The prospects of a Left-supported government was greeted by the Sensex crashing 842 points on May 17, 2004-the worst stock market collapse in history. If the fall didn't acquire the shape of a scandal it was not only because markets recovered soon but also because the plunge was thought to have been caused by two obvious reasons: The rather unexpected defeat of the NDA and a meltdown of stock markets in emerging markets in mid-May. But the Finance Ministry, and so market regulator SEBI, never thought that to be the complete explanation. A hunt was launched to find out if there was foul play: a deliberate attempt to create selling pressure and bring down share prices.
A year later, SEBI has dug up early evidence that could uncover a major scandal, the implications of which will go beyond the events of May 2004. On May 17 this year, SEBI took action against foreign institutional investor (FII) UBS, one of the largest sellers of shares in May 2004. UBS had carried out large-scale selling orders on behalf of unidentified clients, many of whom SEBI suspects could be Indians.
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|"PNs should be issued only to foreign entities with anti-money laundering mechanisms." |
|"Greater disclosures are required. Not all types of money can be allowed to flow in." |
These clients transacted in Indian stocks through UBS, but hid behind a maze of investment deals extending all the way from India to Mauritius, London, British Virgin Islands, the US and back to India. What happened last year, SEBI suspects, is a double whammy. Not only were markets brought down, at least partially, through an artificial selling pressure, but Indians invested in Indian stocks via a route reserved only for foreign investors. That confirms the apprehension among the watchers of Indian stock markets that a large fraction of foreign institutional investment is not really foreign. It is Indian money circulating around the world and reentering the country as foreign money-all illegal, of course (see graphic).
UBS has been prohibited from issuing participatory notes (PNs) for one year. Right now the ban is for non-compliance with the code of conduct for FIIs, though SEBI is further investigating UBS's dealings. PNs are issued by broking firms to investors (individuals or institutional) who prefer not to invest in the country directly because the holdings of Indian shares form a small part of their portfolios. In such cases, foreign brokers buy and sell Indian stocks on behalf of investors and issue them PNs for these transactions outside India. These investors are usually cagey about their identities. The PN issuing brokers (such as UBS) may not know the identity of the investors due to multiple layers of transactions. PNs are globally accepted and are useful source of funds in stock markets, though there have been concerns about their regulation. SEBI prohibits issue of PNs to Indians, non-resident Indians or persons of Indian origin. PNs account for 20 per cent of the FII inflows. This means about $3.7 billion has come into Indian markets through PNs since the beginning of the bull-run in 2003. Some FIIs suspect 50-60 per cent of that amount (about $2 billion) has come from Indians.
Indians misusing this route could be those barred from investing in stocks or those investing black money, or those who don't want to be seen as investing in stocks-promoters trying to shore up their company's share price. SEBI has prescribed a "know your client" policy under which FIIs are supposed to know the ultimate beneficiary when a PN is issued. In reality, FIIs merely ensure they know their immediate client. Investors manage to disguise identities behind long chains of investment outfits most of which are incorporated in places like the British Islands or Bahamas and aren't subject to regulation. That is a source of discomfort for market regulators the world over-including SEBI-who would like investments to come from regulated and known sources.
The Joint Parliamentary Committee that investigated the Ketan Parekh scam of 2001 had found similar misuse of PNs. Unknown investors suspected to be Indian promoters by SEBI had used PNs to buy shares of their companies and transferred them to Ketan Parekh. Later, he dumped these in the markets, hurting unsuspecting small investors the most.
During the course of the year-long investigation, SEBI sought the names of the ultimate beneficiaries of the UBS dealings on May 17, and the assurance that they were not Indians. UBS failed to provide satisfactory answers, citing client confidentiality. The American stock market regulator-the Securities and Exchange Commission (SEC)-shared UBS' client agreements with SEBI, which gave some idea of Indians' involvement. SEBI has not yet disclosed what it calls the "Indian sounding" names. It is also investigating 12 entities other than UBS for similar dealings. The investigation could help SEBI fix a more permanent problem than the crash of May 2004.