In its unwise attempt to regulate investment through participatory notes, the Securities and Exchange Board of India has ignored a fundamental legal maxim of international law, "extra territorium jus dicenti impune non paretur".
That is, "the judgment (or the authority) of one who is exceeding his territorial jurisdiction is disobeyed with impunity." In attempting to regulate the participation of foreign investors through P-notes Sebi has stepped outside its territorial bounds; the consequence is that Sebi's directives will either be ignored or disobeyed.
The Sebi Story: Complete Coverage
In order to understand the nature of Sebi's mistake, it is necessary to explain a participatory note in greater detail. For some curious monopolistic reason foreigners or non-residents are not allowed to invest directly in the Indian stock market.
Their involvement in Indian investment has to be carried out through a foreign institution, which in turn is required to register itself with Sebi. Now what the purpose of this regulation is, must remain like the Indian rope trick, a mystery.
Why an investor is prevented from investing directly, but can if he chooses to invest through an FII is the kind of twist that only an Indian bureaucratic regime can justify. It is deep in the psyche of the bureaucracy that it believes in the value of unnecessary complications.
The presumed theory is that knowing or regulating the intermediary enables the regulator to control the underlying investor. But now suddenly Sebi has discovered the obvious truth that the intermediating FII has really no more knowledge of the character of the final investor than a commercial bank has of one of its depositors.
To rectify this deficiency Sebi has directed foreign institutions as part of the process of "knowing their client" to issue participatory notes only to "regulated entities" meaning presumably those entities regulated by Sebi.
Why such a client would need a foreign institution as an intermediary is not entirely clear but Sebi's convoluted logic obviously looks not for the intermediary institution to know its client but for Sebi to have an opportunity to know the underlying client.
In order to stretch their bureaucratic control further Sebi regulated that these clients who had purchased the participatory notes were not allowed to transfer these to any other person except to those who were regulated.
This proposition was absurd and totally outside Sebi's jurisdictional authority. For the underlying client as a non-resident cannot be regulated by any law or rule passed by Sebi, any more than an Indian can be regulated by dictates of President Mugabe.
The very nature of a participatory note is to place the transaction outside the scope of the Indian authorities. Any attempt to bring it within the parameters of Indian law can be disobeyed with impunity.
For consider a regulated purchaser of a participatory note resident in the Cayman Islands. Such a person transfers the participatory note to another resident of Cayman who is not regulated by Sebi. What effective power would Sebi have to prevent such a transfer?
Sebi can of course file a legal case in Cayman courts to prevent such transfers, but no court in the world would uphold such an argument. Sebi would be told that the legality of an inter Cayman transfer was outside the scope of Sebi's authority.
It is not however, my primary interest to concentrate on the legal issues of Sebi's regulations but on the economic issues that emerge from Sebi's activities.
The first question that we need to ask is the necessity of FII's as an instrument for investment into India. This is not a common place of markets; if for example a non-resident of the US or of England chooses to invest in an American or an English or a German stock he does not have to hold his investment indirectly through a FII but can hold it directly in his own name. An FII in India is a superfluous addition created simply to suit the regulatory requirements of Sebi.
FIIs serve no economic purpose but they exist in order to provide Sebi with a bureaucratic layer between a foreign investor and the regulator. It enables Sebi to pretend that it controls foreign investors when in fact Sebi has no control on the ultimate investor.
It is a good example of obscuring the true character of foreign investment in India through a non transparent and expensive set-up. The P-note is an additional twist in this indirect investment as it enables those who wish to invest in the Indian market to do so without disclosing their identity.
It is part of the curious feature of the Indian system that we are ourselves muddled about what we want so we therefore arrive at irrational decisions. If we want portfolio investment we should allow foreigners to invest directly. If we do not want it we should prohibit FIIs from investing, but it is a pointless exercise in obfuscation to permit portfolio investment only through FIIs.
In order to accommodate indirect investment, Sebi is now willing to play the complicated game of creating rules that can always be rolled back.
First it announced a silly restriction on the rights of participatory note holders, then in subsequent clarifications Sebi rolled back its regulation by stating that it will allow any investor to participate in the purchase and sale of P-notes provided the entity is regulated somewhere in the world.
Such a flexible response is an excellent display of Sebi's resilience but does call in question its original intention of requiring FII's to "know their client". It is clear that if participatory notes can be bought or sold to anybody regulated in some part of the world, the FII is most unlikely to have any knowledge of the client that owns the P-note.
It has now become a feature of this government that it is willing to reconsider economic measures even to the point of rolling back its preliminary decisions. This is not to be deplored for it is better to undermine its own measures if they are likely to cause damage; but it might be better to change this tortuous process of passing edicts and withdrawing them by a wider debate on the merits of existing rules.
For if one were to cite an example of how to carry out a substantial reform, second only to Manmohan Singh's decision on allowing the exchange rate to find its own level, it must be the substantive overhaul of the industrial licensing policy carried out by Rakesh Mohan in 1991. This was not carried out in a piecemeal fashion but by the careful review by a trained economist in cleaning a system that had outgrown its value.
Sebi's rules and regulations need some such overhaul. Too much that is purposeless has accumulated and attached itself to the regulations, and it creates the sort of confusion of which the P-note debacle is merely an illustration.
It is wholly meritorious that Sebi preferred to rollback from its mistake but it would be better if their rules were reformed to play the investment game in accordance with economic principles.