The recent decision of the Securities Appellate Tribunal (SAT) in the Goldman Sachs Investments (Mauritius) Limited case has added a new dimension on the convoluted issue of Participatory Notes (PNs), with two political heavyweights -- Jayalalithaa and Finance Minister P Chidambaram -- slugging out in the open on the issue.

Readers may well be aware that PNs are financial instruments issued by foreign institutional investors (FIIs) to foreign investors (individuals or corporates) who want to invest in India but do not prefer to register with the Securities Exchange Board of India (Sebi). In effect, it is a contract between an FII and a foreigner to invest in India. The underlying securities of PNs, needless to emphasis, are Indian securities.

Till date, it was commonly believed that FIIs cannot issue PNs to Indian nationals, Persons of Indian Origin (PIOs) or Overseas Corporate Bodies (OCBs). But this perception can be largely attributed to various literatures emanating out of the finance ministry itself, not the least being the 'The Report of the Expert Group on Encouraging FII Flows and Checking the Vulnerability of Capital Markets to Speculative flows.'

But this judgment of the SAT order in the aforementioned case simply nails the issue comprehensively and turns on its head the common perception about PNs and the manner in which these PNs are being regulated by the Sebi.

Strangely, it could not have come at a worse time for the finance minister. It was just a few days back that former Tamil Nadu chief minister Jayalalithaa had raised the issue of PNs and how the anonymity associated with them could lead to a terrorist group exploiting the same.

    * What are P-Notes?
    *Responsible policies for FIIs, P-notes

Simultaneously, she wondered whether PNs are the cause of the gyrations in the stock markets. In effect, Jaya was questioning the extant regulations in force vis-?-vis the PNs.

Dismissing her apprehensions, the finance ministry -- in a detailed reply -- pointed out that FIIs were required to report at the end of every month, in a prescribed format, all information relating to PNs issued by them, including the information about the subscribers to the said PNs.

The FIIs, the ministry's reply said, were required to provide an undertaking that they, i.e. the FII and/or its associate, have not been issued, subscribed or purchased any PNs to/from Indian residents, Non-Resident Indians, or Persons of Indian Origin, or Overseas Corporate Bodies during the reporting period.

Implicit in the reply of the ministry was that FIIs are comprehensively regulated by the Sebi.

Surprisingly, as the finance ministry was drafting its reply to Jaya's allegations, the SAT had come out with its order on Goldman Sachs completely blowing holes in the claims of the ministry, especially on the assertion that the Sebi has full particulars of the holders of PNs.

And what must be worrying the mandarins in the North Block is that the reply of the finance ministry completely contradicts the decision of the SAT in the Goldman Sachs case. Surely we are in for interesting political times.

First the facts of the case:

Through a circular in August 2003, the Sebi prescribed a reporting format for FIIs on this issue. This included an undertaking that the said FII or its associates have not issued any PNs directly or indirectly to Indian residents/NRIs/PIOs/OCBs till August 2003.

Goldman Sachs Investments (Mauritius) Limited -- the appellant in the instant case -- is a registered sub-account, and Goldman Sachs & Co is the registered FII. On November 25, 2002, the appellant as a sub-account issued PNs to one of its affiliate. The affiliate in turn issued PNs on the same underlying security on a back to back basis to Magnus Capital Corporation Limited (Magnus, for short) which is an OCB -- an entity to which according the format of the report precluded an FII or its affiliate from issuing PNs to such entities.

Obviously, this placed Goldman Sachs in a quandary as these PNs had been issued way back in 2002. Nevertheless, on the issuance of the August 2003 circular, the appellant was obliged to submit to the Sebi a one-time report indicating the outstanding PNs as at August 15, 2003, in the prescribed form along with an undertaking.

This report was filed by Goldman Sachs without the undertaking in the prescribed format for the period till August 15, 2003.

Nevertheless, it stated, "as far as it was aware" it had not issued into any PNs to Indian Residents, NRIs or OCB's during the fortnight ending August 31, 2003.

In the light of these purported violations in filing these reports in the prescribed reporting format by Goldman Sachs, the Sebi was of the opinion that the former had violated the circular and, therefore, initiated adjudication proceedings.

The Sebi order

The adjudicating officer of the Sebi observed, "I can understand that the noticee was consciously aware of the importance of the declaration and that is why firstly it avoided filing declaration. So according to me, this is an occasion when the noticee first violated the Sebi circular by not providing the declaration and later when after all of its so called discussions/clarifications from the Sebi the noticee claims to have complied with the Sebi circular by filing a declaration entirely different from the prescribed format."

Further, the order 'strongly objected' to the move of Goldman Sachs to change the format of the undertaking as prescribed by the Sebi circular. Finally, the order concluded, "If this is the way a registered entity complies with the Sebi circular, I would say it is no compliance." Accordingly, the Sebi fined Goldman Sachs.

In the process it exposes the hollowness of the full compliance theory of the finance ministry. But more is to follow.

The findings of SAT. . .

This order was appealed in the SAT by Goldman Sachs, who argued that till such time the circular was issued there was no bar on FIIs and their sub-accounts to deal in PNs with Indian residents/NRIs/PIOs/OCBs. In fact, it conceded that many of them 'had been dealing' with them in the past and, therefore, the board could not by this circular in question require such FIIs/sub-accounts to furnish an undertaking that they had not dealt with such persons.

The SAT observed that it found 'considerable force in this contention.' The SAT further observed that since there was no bar on the FIIs and their sub-accounts to issue/subscribe/purchase any PNs to/from Indian residents or NRIs/PIOs/OCBs, it would be "reasonable to presume" that many of them must have dealt with such persons in the course of their business activities.

The SAT concurred with the observation of Goldman Sachs that even as on day there is no provision either in the Act or in the Regulations which debars FIIs or their sub-accounts from dealing in PNs with Indian residents/NRIs/PIOs/OCBs.

The SAT wondered how FIIs could be asked to furnish such an undertaking in the 'absence of any bar' to deal with such persons. This requirement of an undertaking, according to SAT appeared to be opposed to all norms of reason and totally devoid of logic. In fact, it concluded that it bordered on absurdity and is arbitrary.

The crucial observation of the SAT is that when the FIIs and their sub accounts have not been debarred from dealing in PNs with Indian residents/NRIs/PIOs/OCBs and added 'many of them would have dealt with the latter, they could not be asked to furnish the undertaking. We could have appreciated the requirement of the undertaking being given by FIIs and their sub-accounts only if they had first been debarred from dealing with the aforesaid persons. In other words, the bar must necessarily precede the undertaking demanded from the FIIs and their sub-accounts.'

And doesn't the SAT order make the ministry's assertion look like playing football without goalposts? Does it mean that resident Indians could have invested through the PN route from Mauritius absolutely legally and availed of tax exemption?

And doesn't it make all of us who had paid capital gain taxes on shares look like fools?

. . . and its political implications

The SAT findings on the Goldman Sachs case are serious. In a way it substantially demolishes the assertion of the finance ministry made in its reply to Jaya. Simultaneously, the myth that PNs are regulated through a well thought-out regime too has been blown to smithereens.

Where is the question of regulation, declaration and undertaking when there is no bar prohibiting FIIs in dealing in PNs with Indian residents, NRIs, PIOs or OCBs?

The Sebi has, in effect, sought to shift the onus of tracking the beneficiaries of PNs to the issuers -- viz., the FIIs. This is akin to the police shifting their responsibility to bicycle vendors and holding them responsible for monitoring terrorists.

And when the Sebi shifted the onus to the FIIs by seeking an undertaking in the prescribed format, naturally FIIs had to resort to subterfuge by changing the very format of reporting on which the finance ministry places its reliance. And according to SAT, FIIs -- in the absence of a bar -- need not comply with the format prescribed by the Sebi in the first place!

It is quite probable that those who are reporting as per the format could well be bluffing! After all who checks? Yet the finance ministry claims that everything is in order!

If that is the ground reality, the finance ministry has a lot to explain in the ongoing spat between it and Jayalalithaa. And for the moment it is advantage Jaya.