A New Avenue- a new beginning for QFIs

In a move to boost investments and increase investor base in times of significant foreign outflows and rupee volatility, in August 2011, Qualified Foreign Investors (QFIs) were allowed to invest in the units of mutual funds.  This was taken a step further when the Finance Ministry vide its press release dated 1^st January, 2012  has allowed QFIs to further invest on repatriation basis in the equity shares of companies listed on recognized stock exchanges.  This is a huge step for Indian regulatory authorities towards liberalization and allowing capital account convertibility.  Hitherto, only registered foreign institutional investors (FIIs) as also individuals and sub-accounts of the FII were permitted to deal in securities listed on a recognized stock exchange within India.  FIIs were subject to registration and strict regulatory regime for investments. It is therefore pertinent to examine the new regulatory regime now proposed to be introduced (viz.investment by QFIs) vis-à-vis the existing FII investments.

A QFI is a person resident in a foreign country that is in compliance with the Financial Action Task Force (FATF) standards and is a signatory to the International Organizational of Securities Commission’s (IOSCO) Multilateral Memorandum of Understanding (MMOU).  Needless to add a QFI cannot be a FII and/or a sub-account of a FII in order to maintain distinction in the two available routes of investment. While an FII is directly regulated by Securities and Exchange Board of India (SEBI), a QFI’s only point of contact is the SEBI registered depository participant (DP) though whom the investments are routed. The DP has been entrusted with supervisory powers over the QFIs.

QFIs are not completely unregulated.  The DP is required to ensure that only QFIs which meet the requisite Know Your Customer (KYC) norms (i.e. as per FATF standards, Prevention of Money Laundering Act, etc.) are permitted to directly invest in the Indian equity market.  In order to ensure transparency, it has been mandated that the ultimate/ end beneficial owners are known and placed on record.  In the event the details of ultimate/ end beneficial owners are not accessible or ring fenced from each other, the DPs are required to disallow such entities from opening a demat account.  Presumably therefore, listed corporate entities and funds would not be permitted to invest as a QFI.

In order to maintain further control, DP is required to ensure that the same set of ultimate/ end beneficial owners do not open more than one demat account as QFIs and the ultimate/end beneficial owners are not residents of India.  Although this will allow the regulator to keep full and complete track of all the investments being made by the QFIs, it is not clear how this is proposed to be achieved.  SEBI does not have extra territorial jurisdiction and an exercise of such jurisdiction appears to be doubtful in light of the recent judgement of the Supreme Court in the case of Vodafone.  Therefore, any change in the organization of the QFI may not be brought to the notice of the DP frustrating the purpose of the regulations.

SEBI has also in its wisdom, disallowed QFIs from issuing any offshore derivative instruments (ODIs).  This ensures that no back door entry is achieved by third parties through the ODI medium.  However, the enforceability and practicability of these restrictions remains to be seen.

This check is also being maintained through the fiscal routes by not allowing the QFI to open any bank accounts within India.  In order to facilitate investments, DPs have been permitted to open a rupee pool bank account which is to be used exclusively for the purposes of investments by QFIs in India.  The DP is required to clearly segregate the funds of each QFI in the pool account and maintain proper audit trails. However, the retention of shares/funds in pool accounts has historically proved to be fraught with risks and portfolio schemes based on such pool accounts have been discontinued recently. Similarly, although multiple broking accounts have been permitted, order routing is mandatory via the DP only and no direct orders are permitted to be placed by the QFI.  This mechanism appears to be intended to allow both the fiscal and the securities regulator to maintain adequate control over the activities of the QFI through the DP and the banker.

In order to fully appreciate the introduction of the QFI route, we would have to consider the nature and quantum of investments that maybe made by the QFIs.  Presently, investments by QFIs are permissible in mutual fund units, certain non convertible debentures, sale and purchases on stock exchanges through recognized stock brokers, purchase of equity shares in public issues, rights issues, receipt of bonus shares, receipt on account of stock split/ consolidation, receipt due to amalgamation, demerger, receipt of dividends and tendering of equity shares under SEBI (Substantial Acquisition of Shares and Takeovers) Regulations, 2011 or SEBI (Delisting of Securities) Guidelines, 2009 or SEBI (Buyback) Regulations, 1998.  All transactions in equity shares by an QFI is to be only on the basis of taking and giving delivery of equity shares purchased or sold and QFIs have not been permitted to deal in any exchange traded derivatives.  Presumably, this is because short selling and speculative trading in derivatives allows QFIs to bring in volatility in the market without having any corresponding obligations or responsibility.  Further, it appears (at for the time being) that QFIs will not be able to invest in convertible securities, warrants, security receipts, government securities, etc.

Further, the individual and aggregate shareholding of QFIs in any company has been limited to 5% and 10% of the paid up capital of the company, respectively.  As in the case of FIIs, RBI has prescribed that the DPs publish a caution list when the aggregate ceilings are reaching in any company and all fresh purchases would require the prior approval of the depositories.  However, intra QFI transactions have been permitted without the prior approval of the depositories.  In line with the extant foreign exchange regulations, QFIs cannot take funding against the securities held by them whether within India or outside.

These guidelines have been issued by the Government amid pressing times and have given a new access route to investors from more than 70 countries to enter and invest in the Indian equity market. Although great responsibility has been placed on the DPs to ensure the success of this route, the approach does not impose any burdensome conditions or restrictions on the QFI and may  provide the much required impetus and boost to foreign inflows. 

Mr. Dhaval Vussonji is a practicing Advocate and Solicitor and a Partner of Messrs Kanga & Co., a leading firm of Advocates and Solicitors in Mumbai, India established in 1890. He is also qualified as a Bachelor of Commerce and a Chartered Accountant.   

Mr. Vussonji is an expert in varied areas of practice including real estate, international ship building contracts and related international arbitrations, private equity investments, capital market transactions involving public issuances, delisting offers, buy-backs and takeover offers, banking and finance, commercial negotiations of hotel management contracts and litigations.

Prominent deals recently advised by him include an acquisition of real estate in Central Mumbai by the Ajay Piramal Group for a sum exceeding US$ 150 Million, commercial negotiations relating to construction and purchase of 3 ships for a sum exceeding US$ 45 million, a bitterly contested hostile takeover bid for Great Offshore Limited a structured investment by Ess Dee Aluminium in India Foils Limited and an amalgamation of the two listed entities, a structured real estate debt refinancing exceeding US$ 120 million and a reference before the Constitutional Bench of the Supreme Court of India relating to provisions of the Indian Arbitration Act.

Mr. Vussonji can be contacted on +91 22 6623 0000 or by email at dhaval.vussonji@kangacompany.com

Ms Prachi Loona is qualified as an Advocate and Solicitor from Mumbai and is an Associate with Kanga & Co..

She has advised acquisitions of real estate in various parts of India including Maharashtra, Andhra Pradesh and Delhi and has provided opinions on title on those properties, which has been a unique experience given the diverse laws and customs applicable in different parts of India.