The Securities and Exchange Board of India (SEBI) has recently released a consultation paper aiming to address concerns related to the circumvention of financial sector regulations within the Alternative Investment Funds (AIF) ecosystem.
Background:
The AIF industry has witnessed substantial growth, with investments made by AIFs reaching INR 3,53,352 Crore as of September 30, 2023. AIFs play a crucial role in connecting sophisticated investors with enterprises in need of risk capital. Recently, RBI had flagged the issue of ever greening of loans by some lenders through the AIF route, circumventing the RBI norms for recognition of the loan as NPA and the subsequent consequences. RBI then had issued a notification to curb this circumvention.
Few modus operandi used to circumvent regulations:
Ever-greening of loans: RBI regulated lenders use the AIFs structure to facilitate ever-greening of stressed loans. The lenders invest in units of AIFs which extends investments to stressed borrowers which in turn repay the stressed loan to the lender. This circumvents the recognition of the loan as stressed benefiting both the borrower and the lender.
Circumvention of FEMA norms: Some AIFs established to circumvent provisions related to foreign investment. Reporting of downstream investment by AIF is based on the domicile of the manager/sponsor of the AIF. Few foreign investors appear to have set up AIFs with domestic managers/sponsors to invest in sectors prohibited for FDI, or to invest beyond the allowed FDI sectoral limit. Further, foreign investors may set up AIFs to invest foreign money in debt/debt securities where foreign investment is envisaged through the FPI/ECB route.
Circumvention of QIB regulations: Certain AIFs, which have single or very few investors (often belonging to same investor group), invests in IPOs under QIB quota, thereby availing benefits available to QIBs under SEBI. Permitting such AIFs as QIBs would allow otherwise ineligible entities/ persons to influence the price discovery process in the public market, which in turn affects the other retail investors participating in the IPO.
The above list is not an exhaustive list of all cases of AIFs being used as structures to facilitate circumvention of financial sector regulations. The specific instances above were identified on the back of inspections and examination of periodic reports submitted by AIFs. Such practices seriously impact the overall trust and integrity of the AIF ecosystem.
Identified circumvented investments in SEBI investigation, so far.
Proposed Regulations for prevention:
SEBI has proposed regulatory interventions in a manner that shall make a balance between curbing such practices while also maintaining the flexibility of AIFs to carry out genuine and legitimate investments, ease of doing business & ease of compliance. The following measures are proposed by SEBI and are open for comments from the public:
Introduce an obligation in the existing regulations that would require AIFs, managers and their KMPs to ensure that their operations do not facilitate circumvention of regulations of any financial sector regulator.
Use the pilot Standards Forum for AIFs (“SFA”) for formulating standards for ease of implementation of AIF Regulations, in consultation with SEBI.
In case it is ascertained that the participation of an investor in a particular investment of an AIF may facilitate circumvention of a specified regulation, the manager of the AIF has the flexibility to either:
not make the said investment or
exclude the investor from the particular investment.
SEBI has proposed this regulatory intervention on the principles of 'Trust but verify.' Those that intend to stay within the letter and spirit of the AIF regulations should face no challenge in demonstrating adherence to them.
Legal Proposal:
Insert the following provision in Chapter IV (General Obligations and Responsibilities and Transparency) of the SEBI (AIF) Regulations, 2012:
"Every Alternative Investment Fund, Manager of the Alternative Investment Fund and Key Management Personnel of the Manager and the Alternative Investment Fund, shall carry out specific due diligence, as may be specified by SEBI from time to time, with respect to their investors and investments, before each investment, to prevent facilitation of circumvention of extant regulations administered by any financial sector regulator.
Provided that, if participation of an investor of an AIF in an investment opportunity has been ascertained to result in facilitation of circumvention of any extant regulation, the manager of the AIF shall –
(a) not make the investment; or
(b) exclude the particular investor from the investment.
Explanation: “extant regulations” shall mean laws, acts, rules, regulations, guidelines/ circulars framed thereunder that are administered by any financial sector regulator including SEBI."
Specific and verifiable standards for due diligence shall be framed that the AIF stakeholders will need to conduct, for ascertaining as to whether the participation of an investor in a particular investment of the AIF facilitates circumvention of extant regulations. These standards of due diligence, accompanied by suitable standards of reporting by AIFs, shall be formulated by the pilot SFA, in consultation with SEBI.
Conclusion:
The AIF industry stands at a crucial juncture where addressing the identified circumventions is not just a regulatory necessity but a pivotal moment for the preservation of trust. With the industry is witnessing consistent growth and playing a vital role in connecting investors and enterprises, the proposed regulatory measures by SEBI are imperative. Failure to address these circumventions at this stage could lead to a erosion of trust that the AIF ecosystem has worked hard to build.
The proposed framework, while seeking to prevent misuse and enhance regulatory trust, also underscores the importance of preserving the flexibility necessary for legitimate AIF investments. Stakeholders' active participation and thoughtful engagement during this consultation period will play a pivotal role in shaping a regulatory landscape that fosters growth, legitimacy, and, above all, trust in the AIF industry.
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