Capital market regulator Sebi recently made changes to the KYC framework for Foreign Portfolio Investors (FPIs) through a circular on April 10, 2018. The underlying objective behind these changes is to provide a clearer mechanism for identification and reporting of beneficial ownership of FPIs. The circular comes as a relief for Designated Depository Participants (DDPs), which have consistently faced practical difficulties while determining beneficial ownership of FPIs and obtaining related KYC documentation.
Some key changes are discussed below.
The circular provides that a beneficial owner, who is a natural person, would be identified in accordance with the Prevention of Money Laundering (Maintenance of Records) Rules, 2005. For determination of beneficial owners, a materiality threshold has been prescribed. In case of a company, a person holding 25% or more will be considered a beneficial owner and in case of a partnership firm, trust, or unincorporated association of persons, any person holding ownership interest of 15% or more will be considered a beneficial owner.
However, if the FPI is resident in a high-risk jurisdiction as per the Anti-Money Laundering and Countering Financing of Terrorism (AML/CFT) norms prescribed by Sebi, regulated intermediaries are allowed to apply a lower materiality threshold of 10% and obtain KYC documentation accordingly.
A Question of Identification
For identification of the beneficial owner, the materiality threshold must be applied at the level of the FPI entity first and then a look through principle shall be applied to identify the beneficial owner of the material shareholder/ owner entity. In cases where no material shareholder/owner entity is identified by application of the materiality threshold, the senior managing official of the FPI will be deemed to be the beneficial owner.
The Category II and III FPIs have been directed to provide a list of beneficial owners identified in accordance with the circular within six months from the date of the circular, in a prescribed format to ensure uniformity. Further, investment limits of FPIs will also be clubbed on the basis of the beneficial ownership identified in accordance with the thresholds specified in the Circular.
Under the Sebi (Foreign Portfolio Investors) Regulations, 2014 (FPI Regulations), NRIs are not eligible to obtain registration as FPIs. In relation to Indians as beneficial owners of FPIs, the circular has also confirmed the guidance which was previously available under the Sebi FAQs that NRIs/OCIs cannot be beneficial owners of FPIs.
However, NRIs/OCIs are permitted to promote a non-investing Category II FPI which acts as an investment manager for other FPIs.
Further, FPIs or material shareholders/owner entities identified in accordance with the circular are required to certify that they have not issued and do not have any outstanding bearer shares. A bearer share is owned by the person holding the physical share certificate and is transferable by delivery. Restriction on the use of bearer shares ensures that transfer of shares and beneficial ownership over an FPI is better recorded and available for scrutiny.
Important changes have also been made in relation to KYC reviews and documentation. A Sebi circular dated September 12, 2013, prescribes that eligible foreign investors shall be subject to KYC review as and when there is any change in material information/disclosure.
However, for FPIs, Sebi has now decided that a comprehensive KYC review must be conducted on a periodic basis as per their respective risk categorisation. A yearly KYC review will be required in case of high risk clients (including those coming from high risk jurisdictions) and in all other cases, the review will be conducted every three years.
Six Months to Get Act Right
To address concerns raised by DDPs regarding the specific financial documentation for Category III FPIs, Sebi has clarified that audited annual financial statements or net worth certificates from auditors may be obtained from Category III FPIs. Further, FPIs are exempted from furnishing certain KYC documents based on their risk categorisation. However, the circular now requires that FPIs must provide an undertaking to DDPs/custodians confirming that, should regulators or law enforcement agencies demand such documentation, the FPI would furnish such exempted documents.
All non-compliant FPIs on the date of the circular have been provided six months to re-structure or to terminate their position in the Indian securities market. In case the investment limits are breached after the expiry of six months from the date of the circular, the investments will be treated as Foreign Direct Investments from the date of the breach or the holding will have to be reduced below 10% of the paid-up share capital of the company within five trading days from the date of settlement of the trades.
With this circular, Sebi has tightened the noose around disclosures made by FPIs in tandem with the measures prescribed under the Prevention of Money Laundering Act, 2002. The changes made to the KYC framework are a step in the right direction and increase transparency. Moreover, the circular brings further clarity for DDPs/custodians battling with issues around identification of beneficial ownership and related KYC documentation.
Sandeep Parekh is the managing partner of Rajneesh Deka Finsec Law Advisors and is an associate at Finsec Law. Their views are personal.