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Krishnan Thiagarajan

By parting with information that ought to have been within the control of UBS Securities in slow doses, serious loopholes in the regulatory framework governing FIIs in India have been exposed.

WHEN the Securities and Exchange Board of India (SEBI) launched investigations into the market meltdown of May 17 last year, it was widely perceived as a mere cosmetic exercise. After all, the precipitous single-day fall in the indices was preceded by a week in which the Congress-led coalition government assumed power, with support from the Left parties. There was widespread apprehension that the progress in the policymaking process, as spelt out in the draft Common Minimum Programme, in key sectors such as banking, infrastructure, oil and gas and disinvestment will be put on the backburner.

Second, by the end of that week in May, the market had staged a remarkable recovery.

As soon as the market sensed that no payment crisis was brewing, and aided by the right noises from the political and economic quarters, the Sensex recovered from a 15 per cent plunge at the start of the week to end that week with just a 2 per cent decline.

The FII fault line

Precisely a year on, SEBI has issued its first order following its investigations against UBS Securities Asia.

But this order has highlighted serious concerns in the FII (foreign institutional investor) framework rather than expose any significant wrongdoing or collusion among market participants affecting market behaviour on May 17.

The investigations, however, are still at a preliminary stage. As far as the latest order goes, the UBS case stands on a different footing.

Though the probe seeks to draw attention to the fact that UBS had made gains by deliberately selling in the cash market to profit from its short position in the futures market, it is a rather tenuous link. More of that later.

Fortuitously, for SEBI, these investigations have led in a different direction. By parting with information that ought to have been within its control, in slow doses, UBS has exposed serious loopholes in the regulatory framework governing FIIs in India.

Through its latest order prohibiting UBS from issuing and renewing offshore derivative instruments for one year, SEBI is aiming to tone up the regulatory framework for the FIIs in at least three areas:

`Know your client': Any FII operating in India is allowed to issue offshore derivative instruments (such as participatory notes, PNs, or equity-linked notes) to regulated entities in different parts of the world, subject to regulatory jurisdiction.

The essential condition behind this issue is that the FII must `Know the Client' to whom these PNs are issued, so that the ultimate beneficiary of these PNs can be established, even if a multi-layered structure is created. This condition is important because it prevents unregulated and unregistered entities from using these instruments to indulge in money laundering or worse.

But from the SEBI order, it is obvious that for at least five clients out of its 12 clients, UBS either did not furnish full information or submitted partial information to SEBI and that too, only after repeated attempts to secure the information. By failing to co-operate fully in the process, at least in the first round of investigations, UBS appears to have slowed and frustrated the investigation process.

Transaction details: In the Ketan Parekh scam in 2001 involving software companies, the Joint Parliamentary Committee probe had suspected that some promoters of Indian software companies using the NRI/ OCB/`Person of Indian Origin' route to purchase the shares in their own company.

As a fallout, the FIIs were restricted from entering into an Offshore Derivative Transaction with a fund that might have a shareholder who is an Indian National, NRI, OCB or Person of Indian Origin.

To establish that such entities were not manipulating the stock market, SEBI had asked UBS to furnish the names of the major shareholders/top five investors in respect of its top five clients. UBS initially claimed that it had misunderstood the requests from SEBI and later furnished the required information in a phased manner only after the first round of investigations.

Misleading information: In the UBS case, SEBI has gone to the extent of even establishing that UBS had made misleading statements about its transactions with offshore derivative instruments and also made false claims about submission of information to the investigating officers. Considering that UBS has been registered with SEBI since 2000, these acts have shown them in poor light.

Tenuous link in gains: While the regulatory lapses on the part of UBS can be established, SEBI's claim that UBS made substantial profits of Rs 42 crore by selling in the cash market against short positions built up in the futures market may be far more difficult to stick.

Given the political instability at the Centre, as spelt out earlier, any savvy institutional investor would have hedged their position the way UBS did on that day.

Secondly, as a single investor, it did not trade a sizeable position that would have materially altered the trading turnover in both the stock exchanges. Since 11 more entities (five foreign and six domestic) being investigated at various stages, the course of the investigations is not clear now. But on the face of it, SEBI is probably on a weak ground at this stage.

For that matter, instead of confining their investigation only when there is a sharp decline in equity prices, SEBI can consider initiating investigations even when the markets get overheated.

So far, SEBI and the government have only made glowing statements about the markets when they are in a bull run, at times soft-pedalling even sane statements made by the central banker.

For instance, in January this year, when the RBI Governor talked about the possibility of FII flows being hot money and floated the idea of taxing FII flows, the Finance Minister quickly rejected the proposal.

Since then, there has been considerable debate about the quality rather than quantity of FII flows into the country, something that RBI is bound to be worried about.

On its part, SEBI, using its powers of investigation, also needs to ensure that the regulatory lapses on the part of the FIIs or domestic investors do not surface in a bullish phase in the market.

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