Taking cue from Yoda, the adjudication officer of Securities and Exchange Board of India (SEBI) has ordained “Do or do not, there is no try”. This means there can be no halfway compliance with SEBI (Alternative Investment Funds) Regulations, 2012 and circulars issued therein (the AIF Regulations).

The November-end order of the SEBI Adjudicating officer (AO) in the case of the SREI Multiple Investment Trust (the Fund) not only provides an insight into the regulator’s interpretation of the AIF Regulations but it is also the first case of imposition of a monetary penalty for breach of the AIF Regulations. This article critically analyses the AO’s order and summarises the learnings from the same.

Brief Facts

The Fund was set up as a master trust and registered as a Category II fund under the AIF Regulations. The manager and sponsor of the Fund is SREI Alternative Investment Managers Limited (the Manager). The Fund launched a scheme called India Growth Opportunities Fund (IGOF) which had Essar Oil Ltd. (EOL) and SREI Infrastructure Finance Ltd. (SIFL) as its investors and the Manager funded the sponsor commitment. IGOF had a total corpus of INR 12,600 million out of which EOL invested INR 11,950 million. The Fund made investments by way of loans to various portfolio companies. Per a decision of its investment committee (IC), out of INR 13,400 million received by the Fund on account of repayment of loans, INR 7,960 million was reinvested by acquiring loan assets of SIFL and INR 505 million was distributed to the investors (including sponsor) by way of redemption of units and income. Consequent to such redemption, the sponsor’s investment in IGOF reduced from INR 50 million to INR 31.3 million.

Pursuant to an inspection conducted by SEBI on the Fund and the Manager, SEBI observed various irregularities and violations of the AIF Regulations. SEBI issued a show cause notice to the Fund setting out the following allegations:

  1. Non-compliance with the definition/objective of AIF: the Fund had granted loans to portfolio companies instead of making ‘investments’ as per regulation 2(1)(b) of the AIF Regulations.
  2. Non-compliance of investment conditions: the Fund had on two occasions breached the 25% threshold, which is the upper limit for investment in an investee company.
  3. Non-compliance with IC decision: the Fund breached the investment strategy stated in the private placement memorandum (PPM) of the Fund by investing amounts greater than the investment range and at interest rates lower than the IC approved target return.
  4. Failure to maintain the continuing interest by the sponsor: the Fund had, pro rata, redeemed the sponsor’s units causing the sponsor’s holding to fall below the minimum sponsor commitment of INR 50 million prescribed under the AIF Regulations.

Ruling and Analysis

The AO, on allegation no one, decided in favour of the Fund and upheld allegation numbers two to four thereby ruling against the Fund. With respect to allegations two to four, the AO imposed a penalty of INR 1 million for each violation.

Allegation One

As part of the Fund/Manager’s defence, it was demonstrated to the AO that the investment strategy of the Fund and the PPM clearly stated that the Fund will make investments in the form of loans, bridge/interim financing, securitisation of loans/receivables. Further, the Fund was registered as Category II AIF which includes a “debt fund” that invests primarily in debt or debt securities of listed or unlisted investee companies according to the stated objectives of the Fund.

Examining the definition of AIF under regulation 2(1)(b) of the AIF Regulations, the AO observed that the Fund had, at the time of seeking registration, clearly described its investment objective, investment style and strategy. Hence, it was clear from the PPM that the Fund will invest in the form of finance/loans to various companies. Accordingly, the AO held that the Fund had not breached regulation 2(1)(b) of the AIF Regulations.

Points to ponder: The AO’s order seems to conclude that AIFs can engage in lending activities. However, whether AIFs can grant loans has been a bone of contention between the Reserve Bank of India (RBI) and SEBI. RBI, rightly so, is the relevant regulator to regulate lending activities of banks and non-banks. By ruling in favour of the Fund, the AO has legitimised raising of funds from an investor to onward lend to that investor’s group companies without the need to comply with the statutory mandate under the Companies Act and RBI Act. In fact, the order has not taken into consideration the Frequently Asked Questions (FAQs) on the AIF Regulations issued by SEBI. As per FAQ # 7, SEBI’s clarification on ‘debt funds’ states that as AIFs are privately pooled investment vehicles, they shall not utilise the amounts contributed by investors for purposes of “giving loans”. Further, as per the concept paper issued by SEBI in 2012, one of the objectives for introducing the new AIF regime was to do away with regulatory arbitrage of any kind. This ruling, unfortunately, goes against the grain of this objective. Hence, it is probable that SEBI may amend the AIF Regulations by incorporating FAQ #7 clarification.

Allegation Two

In their submissions, the Fund/Manager had admitted that the 25% threshold was breached post the redemption and distribution to investors. Relying on the admission, the AO held that the Fund had breached the 25% threshold and thus violated regulation 15(1)(c) of the AIF Regulations.

Points to ponder: It appears that the AO erred on the interpretation and applicability of the 25% upper limit.

Firstly, this threshold applies when an AIF is making an investment and hence it is an investment restriction. Any subsequent change in the corpus of an AIF on account of any administrative action (including redemption of units) therefore ought not be relevant.

Secondly, the 25% threshold is pegged to the “investible funds” of the AIF. The term ‘investible funds’ is defined under the AIF Regulations to mean “corpus of the AIF net of estimated expenditure for administration and management of the fund”. If an AIF redeems the units during the commitment period, then the “investible funds” quantum does not stand reduced because such an AIF would be entitled to recall the redeemed capital as per its fund documents. Hence, the corpus at the disposal of such an AIF during the commitment period would continue to be the entire aggregate capital commitment less expenses. Accordingly, redemption of units during the commitment period does not lead to breach of the investment limit of 25% of investible funds.

Allegation Three

As per the investment objective stated in the PPM, the Fund proposed to make investments in the range of INR 500-2,000 million, whereas two investments were made in excess of INR 2,000 million. Further, in the IC meeting minutes, it was recorded that the loans acquired from SIFL would generate a yield in the range of 14-16%, whereas loans were given to two companies at 12% and 12.5% interest. Relying on regulation 9(1) of the AIF Regulations (which requires AIFs to state investment strategy, investment purpose and methodology in the PPM) and the SEBI circular dated October 1, 2015 (which mandates managers to carry out all the AIF’s activities in accordance with the PPM), the AO held that the Fund had breached these compliance requirements.

Points to ponder: The AO’s order has adopted a strict and static interpretation to the commercial terms that a sponsor / manager sets out in the PPM and hence is a tad unfair. While one does not disagree that the investment objective needs to be unambiguous, the same cannot be the tone for investment philosophy or strategy especially when a fund, as disclosed in its PPM, intends to apply an “opportunistic” strategy. PPMs are written to provide investors with adequate disclosure on the investment strategy and methodology, but at the same time they include enabling provisions to ensure that the discretion of the manager is not taken away. The manager thus has the necessary flexibility to conduct the activities of the AIF within the stated investment objective. In fact, the June 2014 circular of SEBI recognises that a manager is bound to provide an exit option to dissenting investors only with respect to material deviations from the PPM. Further, Thus, the AO’s conclusion that “what you write, constrains you” appears to be misplaced considering that AIF investors are sophisticated investors who have the ability to trigger harsh haircuts on a manager’s compensation for breach of the fund documents.

Allegation Four

The Fund / Manager admitted that the sponsor’s holding in the Fund reduced to INR 31.3 million as the sponsor, being an investor, was entitled to receive pro-rata distribution. The AO did not accept this argument of the Fund and held that there is no exception to maintenance of a continuing interest obligation by the sponsor and the same has to be complied with at all times.

Points to ponder: The AO’s order seems to contradict the SEBI circular of July 2014 wherein SEBI has confirmed that for the purposes of maintaining the continuing interest under regulation 10(1)(d) of the AIF Regulations, the sponsor commitment can be maintained pro rata to the net amount of funds raised from other investors in the AIF. Hence, once an AIF has held its closing on the basis of capital commitment of the investors and sponsor, it can drawdown and redeem the units by maintaining the pro rata beneficial interest of the unitholders.

Penalty

The AO’s order imposes a monetary penalty for breach of the AIF Regulations. An unexpected fall-out of this order is that it has been issued against the master trust and not the scheme to which the breaches pertained. In a typical fund structure, the master trust will not have the funds to pay the penalty as the funds are raised at each scheme level. Further, it needs to be seen whether the penalty can form part of the “fund expenses” and thus be borne by the Fund? The fund documents of typical AIF would not permit a manager to charge the fund for penalties/costs stemming from its breach of the fund documents or the AIF Regulations. Hence, it is likely that penalties of such nature will have to be borne by the manager.

Conclusion

The AO’s order may appear contradictory to industry practice and SEBI’s intent, but there is no denying that it serves as a wake-up call to all AIF managers to:

  1. Pay careful attention when drafting the investment objective, strategy and philosophy in the PPM.
  2. Set up a real-time robust compliance mechanism that escalates red flags and leads to prompt corrective action.
  3. Weave in protections for the settlor, trustee, sponsor and manager through an appropriate package of rights, liabilities and indemnities.
  4. Ensure appropriate and adequate insurance policies are tied up to protect the investors and the manager / sponsor from losses and penalties.

Hence, may the Force be with you!