The Securities and Exchange Board of India (SEBI) issued an order (Order) in the matter of a domestic fund which was registered with SEBI as a Category II Alternative Investment Fund (AIF) based on an audit which was undertaken by it suo moto. A copy of the Order may be accessed here.

Without necessarily going into the specifics of the said case, what is of more importance are the observations made by SEBI in the process of issuing the order and some facts of the case examined by them which could provide a deeper understanding of a regulator’s thinking behind some of the provisions under the SEBI (Alternative Investment) Regulations, 2012 (AIF Regulations).

At the onset, it would suffice to say that in our view some of the interpretations taken by SEBI under the said Order could come as a surprise to the industry and in fact appears contrary to the general understanding of these provisions by the industry and accepted practices globally.

Snapshot

  • The requirement of the AIF Regulations for the sponsor/manager to invest minimum continuing commitments (Sponsorship Commitment) (i.e. the lower of 2.5% of the fund’s investible funds or INR 5 crores, in case of Category I and Category II AIFs) is required to be complied with even at the time of the AIF exiting from its investments.
  • Interestingly, and contradictory to SEBI FAQs 7 on the AIF Regulations which clarify that “since alternative investment fund is a privately pooled, the amounts contributed by investors shall not be utilised for purpose of giving loans”, SEBI seems to have held that it is permissible for AIFs to advance loans!
  • Upholding the sanctity of the terms of the Private Placement Memorandum (PPM) of a AIF, SEBI has held that any investments of an AIF, made without complying to the investment process as detailed in its PPM, violates the terms of the SEBI Circular dated 1 October 2015 which obliges AIFs to carry out their activities in compliance with the PPM.

SEBI’s interpretation of the provisions of the AIF Regulations could have a far reaching impact on the domestic funds industry. Provided below is a critical analysis of the Order. Please refer to the Annexure for an overview of the facts, the arguments advanced and SEBI’s viewpoint as provided under the Order.

Analysis

While SEBI orders are per se binding only on the parties to the matter, the following noteworthy points emerge from the interpretations and positions adopted by SEBI:

  • SEBI has ruled that the Sponsorship Commitment of the sponsor/manager of an AIF is required to be kept invested in the AIF even when the AIF begins to exit from its investments. This seems to suggest that SEBI expects that Sponsorship Commitment amount should be ‘locked-in’ in the AIF, even when the AIF exits from its investments. This interpretation by SEBI may place sponsors/managers in a disadvantageous position for no apparent reason and may potentially place trustees and the managers in a position of dilemma since they are legally bound by the obligation of treating all of the AIF’s beneficiaries (including manager/sponsor to the extent of their Sponsorship Commitment) at par with each other. The interpretation also does not seem to be in accordance with its underlying philosophy of ensuring the sponsor’s skin-in-the-game by making investments since it does not allow the sponsor to exit at par with other investors.

Typically, the sponsor/manager of a fund invests on the same terms (inter alia, on distributions to be received from the fund) as applicable to other investors, due to which they are entitled to receive pro-rata distributions from the fund. It is unclear as to the basis of SEBI’s ruling against the return of the Sponsorship Commitment by AIFs alongside other investors. This interpretation may also lead to absurd situations since locking in of sponsor’s/manager’s investments, may lead to a situation where the sponsor/manager is provided a higher rate of return (as compared to other investors) since the Sponsorship Commitment would effectively stay invested in the fund for a longer duration. Hence, SEBI’s viewpoint may create hardships for fund sponsors/managers and is susceptible to be challenged on these counts.

Having said that, given SEBI’s views, it becomes important for managers/sponsors to carefully draft the fund documents so as to contain the risk of their investments (in addition to the regulatory minimum amount) being locked down to the minimum amount required to be invested by them as per the AIF Regulations. From a marketing perspective, sponsors/manager would need to make a fine balance between the regulatory requirements and the marketing leverage they aim to gain from their commitments to the fund.

  • A noteworthy aspect of the Order is that contrary to the general perception regarding AIFs being able to invest in shares, securities or LLP interest, but not acting as lending entities (as clear from SEBI’s FAQs on this aspect); SEBI seems to have now agreed on the ability of AIFs to advance loans, provided that the same is permitted by their PPMs.

While this aspect of the Order may effectively create some amount of overlap in the regulatory domains of SEBI and the Reserve Bank of Indiaas independent regulators (where the former primarily operates as a ‘securities regulator’ while the latter governs banks and non-banking financial institutions); the interpretation may provide greater operational flexibility to AIFs as vehicles capable of investing in a wide array of financial instruments including debt instruments as a part of the same fund strategy. Having said that, in our view, clarifications should be sought from SEBI on this count, particularly in view of a contrary stand communicated by the regulator in the past.

  • The third important point emerging from the Order is that SEBI seems to be treating the terms of the PPM as being sacrosanct and binding on the fund. This is indicated from SEBI’s reading of the PPM terms regarding the Investment Committee’s (IC) role in the investment process and the limits prescribed therein on loans being advanced by AIF.

PPMs in the Indian context typically straddle two conflicting purposes viz. a marketing documents as well as a disclosure document. Apart from the commercial fund terms which are typically seen as forming the basis of investment by an investor in a fund, the risk factors serve the purpose of it being a disclosure document. However, the other business sections of the PPM including investment strategy and investment process sections are hitherto perceived to be more of a marketing sections and are generally perceived to be more indicative in nature and not necessarily exhaustive or binding. However, from the current ruling it appears that SEBI is viewing the PPM in its entirety as a binding document for the sponsor and the manager and could suo moto as part of its audit view and deviation as a violation of the AIF Regulations. Hence, a very careful thought and accurate drafting of these business sections should be considered going forward having seen how SEBI as a regulator sees this document.

To conclude, the Order is expected to be challenged before the Securities Appellate Tribunal. It would be interesting to see the matter progress before the SAT.