FII Investments - Usage of P-Notes & PCC Structures

SEBI Circular no. CIR/IMD/FIIC/1/2011 dated January 17, 2011 is in continuation of the government policy intent to balance the need to allow the flow of FII funds and at the same time to ensure that the markets do not become a parking place for tainted money of internal and external entities. Vide this circular SEBI is trying to gather more information on the flow coming in through Off-shore Derivative Instrument (ODI) mechanism. This is an appreciable move in light of what is happening all over both in the realm of corruption and terrorist financing.

Further, some time back, SEBI took steps to restrict the inflow of FII money through the use of certain vehicles like Protected Cell Company (PCC) and others. The ODIs coupled with vehicles like PCC provide an impregnable layered structure which makes it impossible to know the ultimate beneficiaries of these funds.  It will be interesting to know the nature of such structures and whether these policy measures are really going to help in bringing the necessary transparency in the source of funds coming through these routes.  

The concept of Protected Cell Company (PCC) (also called Segregated Cell Company (SCC)) is a new corporate form and originated in the well known off-shore jurisdiction Guernsey in late Nineties. The PCC has a two tire equity structure. The first tire, known as Management Shares or Common Shares or the Core, consists of a single class of shares. The second tire, known as Cell or Class, consists of large class of shares independent of each other which are generally identified by numeric numbers or alphabets.

The management shares are held by the promoters of the company or their nominee and the capital contributed by them is minimal which may be as low as USD 1000. The promoter sells the second tire Cells to other interested investors. The holders of the management shares normally keep the following corporate powers with them:

•  To constitute the board of directors.

• To manage all affairs, property and business of the company of the Core as well as the Cells.

• To receive notice of and to attend meeting of the shareholders of the company.

• The right to amend the constitution documents and the dissolution of the company.

•  In case of liquidation, their rights are secondary to the rights of the holders of the Cells.

• As they are not entitled to receive any dividend, the management shares are classified as voting non-profit sharing shares.

The Cell structure makes each Cell independent and segregated from other Cells. Generally, the ownership of the shares of each Cell lies with a single or related investors. The main features of such a Cell structure are:

• The Cells are classified as non-voting profit sharing shares divided into large number of classes.

• Each Cell is identified with a numeric or alphabet e.g. Class 1, Class 2 or Class A, Class B, etc.

• The board of directors specifies the designation of each Cell, the capital contribution or portfolio and the portfolio from which this Cell will derive its entitlement for profits.

• Cell holders are not entitled to receive notice for the general meetings of the company nor are they allowed to vote in general meetings.  Further, the voting right, if any, may be restricted to one vote for that class of shares irrespective of the number of shares held.

• Cell holders continue to have right to vote separately and individually as a class for certain rights associated with that class of shares.

• The holders of these shares are entitled to receive dividend out of realized profits or surplus from that class of shares only.

• On liquidation of the company, each Cell holders gets the assets and liabilities of that class of shares only.

• Further, liability of the company to any creditor entered with any Cell extends only to assets attributable to that particular Cell and not to the assets of any other Cell. This is so because the assets and liabilities of each cell are considered separately.

The two tire corporate structure ensures opaqueness between the Core and the Cells on the one hand and between the Cells on the other hand. This opaqueness is possible because the company is registered with the registrar at the Core level only with the facility to issue Cells as per the needs. The Cells are not registered with the registrar. Thus, in case of any investigation, information only on the Core would be available and not on the Cells.

Further, debts, liabilities, obligations and expenses incurred by one Cell will only be enforceable against the assets of the same Cell and not against the assets of any other Cell. Such segregation creates a ring-fence around each Cell and this ensures that the activity in any Cell will only affect that Cell and will have no impact and legal recourse on other Cells. Thus, PCC provides for the legal segregation of risks, assets and liabilities of different individuals and corporate entities under a shared structure.

The flexibility of PCC in terms of segregation of assets and liabilities and privacy enhancer has made them attractive vehicles for asset holding and protection, and structured finance business. PCCs can also be structured so as to obtain access to double taxation avoidance treaties and hence obtain favorable tax treatment, while being taxed as a single entity.

Multiclass Share Vehicles (MCV) is a more conventional incorporated entity with a provision to issue many classes of shares. Here each class of shares may invest in a dedicated portfolio (single investor) or multiple classes of shares may have a dedicated portfolio (multiple investors).

PCCs register with SEBI either as FII or sub-account by providing information on the core and not at the cell level. Further, happening at the cell level is not shared with SEBI including addition of new cells. This helps in taking advantage of the opaqueness and flexibility associated with such structures and makes them a preferred vehicle for use towards routing either questionable money or round-trip of the money in Indian capital markets. The impact is that the real ownership of the money remains unknown to all except the promoters of the PCC. However, the requirement to provide an undertaking to SEBI that the FII or the sub-account is not a PCC/SCC structure has reduced the possibility of their direct registration with SEBI as a FII or Sub-account of a FII.

ODI / P-Notes are derivative instruments issued by registered FIIs or sub-accounts to their investors. The underlying in these instruments are the Indian securities which are held by the FII or sub-account on behalf of their foreign investors who are not interested in participating directly in the Indian market. Any dividends or capital gains collected from the underlying securities go back to the investors. For investing through ODI / P-Note mechanism it is not necessary to be registered with SEBI, the only requirement is for the FII or sub-account to conduct the KYC due diligence to whom the instruments are being issued to. These notes are transferable by endorsement and delivery. Investors who use ODI / P-Note route deposit their funds in US or European operations of FII or sub-accounts operating in India. The FII / sub-account use their proprietary account to buy stocks.

However, the investors combine the flow of money through ODI / P-Note with multilayered PCC structure behind it in order to conceal the identity of the original client. Further, features of PCC like use of custodian for registered shares, nominee director or shareholder help in concealing the identity of the ultimate beneficiary.  Many time bankers through which the money is routed tend to act as custodian for the registered shares issued by PCC. In such cases, it is the custodian whose name appears as the ultimate beneficiary owner and the confirmation of having done the KYC due process is for the custodian.  Secondly, the facility of allowing the use of nominee director or shareholder in a PCC structure further makes it impossible to know the actual beneficial owners.

The registry of the countries where such entities are allowed to be registered will have information only on the nominee director or shareholder. The regulatory provisions of the countries allowing such structures does not provide for the service provider disclosing the name of the parties with whom they sign the nominee agreements. So the multi-layered and the custodian mechanism continue to provide means to conceal the identity of the real owner of the funds being routed through this mechanism.  Many foreign banks, under their Private Banking facility provide the above described facilities for managing the wealth of their clients.

Yogesh Kumar, MBA, LLB.

Head – Legal & Compliance, Amicorp Group

 Yogesh is associated with Capital Markets for over 18 years. Views expressed are personal

yogesh_ub@hotmail.com