25 September 2018 EY Regulatory Alert Securities and Exchange Board of India notifies revised Know Your Client requirements and Eligibility Conditions for Foreign Portfolio Investors Regulatory Alerts cover significant regulatory news, developments and changes in legislation that affect Indian businesses. They act as technical summaries to keep you on top of the latest regulatory issues. For more information, please contact your Ernst & Young advisor. Executive summary This Regulatory Alert summarizes two recent Circulars 1 dated 21 September 2018 issued by the Securities and Exchange Board of India (SEBI), amending the Know Your Client (KYC) requirements and Eligibility Conditions for Foreign Portfolio Investors (FPIs). The Circulars have been issued after considering the interim recommendations submitted by the working group chaired by H. R. Khan and comments received from the public. 1 CIR/IMD/FPIC/CIR/P/2018/131 and CIR/IMD/FPIC/CIR/P/2018/132
Page 2 Background The SEBI (FPI) Regulations, 2014 and the related circulars and notifications issued by SEBI from time to time, provide the regulatory framework for FPIs proposing to invest in India under the Portfolio Investment Scheme. As per the various circulars including, inter-alia, Circular dated 5 September 2012 2 and 12 September 2013 3 (collectively referred to as Old KYC Circulars ) issued by SEBI, FPIs investing into the Indian capital markets are required to comply with KYC requirements. Further, SEBI requires various intermediaries (including a stock broker, bankers, depository participant, etc.) to conduct ongoing due diligence of FPIs based on their risk profile and financial position. Following a review of the KYC norms, SEBI issued a circular dated 10 April 2018 4 (April 2018 Circular) amending the Old KYC Circulars. The key takeaway from the April 2018 Circular was the requirement to identify the beneficial owner (BO) being a natural person as per Prevention of Money laundering (Maintenance of Records) Rules, 2005 (PMLA Rules) 5. As per Rule 9 of the PMLA Rules, the BO definition has two elements (i) ownership entitlement/interest; and (ii) control. In addition to the adoption of definition of BO as per PMLA Rules, the April 2018 Circular imposed restriction on non-resident Indians (NRIs), overseas citizens of India (OCI), resident Indians (RIs) from being BOs of FPIs and also stated certain other provisions which could have resulted in the following key consequences/impact on FPI investments/structures: The issuance of the April 2018 Circular resulted in widespread discussions and debates on its likely implications on investments by foreign investors in India through the FPI route. Representations were made by various stakeholders to SEBI in relation to the said Circular, inter-alia, seeking review and additional time for complying with the same. In light of the above, SEBI issued a press release 6 dated 21 August 2018 extending the time limit for compliance with the April 2018 Circular to 31 December 2018 and also referred the matter of examining the contents of the said Circular to an already existing working group 7 chaired by H.R. Khan (WG). Subsequent to wide consultations with various stakeholders including officials of the Ministry of Finance, Government of India, the WG submitted its Interim Report on KYC Requirements for FPIs (Interim Report) to the SEBI 8. The recommendations contained in the Interim Report submitted by the WG and the comments of the public thereon were considered by the SEBI in its board meeting held on 18 September 2018. Subsequently, SEBI has issued two Circulars dated 21 September 2018 9 (September 2018 Circulars) which states that the BO criteria as per the PMLA Rules will be applicable only for the purpose of KYC and not for determining eligibility criteria for FPIs and that the clubbing of investment limit for FPIs shall also not be done on the basis of BO of FPIs (determined as per the PMLA Rules). This alert summarises the contents of the September 2018 Circulars. Eligibility conditions for FPIs Restriction on NRIs, OCIs, RIs and entities owned/controlled by them from acting as investment manager (IM) to a FPI; Deeming senior managing official (SMO) of the FPI to be the BO, where BO cannot be identified based on ownership interest or control criteria; Clubbing of investment limits of FPIs on the basis of the revised BO requirements including by virtue of having a common IM or SMO. NRIs 10 / OCIs 11 / RIs shall be allowed to be constituents of FPIs subject to the following conditions:- Contributions by NRI/ OCI/ RI 12 including contributions by NRI/ OCI/ RI controlled IM in the FPI should be below 25% of the assets under management (AUM) from a single investor and in aggregate below 50% of AUM. 2 CIR/MIRSD/11/2012 3 CIR/MIRSD/07/2013 4 CIR/IMD/FPIC/CIR/P/2018/64 5 BO is the natural person(s) who ultimately owns or controls an FPI. PMLA Rules specify a materiality threshold on controlling ownership interest of 25% in case of company and 15% in case of partnership firm, trust and unincorporated association of persons for the purpose of identifying BOs. 6 Press Release 36/2018 7 The Working Group chaired by H.R. Khan was formed by SEBI on 26 March 2018 with the initial brief of reviewing and redrafting the SEBI (FPI) Regulations, 2014, frequently asked questions (FAQs) and operating guidelines relating to FPI registration and operations in India. The Working Group has representatives from reputed law firms, tax firms, custodians and SEBI officers. 8 Refer EY Alert dated 12 September 2018 for a summary of the recommendations of the WG. 9 CIR/IMD/FPIC/CIR/P/2018/131 and CIR/IMD/FPIC/CIR/P/2018/132 10 The term NRI has been defined as per the Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2017 to mean an individual resident outside India who is a citizen of India. 11 The term OCI has been defined as per Foreign Exchange Management (Transfer or issue of security by a person resident outside India) Regulations, 2017 to mean an individual resident outside India who is registered as an OCI Cardholder under Section 7(A) of the Citizenship Act, 1955. 12 RI s contribution permitted is that made through the Liberalised Remittance Scheme approved by the Reserve Bank of India in global funds whose Indian exposure is less than 50%.
Page 3 NRI/ OCI/ RI should not be in control 13 of the FPI. However, this condition shall not be applicable to FPIs which are offshore funds for which noobjection certificate has been provided by the SEBI in terms of the SEBI (Mutual Funds) Regulations, 1996. The above-mentioned restrictions will not be applicable to FPIs investing only in mutual funds in India. A non-investing FPI may be directly or indirectly fully owned and/ or controlled by a NRI/ OCI/ RI. FPIs can be controlled by IMs which are controlled or owned by NRIs/ OCIs/ RIs, if any of the below conditions are fulfilled: IM is appropriately regulated in its home country and registered with SEBI as a non-investing FPI; IM is incorporated or set-up under Indian laws and appropriately registered with the SEBI. Appropriate modifications to the SEBI (FPI) Regulations, 2014 will be notified separately to give effect to the above amendments. Existing FPIs and new applicants are required to satisfy the eligibility conditions within a period of two years from the date of coming into force of the amended regulations or from the date of registration, whichever is later. In case of temporary breaches, a time period of 90 days has been provided to ensure compliance with the said conditions. Key amendments in the KYC requirements The KYC requirements specified in the September 2018 Circulars supersede the conditions stated in the April 2018 Circular and are in partial modification to the Old KYC Circulars. Identification and verification of BO For Category II and III FPIs prescribed in the September 2018 Circulars 14 which needs to be certified by the FPI along with a declaration that there are no other BOs other than those indicated by the FPI. BOs of FPIs having General Partner/ Limited Partnership structure shall be identified on ownership or entitlement basis and control basis. In respect of FPIs coming from high risk jurisdictions, a lower materiality threshold of 10% may be applied for identification of BO and KYC documentation as applicable to Category III FPIs should be obtained. Materiality threshold to identify the BO should be first applied at the FPI level and then look through principle should be applied to identify the BO of the intermediate shareholder/ owner entity of the FPI. It is relevant to note that only holdings which are equal and above the materiality thresholds need to be identified through the aforesaid look through principle. The details in respect of intermediate material shareholder/ owner entity which need to be disclosed include name, percentage of holding, whether direct/ indirect stake, method of control, etc. Intermediate material shareholder/ owner entity that is eligible for being registered as Category I FPI, is exempted from identification and verification of BO of the said entity. SMO 15 for the purpose of identification of BO has been defined to mean an individual as designated by the FPI who holds a senior management position and makes key decisions relating to the FPI. No foreign company shall be entitled to exemption under Rule 9(3)(f) of the PMLA Rules 16. In case of companies/ trusts represented by service providers like lawyers/ accountants, FPIs should provide information of the real owners/ effective controllers of those companies / trusts. BOs are natural persons who ultimately own or control an FPI and should be identified in accordance with the PMLA Rules 5. FPIs are required to provide a list of their BOs in the format If the BO exercises controls through means like voting rights, agreements, arrangement etc., the same should also be specified. 13 The term control has not been defined in the September 2018 Circulars. 14 The details to be provided in respect of BOs include name, address, date of birth, tax residency jurisdiction, nationality, tax residency number/ social security number/ passport number/ any other government issued identity document number (eg. driving license), etc. 15 As per the PMLA Rules, a SMO shall be considered to be the BO of an FPI where a BO, being a natural person, cannot be identified based on ownership interest or control criteria. 16 Rule 9(3)(f) of the PMLA Rules provides that where the client or the owner of the controlling interest is a company listed on a stock exchange, or is a subsidiary of such a company, it is not necessary to identify and verify the identity of any shareholder or BO of such companies.
Page 4 BO should not be a nominee of another person and real BO should be identified. Enforcement Agencies, the relevant documents would be provided. FPIs issuing Offshore Derivative Instrument shall also identify and verify the BOs in the subscriber entities as per these guidelines. Periodic KYC review Category III FPIs who were exempted by the Old KYC Circulars from the submission of proof of address of BOs, senior management and authorised signatories would now need to provide a declaration on its letterhead. FPIs shall be subject to KYC review as and when there is any change in material information/ disclosure. KYC review of FPIs (including change in BOs /their holdings) should be done based on risk categorization of FPIs. In case of Category III and Category II FPIs from high risk jurisdictions, KYC review should be done on a yearly basis. In case of all other clients, KYC review should be conducted at the time of continuance of FPI registration. In the event of non-submission of KYC documents, no further purchase transactions would be permitted for such FPIs. Data Security The KYC Registration Agencies (KRAs) shall lock personal information provided with regard to the BO and SMO of the FPI. Information should be made available only on need to know basis using an authentication method (similar to One Time Password) after the KRA gets confirmation from the FPI or its Global custodian. For this purpose, the KRA needs to maintain email ids of the FPI and its Global custodian. The above functionality will be optional and it will be deactivated only upon receipt of instruction from the FPI to the KRA. Period for maintenance of records KYC documentation for Category III FPI The Old KYC Circulars had prescribed that Financial Data is a mandatory documentation requirement for Category III FPIs. Additionally, Category III FPIs were also required to provide its constitutive documents. The September 2018 Circulars clarifies that the following documents shall be acceptable for financial data: Audited annual financial statement or a certificate of net worth from the auditor. In case of new funds/ companies/ family offices, the audited financial statements of the promoter may be obtained. Custodian should maintain the KYC records in original for a minimum period of five years from the date of cessation of the transactions with the FPIs. Where any litigation is pending in case of an FPI, such records should be maintained by the Custodian till the completion of the proceedings. Timeline for compliance Category II and III FPIs registered prior to the September 2018 Circulars (existing FPIs) should provide the list of BOs (as per the prescribed format) and applicable KYC documentation within six months from the date of September 2018 Circulars i.e. by 21 March 2019. In respect of constitutive documents, the September 2018 Circulars state that prospectus and information memorandum are acceptable in lieu of an official constitutive document. Where an existing FPI does not comply with the KYC requirements within the prescribed timeline, the following measures would be adopted: Exempted documents to be provided during investigations/ enquiry Where FPIs have been exempted by the Old KYC Circulars from furnishing certain supporting KYC documents depending on risk involved (eg. proof of identity and address for whole time directors, partners, trustees, etc for Category II FPIs, etc), an undertaking is required to be provided by such FPIs to the Designated Depository Participant/ Custodians, that upon demand by Regulators/Law Custodian shall not allow the FPI to make fresh purchases until the necessary compliances have been achieved. However, sale of securities already purchased shall be permitted; FPIs shall be allowed to disinvest its holdings within a period of 180 days from the expiry of the timeline; Where compliance is not achieved even after 180 days from the said deadline, the FPI registration would become invalid and
Page 5 the FPI would have to disinvest its holdings immediately. Comments SEBI s Circular of 10 April 2018 was a source of significant debate and discussion on the implications for investments into India through the FPI route. Specifically, for FPIs managed by NRIs/OCIs/RIs, the said Circular was of significant concern given that it seemed to prohibit NRIs/OCIs/RIs or entities promoted by them from being IM of FPIs. The Interim Report of the Working Group chaired by H.R. Khan (WG) addressed most of the concerns of the FPI community arising from the above Circular. Most of the recommendations of the WG have been accepted by the SEBI including the key position that the BO norms should only be used for the purpose of KYC and not for determining the eligibility criteria for FPIs. This has provided the much needed relief to FPIs and specifically to NRI as well as resident Indian fund managers. However, there still remain certain suggestions of the WG which the SEBI has either rejected or not commented upon providing exemption from beneficial owner (BO) identification for listed entities has been rejected by the SEBI, manner in which clubbing of investment limits of FPIs shall be undertaken has not been indicated by the SEBI except stating that clubbing would not be done on the basis of BOs as per PMLA Rules, etc. Additionally, with respect to another key area of concern of the FPI community relating to sharing personal information of BOs, the SEBI seeks to put in place a policy where the data will be shared only on a need to know basis using an authentication method and after obtaining consent from the FPI or its Global Custodian. This measure should address the apprehension on data security which was raised after the issuance of SEBI s Circular of 10 April 2018. Overall, the two Circulars dated 21 September 2018 issued by the SEBI seek to provide respite to FPIs and seeks to attend to a very important and growing class of fund managers.
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