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FAQs on Regulatory Amendments to AIF Regulations (Ambiguous GAAR Style Obligations Prescribed for Managers and KMPs)

The Securities Exchange Board of India (“SEBI”) has notified amendments to the SEBI Alternative Investment Funds Regulations, 2012 (“SEBI AIF Regulations”) on April 25, 2024, to:

  • permit a “dissolution period” to liquidate assets after the expiry of the liquidation period (being one year from end of tenure) by filing an “information memorandum” with SEBI through a merchant banker. The dissolution period cannot be longer than the scheme’s original tenure or be extended.
  • enable Category I and Category II AIFs to create encumbrance on equity of investee companies that develops, operates or manages projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Central Government, solely for the purpose of borrowing by such investee company; and
  • require AIFs, their investment managers and Key Management Personnel (“KMP”) to conduct specific due diligence (as SEBI may prescribe) concerning their investors and investments to prevent any attempts to circumvent pertinent laws (including Acts, Rules, Regulations, Guidelines or circulars administered by financial sector regulators, including SEBI).

SEBI has issued detailed Circulars on above mentioned points (i) and (ii) on April 26, 2024.

FAQs on SEBI Notification and Circulars

Dissolution Period

What are the key benefits arising from AIFs being permitted a Dissolution Period?

Prior to the amendments, AIFs had the option to either distribute unliquidated assets in specie or set up a separate liquidation scheme and transfer the assets to such scheme. Through a two-step swap mechanism, the liquidation scheme would acquire the assets and issue its units to the original scheme which would in turn distribute the units to LPs. There were various commercial, tax and exchange control related challenges arising for AIFs looking to implement this arrangement. The enabling of a dissolution period in the original scheme will do away with such challenges.

Can fresh commitments be accepted during the dissolution period? Can Management Fees be charged?

The scheme of the Alternative Investment Fund shall not accept any fresh commitment from any investor and shall not make any new investment during the dissolution period.

Management Fees cannot be charged during the Dissolution Period.

Can AIFs launch new liquidation schemes?

Following SEBI’s amendment notification , no new liquidation schemes can be launched. . However, liquidation schemes that have already been launched will be grandfathered and allowed to operate under the provisions of the regulations until such liquidation schemes are wound up.

What are the options if the assets cannot be sold during the liquidation period?

If the scheme of an AIF enters into a liquidation period and is unable to liquidate its portfolio, it may either obtain requisite investor consent for entering into dissolution period or make in-specie distribution. If both are not feasible, then the unliquidated investments shall be mandatorily distributed to investors in-specie, without the requirement of obtaining consent of 75% of investors by value of their investment in the scheme of the AIF. However, pricing norms under exchange control laws may pose a challenge for making in-specie distributions to foreign investors.

In case any investor is not willing to take in-specie distribution of unliquidated investments, such investments shall be written off.

What are the options if the assets cannot be sold during the dissolution period?

If the scheme of an AIF enters into a dissolution period and the unliquidated investments of the scheme are not sold by the expiry of the dissolution period, no further extension or liquidation period shall be available to these schemes after the expiry of dissolution period. Any illiquid investments shall be mandatorily distributed in-specie to the investors, in the manner as may be specified by SEBI.

However, pricing norms under exchange control laws could be a challenge in making in specie distributions to foreign investors.

Given that the dissolution period can be commenced during the liquidation period with the consent of 75% of investors by value, would it benefit schemes that have already reached the expiry of their liquidation period?

If the liquidation period for a scheme of an AIF has already expired or is expiring within three months from the date of notification of the SEBI AIF Regulations (i.e. July 24, 2024), it will be granted an additional liquidation period till April 24, 2025 provided there are no investor complains pending regarding non receipt of funds/securities as of April 25, 2024.

During the fresh Liquidation Period, the scheme shall fully liquidate its investments, or distribute the investments in-specie or opt for the Dissolution Period.

Can the scheme of an AIF enter a dissolution period if it fails to arrange a bid of 25% of its units for value of its unliquidated investments (to grant exit to dissenting investors)?

As per the SEBI Circular on dissolution period, AIFs must arrange a bid for a minimum of 25% of the value of its unliquidated investments before seeking the 75% investor consent for entering a dissolution period. This bid will represent the consolidated value of all unliquidated investments of the scheme’s investment portfolio and will be used to provide an exit option to the dissenting investors.

If the AIF fails to arrange a bid for a minimum of 25% of the value of the scheme’s unliquidated investments, the AIF can still opt for dissolution period, provided it obtains consent of at least 75% of the investors by value of their investment in the scheme of the AIF.

Encumbrances on AIF’s equity

Can Category I or II AIFs create encumbrances on NCDs? Can securities of a portfolio in real estate sector be encumbered by AIFs?

No. Category I and II AIFs can create encumbrance on equity of investee company that is in the business of development, operation or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure[1] issued by the Central Government, only for the purpose of borrowing by such investee company, subject to explicit disclosure of such encumbrance in the private placement memorandum (“PPM”) of the scheme.

Any encumbrances already created by a scheme of Category I or II AIF prior to April 25, 2024, on the securities of investee company for borrowing of such investee company may continue if the PPM contained an explicit disclosure pertaining to the same.

What are the exchange control norms applicable to AIFs that wish to pledge their equity investment in a portfolio company?

Any Category I or II AIF that either (i) receives more than 50% foreign investment; or (ii) has a foreign sponsor or investment manager; or (iii) appoints persons other than resident Indian citizens as external members (members who are not directors or employees of the investment manager) in its investment committee, which is set up to approve its decisions; shall ensure compliance with para 7.11.2 of RBI Master Direction dated January 04, 2018 on “Foreign Investments in India”, as though the AIF is a person resident outside India, which inter alia requires that in case of invocation of pledge, transfer of equity instruments of an Indian company or units pledged shall be in accordance with entry routes, sectoral caps/ investment limits, pricing guidelines and other attendant conditions at the time of creation of pledge.

Due Diligence Obligations regarding Circumvention of Laws

What is the background to the obligation of AIFs, managers and KMPs to exercise due diligence with respect to investors and investments to prevent facilitation of circumvention of such laws, where laws are defined to mean any legal prescription of a financial sector regulator?

In a consultation paper dated January 19, 2024, SEBI drew attention to the scope for regulatory arbitrage that has emerged because of the classification of downstream investments by AIFs on the basis of the domicile of ownership and control of the investment manager or sponsor of the AIF. Foreign investors are setting up AIFs with domestic investment managers or sponsors to invest in sectors prohibited for Foreign Direct Investment (“FDI”), or to invest beyond the allowed FDI sectoral limits.

The consultation paper further discussed how foreign investors are setting up AIFs to invest foreign capital in debt or debt linked securities, which as per Indian exchange control laws, must follow the Foreign Portfolio Investor (“FPI”) or External Commercial Borrowing (“ECB”) route.

The other issues highlighted by SEBI under the consultation paper were regarding creation of junior-senior class of units (for which RBI has already disincentivised banks, NBFCs and financial institutions by prescribing provisioning requirements) and regarding AIFs with single or few investors benefitting from QIB status during IPOs (for which SEBI has already proposed to withdraw QIB status for AIFs with primary contributions from affiliated investors).

What challenges does the aforesaid due diligence obligation create for AIFs from a FEMA perspective?

The FEM (NDI) Rules, fundamentally considers the Indian owned and controlled (“IOCC”) status of managers and sponsors of AIFs (where they in-turn control the AIF to “general exclusion of others”) in determination of whether their investments should be considered as “indirect foreign investments” or not. However, Cat III AIFs accepting foreign investments are permitted to make “portfolio investments” in only in those securities or instruments in which a FPI is allowed to invest.

The above rules allow AIFs (with foreign investments and with IOCC managers and sponsors) to make downstream investments that need not be considered as “indirect foreign investments”; a conscious policy boost granted to promote onshore pooling and growth of asset management industry in India. With clear and settled rules of FEMA, an imprecise and wide obligation on investment managers and KMPs to prevent circumvention of regulations, with respect to investors and investments, seems like reminiscence of general anti avoidance rules under tax laws (“GAAR”).

India needs stable policy and laws to fully capitalise on the limelight casted on it by global investors. Regulatory provisions with increased subjectivity, especially ones at odds with settled rules of FEMA would not aid the growth of alternatives asset management in India.