Remembering the year 2020 could easily turn one pensive. The year posed unprecedented challenges for the funds industry, driving-forth fundamental changes in the manner business would be conducted alongside the pandemic. The year also marked an important milestone in the ever-evolving regulatory landscape, with several amendments critical for funds and fund managers being rolled out.
This annual round-up takes a closer look at 2020’s most important regulatory developments impacting funds and fund managers and analysing their impact on the industry.
1. PPM Standardisation, Audit Requirement and Performance Benchmarking for AIFs: In order to streamline disclosure standards for alternative investment funds (“AIFs”), SEBI had vide a Circular dated February 5, 2020 prescribed standard templates of private placement memoranda (“PPMs”) with specified disclosures for all three (3) categories of AIFs. Interestingly, the SEBI Circular also provides that the contribution agreement or the subscription agreement of an AIF shall not go beyond the terms of its PPM.
Through the aforesaid Circular, SEBI has prescribed mandatory annual audit to ensure compliance of the terms of the PPMs by AIFs. The audit may be carried out by an internal or an external auditor, and the findings of the audit, along with corrective steps, if any, shall be communicated to the AIF’s trustee, the investment manager (“Manager”) and to SEBI. Notably, exemptions from the above requirements have been provided to Category I AIF – angel funds and to AIFs in which each investor commits a minimum capital contribution of Rupees Seven Hundred Million (INR 700,000,000) or US dollars Ten Million (US$ 10,000,000) provided that each such investor waives the above requirements through a waiver letter prescribed by SEBI.
SEBI had also prescribed mandatory benchmarking of performance of AIFs by benchmarking agencies notified by AIF associations. The benchmarking agencies have collected performance related data from AIFs which have completed at least one (1) year from their first closing, and performance versus benchmark report provided by such benchmarking agencies are required to be provided to investors along with any marketing or promotional material where past performance of the AIF is mentioned.
The aforesaid measures taken by SEBI are expected to improve transparency and disclosure standards for AIFs, thus benefitting both investors and fund managers in the long run.
2. Regulatory Prescriptions for Investment Committees of AIFs: The SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) recognise the Manager as the person responsible for the overall management of the AIF. It is typical for fund managers to set up investment committees (“IC”) to review and approve decisions pertaining to critical matters, like investment or divestments by the AIF.
SEBI, vide an amendment to the AIF Regulations, prescribed that the Manager shall be responsible for investment decisions of the AIF, provided that the Manager may constitute an IC (by whatever name given to it) to approve investment decisions of the AIF, in which case, the members of IC shall be equally responsible as the Manager for investment decisions of AIF. The amended regulations further provide that the Manager and the members of the IC shall jointly and severally ensure that the investments of the AIF comply with the provisions of the AIF Regulations, the terms of the placement memorandum, agreement made with the investor, any other fund documents and any other applicable law.
This responsibility to ensure compliance has led to widespread concerns regarding liabilities of individual IC members. Going forward IC members may demand additional protection from Managers of AIFs in the form of contractual indemnities, liability protection insurance etc.
The amended regulations also provide that the external members whose names are not disclosed in any agreement made with the investor or any other fund documents at the time of on-boarding investors or the placement memorandum, can be appointed to the IC only with the consent of at least seventy five percent (75%) of the investors by value of their investment in the Alternative Investment Fund or scheme.
External members of IC could bring about added independence and fairness in review of the Manager’s proposals for the AIF and the requirement to procure investor consent for appointing external members could lead to added administrative hassles, and may also lead to dysfunctional ICs in specific cases. Further, the above amendments could impact governance structure of AIFs and terms related to GP and LP representation on the IC, which calls for careful documentation of the investment process and governance norms for AIFs in their documentation.
In a separate development, SEBI has decided to put on hold AIF registration applications where the IC proposed to be constituted includes external members who are not ‘resident Indian citizens’, until receipt of clarification pertaining to the FEMA classification of investments of AIF sought by it from the Government of India and the Reserve Bank of India (“RBI”). It is noteworthy that under the extant foreign exchange rules, the classification of an AIF investment depends on whether the sponsor and Manager of the fund are owned and controlled by resident India citizens, and whether such sponsor/Manager control the AIF with the general exclusion of others. Further, a Category III AIF which has received foreign investments are permitted to make portfolio investments in only such securities and instruments in which a foreign portfolio investor (“FPI”) is permitted to invest.
3. Relaxations for IFSC-AIFs from Specific Conditions of AIF Regulations: The International Financial Services Centre (“IFSC”) in Gujarat International Finance Tech City (“GIFT”) is being developed by the Indian Government with the objective of setting-up a world class financial centre in India. A series of regulatory measures have been taken by SEBI and the RBI to promote fund raising and asset management in the IFSC, including the rolling out of SEBI (International Financial Services Centre) Guidelines, 2015 which allow AIFs to be set up in IFSC, Gift city.
Funds set up in IFSC are permitted to invest in India under the FDI, FVCI or the FPI routes as ‘persons resident outside India’. Moreover, various direct and indirect tax benefits have been allowed for funds and fund managers located in IFSC. Further, the Government has notified a unified financial regulatory authority i.e. the International Finance Services Centres Authority (“IFSCA”) to provide for a single window regulatory institution for the financial services players in IFSC.
The attractiveness of IFSC as a jurisdiction for setting up funds has got a fresh boost vide a Circular of the IFSCA dated December 9, 2020 whereby the following key dispensations from the AIF Regulations have been granted to AIFs set up in IFSC:
- IFSC-AIFs are permitted to borrow funds or engage in leveraging activities, subject to adequate disclosures on leverage being provided in the PPM, procuring investor consent and adopting a comprehensive risk management framework for the AIF.
- IFSC-AIFs may co-invest in portfolio companies through a segregated portfolio by issuing a separate class of units, provided that such co-investments through the segregated portfolios shall not be on terms more favourable than the terms offered to the blind pool of the AIF.
- IFSC-AIFs are permitted to co-invest in other Indian AIFs, alongside other permissible investments.
- IFSC-AIFs are not subject to the restrictions on investments made in a single portfolio company exceeding twenty five percent (25%) of investible funds in case of Category I and II AIFs, and ten percent (10%) of investible funds in case of Category III AIFs.
The aforesaid relaxations granted to IFSC-AIFs are materially more beneficial to the conditions of the AIF Regulations as applicable for AIFs in general. Thus, it is now possible to curate AIFs in IFSC with greater operational flexibility, making IFSC an attractive jurisdiction for setting up funds in India.
4. Tax Exemption for Sovereign Wealth Funds and Pension Funds: The Indian Government has notified exemption from tax in India in respect of income in form of interest, dividend or long-term capital gains of a wholly owned subsidiary of Abu Dhabi Investment Authority, foreign ‘pension funds’ (“PF”) and ‘sovereign wealth funds’ (“SWF”). The exempt income would include interest, dividend or long-term capital gains arising from their investments made in (a) company or entity engaged in developing, maintaining or operating an ‘infrastructure facility’ (“Infra Companies”); (b) Category-I and Category-II AIFs which have in turn made all their investments in Infra Companies; and (c) business trusts (i.e. Real Estate Investment Trusts (“REITs”) and Infrastructure Investment Trusts (“InvITs”). These exemptions are available if the specified investors meet certain conditions, including the requirement that they should be notified by the Indian Central Government in this regard.
The tax exemption would help fund managers in attracting the much-needed patient capital in the infrastructure sector, by setting up AIFs, REITs or InvITs.
5. Revamping of SEBI Portfolio Managers Regulations: Supplanting the erstwhile SEBI (Portfolio Managers) Regulations, 1993, SEBI rolled out the SEBI (Portfolio Managers) Regulations, 2020 (“PM Regulations”) on January 16, 2020.
The new PM Regulations have increased the minimum net worth criteria for portfolio managers (“PMs”) to Rupees Fifty Million (INR 50,000,000) from previous threshold of Rupees Twenty Million (INR 20,000,000). The minimum investment criteria for a PM’s clients too has been increased to Rupees Five Million (INR 5,000,000) from Rupees Two Million and Five Hundred Thousand (INR 2,500,000).
The new PM Regulations prescribed requirements for PMs to have a principal officer (who will, inter alia, be responsible for all decisions made by the PM for management or administration of portfolio of securities or funds of the client), a compliance officer and at least one employee in addition to the principal officer. The PM Regulations also prescribe eligibility criteria and experience requirements for the principal officer and the additional employee.
Another salient feature of the new PM Regulation is that it requires portfolio managers to make investments for their discretionary client in only securities which are listed or traded on a recognised stock exchange, money market instruments, units of mutual funds and other securities as specified by SEBI from time to time. In case of non-discretionary/advisory clients, PMs are permitted to invest or advice for investment up to twenty five percent (25%) of the Asset Under Management (“AUM”) in unlisted securities, in addition to securities permitted for discretionary portfolio management.
In addition to the above, SEBI has prescribed ‘Guidelines for Portfolio Managers’ vide its Circular dated February 13, 2020 providing the following:
- PMs shall not charge any upfront fees to their clients.
- Operating expenses excluding brokerage, over and above the fees charged for Portfolio Management Service, shall not exceed one-half of a percent (0.50%) per annum of the client’s average daily AUM.
- SEBI has prescribed caps on the amount of exit load that may be charged to PM clients, such that no exit load may be charged to investor if redemption occurs after a period of three (3) years from the date of investment.
- PMs shall provide an option to clients to be on-boarded directly, without intermediation of persons engaged in the distribution services.
- PMs shall engage with only such distributors who have a valid Association of Mutual Funds in India (“AMFI”) registration number or have cleared the National Institute of Securities Markets (“NISM”) Series-V-A exam, and requires PMs to ensure that distributors comply with a code of conduct for distributors as prescribed under the new PM Regulations.
In a nutshell, the new PM Regulations provide for higher substance requirements, has tightened regulatory norms for portfolio managers and offer better investor protection norms. Importantly, the PM Regulations have restricted the use of PM schemes for making investments in unlisted securities as a primary strategy. Such strategies could still be offered to investors using the AIF platform.
6. Revised framework for SEBI Registered Investment Advisors (“IA”): By way of an amendment of the SEBI (Investment Advisors) Regulations, 2013 (“IA Regulations”), and a Circular dated September 23, 2020 the following important changes were introduced by SEBI:
- The family of an individual investment adviser shall not provide distribution services to the client advised by the individual investment adviser and no individual investment adviser shall provide advice to a client who is receiving distribution services from other family members. A non-individual investment adviser shall have client level segregation at a group level for investment advisory and distribution services.
- IAs are permitted to charge fees to their clients under either of the following (a) asset under advice (“AUA”) mode; or (b) fixed fees mode. The maximum fees that IAs may charge under the former mode shall not exceed two and a half percent (2.5 %) of AUA per annum per client across all services offered. The maximum fees that IAs may be charge under the latter mode shall not exceed Rupees One Hundred and Twenty-Five Thousand (INR 125,000) per annum per client across all services offered.
- IAs may render implementation or execution services to their clients but are not permitted to charge fees for such services.
The restrictions placed on the fees which IAs may charge from its clients and the mandate of ensuring client level segregation (at group level) for IA and distribution services seem rather restrictive. In a few cases, financial service groups have been compelled to choose between operating their distribution arm or the IA arm. In our view, a careful evaluation of pros and cons of an IA license in correlation to the wider group level activities would be critical before the efficacy of the license could be ascertained.
To conclude, the regulatory developments in the year bygone would have an impact on the legal structures adopted by fund managers in 2021 and thereafter. The a general trend of the regulators looking for added substance, transparency and higher accountability across regulatory platforms would be an important consideration going forward.