De-mystifying the reporting obligations of depository receipts in India
Shruti Rajan, Anurag Gupta and Vidhi Shah of Trilegal discuss the relationship between foreign portfolio investors and the Securities and Exchange Board of India
During the 25 years since they were introduced as an investor class, foreign portfolio investors (FPIs) have shared a piquant relationship with the Securities and Exchange Board of India (SEBI), the Indian securities market regulator.
FPIs, as they are commonly referred to, are significant contributors to the Indian public markets and have been subject to increasing regulatory supervision in India over the past couple of decades, on issues ranging from their beneficial ownership structures, offshore derivative products and the nature of reporting requirements they have to adhere to in India.
October 2020 saw the introduction of a significant requirement, in the context of global depository receipts issued by Indian companies. It mandated FPIs to “report details of all such FPIs forming part of the same investor group as well as offshore derivative instruments subscribers and/or DR holders having common ownership, directly or indirectly, of more than fifty percent or on the basis of common control, to its designated depository participant”.
After multiple rounds of discussions between industry participants and the SEBI, this circular has been put in abeyance (but not withdrawn) until further notice, but not before it drew attention to certain critical legal and operational issues, some of which is discussed here.
“the SEBI had been raising its concerns on the American depositary receipt (ADR)/GDR regime as the same are difficult to monitor and may be used for money laundering, market manipulation and round tripping”
Controversy surrounding GDRs
Global depositary receipts (GDRs) are negotiable instruments which represent ownership of underlying shares of a company and growing complexities in ownership structures, tax considerations, money laundering, etc. has made is essential for financial regulators to be aware of the ownership structure of key shareholders in Indian listed corporates.
With depositary receipts (DRs), the de-mystification process gets tougher, since these are listed overseas and the identity of the ultimate natural owner is not always known. The fact that the DR holders overseas have trading accounts and are KYCed as per local norms is of considerable comfort, but matters get more knotted where voting rights are exercised by DR holders and collusion becomes harder to detect.
In terms of relevant SEBI circulars, voting rights “shall be exercised by the DR holder through the Foreign Depository pursuant to voting instruction only from such DR holder”. The SEBI had been raising its concerns on the American depositary receipt (ADR)/GDR regime as the same are difficult to monitor and may be used for money laundering, market manipulation and round tripping and over the years, the SEBI has undertaken massive probes and taken stringent action against companies where DR issues have been found to be misused.
Requirements cast by the SEBI
In an attempt to address the above issues including identification of DR holders and preventing any unwarranted and indirect breach of foreign shareholding limits, the SEBI, in October 2020, devised a reporting framework for foreign portfolio investors (FPIs) having exposure in Indian securities, although the operational details were left to the depositories.
The SEBI directed that FPIs must report details of all FPIs forming part of the ‘same investor group’, along with offshore derivative instrument holders and DR holders to SEBI, through their depository participant. Thereafter, on a monthly basis, the number and value of securities (including through DR) held by such same investor group was to be reported to its custodian, in order to monitor foreign holding limits.
Interestingly, the scope of ‘same investor group’ has to be determined on the basis of common control or ownership in such entities and the SEBI’s directive remains unclear on whether non-FPI entities, without any business or economic presence in India, would have been brought within the fold of such calculation as well. This raised concerns around extra-territorial powers of the SEBI which has some judicial backing in India, especially in the context of depository receipts and its effect on the Indian markets, but when juxtaposed with data privacy/confidentiality limitations, stirs the pot considerably.
Such requirements are also burdensome on the intermediaries involved; in case of this SEBI directive, the impact on custodians and depositories as the chief collators of data that they have no ownership or oversight on, caused considerable confusion, particularly in computing the foreign investment limits of client FPIs and accounting thereof.
What would be the liability (both organisational and personal) for erroneous reports or passive breaches, how would that be contractually solved for between the FPI and the custodian are all issues that the industry continues to grapple with, given the inevitable complexities in ascertaining and accessing such information on the shareholding?
Regulatory reaches made outside of their territorial domain is not uncommon; but whether it is merely an outreach to aid better regulation, or an overreach, has been a question of some debate.
There are a number of imperatives that fuel the requirements for regulators to cast reporting requirements upon entities that do not have a physical presence or a business relationship directly within their territorial domain.
From the SEBI’s standpoint, managing the risks that radiate out of a complex market structure requires newer reporting structures, data security features and novel information sources to be tapped into. However, such demands can pose multiple constraints on market participants and deepen the costs of doing business in a country. Enforcing powers akin to long arm statutes requires a degree of financially strong arming that not many economies are always equipped to wield.
Formulating a predictable compliance and regulatory culture within the securities market is essential for cross-border markets to thrive.
It is too soon to tell if this SEBI mandate to disclose DR holdings has turned cold or if it will soon resurface, in a modified form or otherwise. But the lesson at both ends of this experience is to modify the design of our regulations and seek to use international platforms like IOSCO to enhance inter-regulatory cooperation and reduce the barriers for cooperation. This ensures that domestic regulators do not feel the need to stockpile information from varied sources, in anticipation of an enforcement action that may require a swift joining of the dots.
T: +91 22 4079 1083
Shruti Rajan is a partner in the Mumbai office of Trilegal.
Shruti heads the financial regulatory practice at Trilegal. She has extensive experience in advising regulated entities and listed companies on regulatory risk identification, managing conflicts of interest, review of internal controls and processes, policies as well as governance structures and senior management and board liability. On the contentious side, she regularly represents clients before the financial services regulators in India.
T: +91 22 4079 1000
Anurag Gupta is an associate in the Mumbai office of Trilegal.
Anurag is an alumnus of NALSAR University of Law, Hyderabad. He is presently an associate at Trilegal and is a part of the financial regulatory practice.
Anurag advises various financial institutions including banks, capital market intermediaries and insurance intermediaries in relation to, inter alia, corporate governance, diversification of business and foreign investment.
T: +91 22 4079 1000
Vidhi Shah is an associate in the Mumbai office of Trilegal.
Vidhi advises on matters involving securities regulation and enforcement, corporate governance and foreign exchange management.
Vidhi is an alumnus of the Government Law College, Mumbai and the University of Pennsylvania Carey Law School.