In a recent order (“Order”), the Securities and Exchange Board of India (“SEBI”) held that a category I alternative investment fund registered with it (“Fund”); its investment manager (“Manager”); and its trustee (“Trustee”), were in violation of certain SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”). Specifically, these violations were with respect to provisions associated with (i) the code of conduct applicable to the Fund, Manager and Trustee; and (ii) provisions related to leverage and borrowings applicable to the Fund.
SEBI conducted an inspection of the Fund and concluded that the Manager, the Fund and the Trustee were in violation of AIF Regulations by pledging the securities (including shares and debentures) of the Fund’s portfolio entities in order for those entities to raise capital from lenders.
The specific violations adjudicated by SEBI in the Order related to the Fund are under regulation 16 (1) (c); regulation 20 (1); and clause 1 (b) of the code of conduct of the AIF Regulations. Breaches relating to the Manager are under regulation 20 (1); regulation 20 (2); and clause 2 (d) of the code of conduct of the AIF Regulations. Violations in relation to Trustee are under regulation 20 (1); regulation 20 (2); and clause 3 (d) of the code of conduct of the AIF Regulations.
SEBI’s Order seems to be based on the premise that category I AIFs are not allowed to borrow or leverage other than for temporary funding requirements. The SEBI officer noted that the act of pledging the securities of portfolio entities is a clear breach of the fiduciary duties of the Manager. It was also observed that the Trustee had failed in its duty to act in a diligent manner while exercising its independent professional judgment. It is pertinent to mention that capital was raised from the lenders at the portfolio entity level only, which is an entity distinct from the AIF and is not subject to restrictions of the AIF Regulations, which are prima facie applicable to the AIF and its Manager. There was no borrowing (directly or indirectly) that was availed by the Fund in any capacity in the facts of the case adjudicated by SEBI. Considering that the Trustee was also a party to the Order, it is possible that in near future trustees may not be comfortable allowing Category I and II AIFs to pledge their holdings to enable portfolio entities to raise any credit.
This Order, while seemingly innocuous, may have far reaching implications on the funds industry in India. With SEBI’s interpretation under the Order, alternative investment funds (category I and II) may face significant push back from potential investee entities for accepting any meaningful stake of such AIFs in such portfolio entities. Notably, certain strategies like infrastructure funds within Category I AIFs often set up wholly owned special purpose vehicles where loans are availed for the purpose of infrastructure projects. SEBI’s Order may have a direct impact on such structures.
It is quite common for promoters / significant stakeholders (especially holders of equity instruments) to offer their holdings to entities to raise additional capital from different lenders. This practice may not necessarily have negative impact on the value of the securities. We believe that if the managers and trustee of the alternative investment funds do an independent analysis (legal and commercial) prior to pledging securities, subject to AIF documents permitting the same, then such pledges need not be treated as breach of their duties and responsibilities under AIF Regulations.
On the contrary, there is a strong commercial argument in favour of pledging securities by majority stakeholders / promoters, which may lead to appreciation of the securities itself. The investors may not receive ideal returns if the portfolio entities are not able to arrange credit as and when required.
In a nutshell, SEBI seems to have taken a strict interpretation of the AIF Regulations. We recommend all market participants to reach out to SEBI for ensuring that the regulator receives appropriate feedback from the industry.
 SEBI Order dated May 31, 2023 in the matter of India Infrastructure Fund II.
 Conditions for Category I Alternative Investment Funds.
Regulation 16 (1) (c):
16. (1) The following investment conditions shall apply to all Category I Alternative Investment Funds:-
(c) Category I Alternative Investment Funds shall not borrow funds directly or indirectly or engage in any leverage except for meeting temporary funding requirements for not more than thirty days, on not more than four occasions in a year and not more than ten percent of the investable funds.
20 (1) Alternative Investment Fund, key management personnel of the Alternative Investment Fund, trustee, trustee company, directors of the trustee company, designated partners or directors of the Alternative Investment Fund, as the case may be, managers and key management personnel of managers shall abide by the Code of Conduct as specified in the Fourth Schedule.
Explanation.– For the purpose of this sub-regulation, ‘key management personnel’ shall have the meaning as specified by the Board from time to time.
(2) The Manager and either the trustee or trustee company or the Board of Directors or the designated partners of the Alternative Investment Fund, as the case may be, shall ensure compliance by the Alternative Investment Fund with the Code of Conduct as specified in the Fourth Schedule.
Fourth Schedule – AIF Regulations
[Regulation 20(1) and 20(9)]
I. Code of Conduct for Alternative Investment Funds
1. An Alternative Investment Fund shall:
(b)be operated and managed in the interest of all investors and not only in the interest of the sponsor, manager, directors or partners of the sponsor and manager or a select class of investors.
II. Code of Conduct for the Managers of Alternative Investment Funds and key management personnel of Managers and Alternative Investment Funds
2. Every Manager of Alternative Investment Funds and key management personnel of the manager and Alternative Investment Funds shall:
(d) act in a fiduciary capacity towards investors of the Alternative Investment Fund and ensure that decisions are taken in the interest of the investors;
III Code of Conduct for members of the Investment Committee, trustee, trustee company, directors of the trustee company, directors or designated partners of the Alternative Investment Fund
3. Members of the Investment Committee, trustee, Trustee Company, directors of the Trustee Company, directors or designated partners of the Alternative Investment Fund shall:
(b) ensure proper care and exercise due diligence and independent professional judgment in carrying out their roles;