Are FIIs dumping shares borrowed from P-note accounts?

Santosh Nair
Moneycontrol.com

Definitely, say a section of fund managers at domestic mutual funds, and dealers in foreign stock broking firms. And while it is hard to prove—given that the ownership of the shares don’t actually change hands—the price pattern in many stocks indicate that some foreign players are borrowing shares held in participatory note (P-note) accounts, dumping those shares, and then buying them back at lower levels. There are foreign investors who are bearish on Indian equities, but do not own shares to be able to sell. This form of borrowing is ideal for such investors, who are betting that stock prices are likely to decline in the short term. They pay an interest charge to the foreign broking firms that lend the shares. Market sources say Maruti Suzuki , Bharat Heavy Electricals and Hero Honda Motors are some of the counters, where such dealings could have taken place.

Participatory notes or P-notes are derivative instruments, with Indian equity shares as the underlying. Foreign investors who want to invest in India, but do not want to register with market regulator Sebi, the P-note route is ideal. They buy the P-notes through foreign broking houses that are authorized to issue them. The underlying shares remain in the custody of the broking house, but the P-note holders are entitled to dividends on those shares. The broking house is merely a custodian of those shares.

During the bear phase of 2008, many foreign institutional investors were rampantly borrowing shares from broking firms with P-note accounts, and dumping them in the market, triggering steep slides in many stocks. This prompted Sebi—then with CB Bhave at the helm— to call for disclosures from foreign broking houses on the stocks they were lending shares to overseas entities. Eventually, the regulator made it clear that it did favour this (disclosed) form of lending-borrowing, and the practice stopped altogether.

In April 2008, Sebi had introduced a Stock Lending Borrowing (SLB) mechanism, which allowed institutional investors to borrow shares. But that system never really took off. For one, foreign institutional investors felt the margin requirements were too stiff. But more importantly, many of them did not want to disclose their transactions on a public platform. The Indian market not being as liquid as some of the global markets, there were concerns that bull cartels could manipulate the prices of stocks where it was known that institutional players had borrowed and sold in the market. Once the price shoots up, the sellers of the borrowed shares would have to either cover their positions, or pay more margins to hold on to those positions.

Dealers say it is difficult for Sebi to keep track of borrowing/lending of shares in the P-note even if it calls for stringent disclosures, mainly because there are too many layers of ownership.

“The eventual beneficiary of a P-note account, even if it is shown to be domiciled in Mauritius, could be some entity in Bahamas, who has made the investment through a chain of holding companies in various tax havens. So if the shares from the P-note account are offloaded in India (without being transferred into the account of the entity borrowing it) and the interest payments are settled in Bahamas) it will be very tough for Sebi to establish that transaction,” says a fund manager at a domestic mutual fund.

Dealers say it also happens that the foreign broking house holding the P-note shares, may at times be lending the shares to interested parties, without the knowledge of the original beneficiary. Very much like a laundry assistant lending some customer’s suit to another customer with the promise that the suit will be returned within a specified time. The laundry assistant is in trouble if the suit is not returned in time, or the owner comes asking for it earlier than the laundry assistant thought he would.

The Indian securities arm of a prominent US-based financial services major was caught on the wrong foot some time in 2007. This broking firm lent shares of SBI from one of its P-note client’s accounts, to another client, who then sold the shares in the market. But the client to whom the shares originally belonged, unexpectedly turned up with a demand to sell the shares. The broking firm had no option, but to buy SBI shares from the open market in its own account and then sell them on behalf of the client.

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