Demystifying FEMA - Part 3

PART - 3

Foreign Portfolio Investors

Equity and debt are the two sources of raising funds available with the companies. At the beginning of the liberalisation, short term and long term foreign investments were envisaged in equity segment. Keeping this classification in mind, two types of schemes were formulated, Portfolio Investment Scheme (PIS) for short term foreign investment and Foreign Direct Investment scheme (FDI) for long term foreign investment. Conceptually, a great degree of difference exist between the two schemes with only commonality between the two is the investment in equity. As noted in an earlier part that investment under PIS is easily convertible as opposed to investment under FDI scheme. Investors under PIS want easy in and out option, and it is the reason of such difference. Under PIS, the investor’s focus is mostly on earnings resulting from the acquisition and sales of shares without expecting to control or influence the management of the assets underlying these investments. Portfolio investors do not have as an objective any long-term relationship. Return on the assets is the main determinant for the purchase or sale of their securities.

Another distinguishing feature is the emphasis of PIS on negotiability of securities which is a way of facilitating trading, allowing them to be held by different parties during their lives. Negotiability allows investors to diversify their portfolios and to withdraw their investment readily. Generally, such negotiability is found only in listed securities.

Initially, Foreign Institutional Investors (FII), Non-resident Indians (NRI) and Overseas Corporate Bodies (OCB) were allowed to invest under PIS. In year 2012, to attract more foreign exchange in the face of severe devaluation of rupee, govt. recognised new class of investors as Qualified Foreign Investors (QFI).

PORTFOLIO INVESTMENT SCHEME (PIS)

PIS has been enshrined in Foreign Exchange Management (Transfer or Issue of Security by a Person Resident outside India) Regulations, 2000 (FEMA 20).  Schedule 2, 2A, and 3 to FEMA 20 contain PIS. It is worth noting that every schedule to FEMA 20 contains a scheme, for e.g. schedule 1 contains FDI scheme. Foreign investment in equity shares and in securities convertible into equity shares is counted as investment under PIS. As learned earlier, there is almost full convertibility for PIS. Following principles are the identities of PIS:

• ·         No restriction on repatriation on investment made under PIS scheme.
• ·         No minimum lock-in period on investment made under PIS scheme.
• ·         Different caps of PIS have been prescribed according to the types of investors.

PIS scheme varies according to the types of investors. NRIs have been given special treatment in FEMA 20. First two conditions are essential to attract portfolio investment from FII, but the condition of repatriability is not uniformly applicable on portfolio investment from NRIs. Where NRIs’ investment under PIS results in fresh inflow of foreign exchange into the country, repatriation of that investment is allowed. Generally, NRIs also have Indian money to invest, so to make sure that repatriation is only possible where investment made by fresh flow of foreign exchange, there are restriction on repatriation on investment made by NRIs under PIS in schedule 3.

Schedule to FEMA 20	Investor	Investment Options
2	FIIs	Shares/Convertible Debentures ·         Investment through stock exchange ·         Investment in private placement by company (listed and unlisted companies) ·         Investment in offer (company intended to get listed)
3	NRIs[1]	Shares/Convertible Debentures ·         Investment through stock exchange via authorised dealer. (only listed)
8	QFIs	Investment in Equity Shares through QDPs ·         Investment through stock exchange (listed) ·         Public offer as per ICDR, 2009 (company intended to get listed)

Like schedule 2 and 3, schedule 8 on QFI investment in equity shares does not specifically named such investment scheme as portfolio investment scheme. But the basic principles of PIS can be found in schedule 8, so for the matter of convenience, investment by QFI is considered under PIS for this article. This view is reinforced by the recent regulatory changes where FIIs and QFIs categories have been merged as Foreign Portfolio Investors (FPIs). Discussion on FPI is covered latter in this part.

The points to be noted here is that while FIIs and QFIs have been allowed to invest in public offer of Indian companies under PIS, NRIs cannot invest in public offers under PIS. FIIs have also been allowed to invest in private placements of Indian companies under PIS, both NRIs and QFIs are not allowed to invest in private placements under PIS. It is widely held misconception that under PIS, foreign investors can invest only in listed companies. This misconception flows from the understanding that under PIS companies don’t get money from buying selling of their securities as opposed to under FDI scheme. This general understanding is correct in its place, but the counters can be changed according to the development of the market. This general rule is true as far as investment from NRIs and QFIs are concerned, FIIs can invest in unlisted companies as well under PIS. Point 5 of para 1 of schedule 2 allows FIIs to invest in equity shares and convertible securities of an Indian company through private placement subject to the pricing guidelines. The words “an Indian company” covers both listed and unlisted companies.

Investors	Regulators for PIS
FIIs	SEBI
NRIs	Bank as Authorised Dealers (ADs)
QFIs	Qualified Depository Participants (QDPs)

Investors	Individual Limits	Aggregate Limits	Maximum Limit
FIIs	10% of paid-up share capital or 10% of paid-up value of each series of convertible debentures	24 per cent of paid-up equity capital or paid up value of each series of convertible debentures	Aggregate Limit can be raised up to sectoral cap by passing special resolution at general meeting of the company
NRIs	5% of paid-up share capital or 5% of paid-up value of each series of convertible debentures	10 per cent of paid-up equity capital or paid up value of each series of convertible debentures	Aggregate Limit can be raised up to 24% by passing special resolution at general meeting of the company
QFIs	5% of paid-up share capital	10 per cent of paid-up equity	Cannot be raised

New Regulatory Changes

In January, 2014, SEBI issued (Foreign Portfolio Investors) Regulations, 2014 (FPI regulations). In FPI regulations, FIIs and QFIs categories of investors have been merged into one category named Foreign Portfolio Investors (FPIs). Distinction between FIIs and QFIs is there till the expiry of respective registration of FIIs and QFIs as such. Regulation 4 on FPI regulations covers investors who are as of now registered as FIIs and QFIs. These investors have to get registered themselves as FPIs in future. Earlier FIIs needed to be registered with SEBI, now the certificate of registration of FPI will be provided by Qualified Depository Participants (QDPs) on Know Your Clients' Norms (KYC). KYC norms are progressively stringent according to risk associated with every type of investors.

In FEMA 20, a new schedule 2A was inserted to facilitate portfolio investment by FPIs. This scheme is named as Foreign Portfolio Investment Scheme (FPIS).  

Schedule to FEMA 20	Investor	Investment Options
2A	FPIs	Shares/Convertible Debentures •Investment secondary market •Investment in offer/private placement by company

Investors	Individual Limits	Aggregate Limits	Maximum Limit
FPIs	10% of paid-up share capital or 10% of paid-up value of each series of convertible debentures	24 per cent of paid-up equity capital or paid up value of each series of convertible debentures	Aggregate Limit can be raised up to sectoral cap by passing special resolution at general meeting of the company

Schedule 2 and 2A are pari-materia same, but at the same time schedule 2A avoided the obvious ambiguity which was in schedule 2. Point 2 of para 1 of schedule 2 mandates FIIs to invest in equity shares and convertible securities through registered broker at stock exchange, and at the same time FIIs are allowed to invest in unlisted companies where there is no need of registered broker. Schedule 2A allows FPIs to invest in equity shares and convertible securities of Indian companies but it does not mandate it to be done through stock broker. But, the regulation 21(1) (a) of FPI regulations issued by SEBI mandates that FPIs can only invest in listed or to be listed companies. So FPIs will not be allowed to invest in unlisted companies under FPI scheme.   

Schedule 4 - Investment by NRIs in Equity Shares and Convertible Securities on Non-Repatriable Basis

As earlier noted that each schedule to FEMA 20 contains a new scheme. Under scheme of schedule 4, NRIs have been allowed to invest without any limit in equity shares and convertible securities of an Indian company on non-repatriable basis. Peculiar point of this scheme is unlimited investment, and this is in contrast to PIS for NRIs in schedule 3 under which maximum limit of aggregate investment by NRIs could be raised to 24% by passing special resolution at a general meeting of the company. This scheme is not named as PIS may be because there is no repatriation possible under this scheme. Since, under schedule 2, NRIs can only invest in listed companies (stock market), under schedule 5, NRIs can also invest in unlisted companies and companies intended to get listed (Public offer). Para 2 of schedule 4 allows NRIs to invest through public issue, private placement, and right issue.

Schedule 5- Investment by FIIs, NRIs, QFIs and FPIs in Securities Other Than Shares and Convertible Securities

Under this scheme, investment in debt securities by four classes of investors is covered. This scheme allows the investors to invest in dated Government securities/treasury bills, listed non-convertible debentures/bonds issued by an Indian company, commercial papers issued by an Indian company, units of domestic mutual funds, Security Receipts issued by Asset Reconstruction Companies etc. This scheme is aimed at attracting investment in debt securities from portfolio investors. Though the investors are portfolio investors, this scheme is not PIS because it allows investment in securities other than shares and convertible securities.  Investment in these securities allows investors to diversify their portfolio to manage the risk. There are three types of portfolios:

·         First- Growth Based- investment in equity based instrument is the identity of these portfolios. Investment in equity based instruments offers opportunities of capital appreciation, but at the same time, there is a risk of capital depreciation due to volatility in stock market.

·         Second – Income Based – Investment in debt instruments offers income at constant rate without the risk of capital depreciation. Redemption of these securities at the face value by the issuer insures no risk of capital depreciation. However, there is a risk of default of issuer. This risk varies issuer to issuer, in case of govt. securities, there is no risk of default, but, in case of private issuer, there is always a risk of default. Credit rating agencies rate debt instruments based on credit worthiness of the issuers. Though, there is risk of default, investment in debt securities is not considered as risky investment because of no risk of capital depreciation.

·         Third – Hybrid – These portfolios consist of combination of debt and equity based securities. An optimum combination of both type of securities can offer opportunities of growth with steady flow of income.

India has constantly been raising the limit of investment in govt. securities for these investors. During a financial crises, investment in these securities is the main source of foreign exchange since investors all over the world look for risk free investment opportunities.

This concludes discussion on portfolio investors, and various methods and avenues available to them for investment. Next part will be focused on operation and fundamental aspects of Foreign Direct Investors i.e. long term investors. There will be discussion on schedule 1 and 6 of FEMA 20.

---

[1] Portfolio Investment Scheme for NRIs < http://www.icicibank.com/nri-banking/faq/detail.page?identifier=prod-portfolio-investment-scheme-20132412112332725 Last Accessed at February 9, 2015>