance measures designed to mitigate potential threats to the Indian market and investors. The author in this post delves into the backdrop of FPI regulations in India, the circular’s causal association with the recent Adani stock controversy, the new requirements and their implications on major FPIs and other stakeholders, and the related disparities.
Backdrop and Shifting Paradigms
In 2014, SEBI introduced the opaque structure clause (OSC) in its FPI regulation framework. As prescribed in the SEBI (Foreign Portfolio Investors) Regulations 2014 (FPI Regulations), if an FPI is discovered to have a “lack of transparency” in its structure, it would be considered ineligible for registration. This measure was put in place to prevent FPIs from organising their entities in a manner that conceals essential ownership details. However, in 2018, SEBI made a policy shift making it mandatory for all FPIs (excluding sovereign funds) to disclose information regarding their beneficial ownership, and thus the requirement to disclose the economic interests of every ultimate natural person in FPI was withdrawn. This abrupt transition from stricter norms to a more sympathetically allied approach towards FPI was unexplained and garnered criticism. The Adani-Hindenburg controversy serves a crucial case study that demonstrates the implications of SEBI’s move.
The Adani-Hindenburg Row
Earlier this year, the Hindenburg Report levied serious allegations of “accounting fraud and stock manipulation using shell entities” against the Adani group. The report also alleged that some of these FPIs are just the fronts of promoter entities. Some FPIs holding shares in Adani Group companies were believed to have concentrated a portion of their equity portfolios in only Adani Group companies, which made it difficult to track the last natural person owner. In response to this, SEBI, on the direction of the Supreme Court, started investigating these allegations and found that 13 overseas FPIs were classified as public shareholders by the group. These entities were located in tax haven jurisdictions, which made it challenging to establish their economic interests as FPIs and BOs. The withdrawal of the OSC by the regulator made it harder to investigate the situation more exhaustively.
In an effort to address these issues, the Supreme Court constituted an Expert Committee, under the chairmanship of Justice AM Sapre. The committee in its report identified the core issue impeding SEBI's enquiry was the weakening of disclosure standards. The absence of a proper regulatory framework signalled an exploitation of the market system, as the same hindered the disclosure of the last identified natural person or the last substantive owner of the FPI, who often remained elusive. The predicament was termed as “chicken and egg situation” by experts, underlining the regulator’s failure to prevent the menace.
Challenges to SEBI’s FPI Oversight
The sympathy towards FPIs for the promotion of ease of doing business, despite several warnings from other regulators like the RBI, was not a well thought move by SEBI. The removal of the OSC resulted in the dilution of disclosure norms, enabling entities to undertake intricate structures so as to obfuscate true ownership and related party transactions. These inadequate disclosure requirements hindered the detection of potential violations of BO norms and limited access to information regarding the 13 foreign entities, thereby averting timely regulatory action. The measures taken by SEBI proved to be inept in evaluating the need for stricter regulations in the FPI sphere.
The Expert Committee gave a clean chit to the Adani group, due to the deficiencies in the FPI regulations. The regulator’s inability to prove any substantial securities law violations against the conglomerate raises questions concerning the efficacy of its FPI oversight. The inadequate measures further enabled the entity to circumvent obligations, leading to a concentration of investment in a single corporate entity. Insufficient disclosures did not give a clear picture regarding alleged infractions or the overall general operations of the organisation, making it difficult to build a strong case or initiate necessary enforcement action against the Adani group, rendering the investigation at a standstill. The recent move is a response to the impediments faced by SEBI in identifying and policing such circumstances.
Decoding the Recent Circular: Implications and Discrepancies
The recent circular by SEBI mandates the disclosure of granular details of all the investors that are holding any ownership, economic interest, or exercising control in the FPIs that are holding either more than 50% of their Indian equity Assets Under Management (AUM) in a single Indian corporate group or more than INR 25,000 crores of equity AUM under Indian markets. On a thorough “look through” basis, the high-risk FPIs and all their affiliated companies will be required to disclose minute details up to the level of all natural people and/or public retail funds or significant publicly traded businesses. This promises greater transparency on “high-risk” FPIs as compared to the existing framework. The comprehensive information sought by the regulator could solve the issue faced with respect to tracking the last identified natural person of the FPIs and curing the prevalent misuse of such structures, as witnessed in the Adani case. Non-compliance with the disclosure criteria could result in FPI registration becoming invalid, a deterrent consequence of which would be the winding down of their investments within 6 months.
These new rules may pose certain implications for institutional or major financial investors, necessitating a re-evaluation of their investment strategies to avoid falling under the obligated criteria. This could severely impact the market structure due to significant sell-offs in the shares of the entities in the process of complying with the rules, resulting in lower stock prices. Additionally, the heightened scrutiny and stricter regulations may deter certain investment activities and increase compliance costs, particularly in cases involving complex arrangements and structures.
It is worth noting that the circular exempts government and government-related FPIs under Regulation 5(a)(i) of the FPI Regulations. It also excludes public retail funds as defined under Regulation 22(4) of the FPI Regulations. Considerable exemptions are also granted to exchange-traded funds, newly registered FPIs within the first 90 days following the settlement of their first trade, FPIs unable to liquidate excess assets due to statutory constraints, and FPIs in the process of winding down investments after intimation to their Designated Depository Participants.
Though the prescribed exemptions are incorporated to facilitate the interests of presumed low-risk entities, the threat still persists. Even if such entities are excluded for being perceived to be innocuous, they can still be misused to circumvent regulations. To avoid compliance with the new disclosure rules, an FPI can, for example, structure its investments to fall under one of the exemptions, even if it does not qualify to be one. Exempting such entities from disclosure norms may potentially lead to BOs concealing crucial information, perpetuating ambiguity and facilitating exploitation for illicit purposes. Further, the exemptions, if not supported with additional dedicated guidelines, can promote the low-risk entities to bypass regulations, posing a potential threat of regulatory arbitrage.
Conclusion
The Adani case has emerged as a pivotal precedent, illuminating the compelling necessity for augmented disclosure requisites and the imperative to rectify the ramifications of inadequate regulatory measures. The deficiencies that hindered the regulator's investigation in this case underscore the exigency for a relook towards both the regulatory framework and the investigation protocols. These reforms are indispensable not only for upholding regulatory compliance but also for serving as a potent deterrent against non-compliance.
The recent disclosure mandates offer a more robust and resilient framework, poised to mitigate the risks associated with severe market fluctuations. To effectively execute these stipulated standards, SEBI must contemplate the adoption of a risk-based approach. This approach would entail subjecting entities, including those that enjoy exemptions, to varying levels of due diligence contingent upon their risk profiles. Such a stratagem ensures that high-risk entities face rigorous controls, whereas low-risk entities are not inundated by onerous procedures. While the circular represents a positive stride toward fortifying FPI disclosure regulations, it is apparent that the aforementioned issues warrant a comprehensive overhaul of its implementation, necessitating appropriate modifications in the foreseeable future.