Foreign Funds Can Issue P-Notes to Investors: What They Are and Why It Matters

In 2001, a massive financial scam shook the Indian stock market. Ketan Parekh, a clever Chartered Accountant, swindled ₹40,000 crores by artificially inflating stock prices and selling them at their peak.

One of his tricks involved using Participatory Notes (P-Notes), a method allowing foreign investors to invest in the Indian stock market anonymously.

Typically, investors sign up with a broker, set up a demat account to hold their investments, and start trading. But for foreign investors, registering with SEBI (Securities and Exchange Board of India) is a complicated process.

P-Notes simplify this. Foreign investors approach a registered entity or bank, asking them to invest in Indian stocks on their behalf. The entity issues a P-Note as proof and invests in the market under its own name, keeping the real investor anonymous.

This anonymity was perfect for Parekh. He set up accounts with registered foreign investors, funneled money into select stocks via P-Notes, and drove up stock prices, attracting more Indian investors.

Since P-Notes are tied to these stocks, Parekh used his highly valued P-Notes as collateral to borrow money from foreign banks. He then secretly reinvested this borrowed money into the market, driving prices even higher and sparking a stock market rally.

However, this rally halted abruptly when the US dot-com bubble burst. Overvalued technology companies’ stock prices nosedived, causing a global domino effect. Parekh’s investments plummeted, leading to massive debt defaults.

Now you might wonder, “Why discuss a scam from over two decades ago?”

Recently, the value of P-Notes, the instruments behind Parekh’s scam, has surged to ₹1.49 lakh crores. The last time P-Notes saw such high investments was in 2017.

While this sounds worrisome, P-Notes aren’t pure villains. Introduced in FY92 to attract foreign investments, P-Notes helped when India was low on foreign exchange reserves. Over the years, however, these instruments provided a backdoor into the Indian markets, leading to illegal practices.

Wealthy Indians with unaccounted income sent their money to tax havens like the Cayman Islands and Mauritius, then round-tripped that money into Indian markets via P-Notes, avoiding taxes. Terrorists and money launderers also parked their money in India using P-Notes, tarnishing their reputation.

In 2007, P-Notes accounted for over half of India’s total foreign investments. Regulators like SEBI and RBI considered banning them, but new rules to tame P-Notes often crashed the stock market. For instance, on October 17, 2007, the government’s intention to ban P-Notes caused a nearly 10% drop in Indian markets, prompting stock exchanges to suspend trading.

Regulators then began tweaking the rules, tightening KYC (Know Your Customer) norms, stopping P-Note issuances to non-compliant countries, and requiring frequent disclosures of unusually high investments. This worked, reducing P-Notes’ share in foreign investments from over 50% in 2007 to about 2% now.

The current rise in P-Note investments, still within that 2% threshold, likely results from weaker global markets and Western investors seeking to reduce exposure to China’s industrial stocks. India’s economic growth and booming stock markets appear to be their best bet now.

However, the story isn’t over. Hindenburg Research’s controversial report on the Adani Group last year suggested the Group used P-Notes to invest anonymously in its own stocks, inflating their prices. Though unproven, it hints that some astute investors still camouflage their way into the Indian stock market.

Unless this loophole is closed, P-Notes can’t receive a clean chit.