Are P-Notes Classified As Derivatives Under GAAP?

By James W. Kaiser, CPA
Partner, Investment Management Group

I recently received a question regarding a Fund that invests in India through the purchase of Participatory Notes (“P-Notes”).  The question was whether or not P-Notes should be classified as derivatives for the purposes of the financial statements and related disclosures.  On the surface, this seems like a simple question.  A P-Note is a note issued by a broker registered with the Stock Exchange Board of India (“SEBI”).  The issuer of the note purchases the underlying security and passes the income/loss generated by the security to the note-holder.  SEBI does not allow investors to invest directly in Indian securities unless such investors are registered as Foreign Institutional Investors (FIIs).  P-Notes allow investors to gain exposure to Indian securities without registering with SEBI. 

Since a P-Note derives its value from an underlying security, one might conclude that a P-Note is a derivative.  In financial terms, I would agree with such a conclusion.  However, it would be too easy for the Financial Accounting Standards Board (FASB) and the financial world to have the same definition of a derivative.   Per FASB, deriving value from another security will not automatically render an instrument a derivative.  One characteristic that an instrument must have to be considered a derivative per FASB is that the instrument would require no initial investment or an initial investment that is smaller than would be required for other types of contracts that would be expected to have a similar response to changes in market factors.  This characteristic is not met with a P-Note.  There is also a net settlement requirement in the FASB definition.  Once an investor purchases a P-Note, the investor has no further obligation.  Thus, the concept of a net settlement would not seem to apply.  Therefore, my conclusion is that a P-Note, while certainly a derivative in financial terms, is not considered a derivative for financial statement purposes.  While it may look and feel like a derivative, it is more akin to an ADR.