Tag Archives: AIF

Opportunities and Challenges for AIFs in India’s first IFSC, GIFT City, Gujarat.

We are pleased to share with you an article that our Founder Sharda Balaji along with our Associate Avaneesh Satyang contributed to the 2nd volume, Issue 2 of the KNOWLEDGEex Magazine released by Indian Association of Alternative Investment Funds (IAAIF). 

Introduction to IFSC and GIFT City

India has been witnessing a high growth in the investment funds domain, ranging from fund-raising activity to active investments by funds, and also an adaptive and dynamic regulatory environment conducive to the witnessed growth. The formation of most of these funds however have been concentrated to the well-known financial hubs such as Hong Kong, Mauritius, Singapore, etc. The success of theses financial hubs is generally attributed to the regulatory, tax and other business-conducive financial service centres. The International Financial Service Centre (IFSC), is India’s attempt to create an avenue into financial globalisation.

An IFSC allows overseas financial institutions and overseas branches/subsidiaries of Indian financial institutions to operate within India and cater to customers outside the jurisdictions of India. This is achieved only when the IFSC provide favourable regulatory regimes and business environment to investors and financial institutions.

Provisions for the setting up and regulations of an IFSC were thus introduced in the Special Economic Zone Act, 2005, and in 2015, Gujarat International Finance Tec-City (GIFT City) came into being to facilitate such financial services within the geographical territory of India, which would otherwise have been carried on abroad or through offshore branches/subsidiaries of Indian financial institutions.

As an IFSC, GIFT City is regulated under specific regulations and guidelines by India’s major financial sector regulators, i.e. the Reserve Bank of India (RBI), the Securities Exchange Board of India (SEBI), and the Insurance Regulatory and Development Authority of India (IRDA). This is because of the major identified thrust areas for IFSCs in India, which would need regulation as follows:

  • Banking and Forex: to be regulated by the RBI
  • Capital Markets: to be regulated by SEBI
  • Insurance: to be regulated by IRDA

Why consider AIFs in GIFT City?

GIFT City as a facilitator of international business has already set a firm initial footing in the above identified thrusts areas with more than 150 units licensed by the financial regulators already operating in GIFT City. The banking units at GIFT City are working well with transactions of more than USD 16 Billion having taken place. In the insurance sectors, the IRDA has licensed entities engaged in insurance business. And for the Capital markets, both National Stock Exchange (NSE) and Bombay Stock Exchange (BSE) are operating out of GIFT City, and several SEBI licensed companies are offering IFSC products from GIFT City.

Setting up of Alternative Investment Funds (AIFs) in GIFT City, being the species of private pooled funds recognized in India, becomes another important step in commencing the third stage of proliferation of financial and capital market activities.

It is to be noted that the authorities at GIFT City and the SEBI are fully aware that India has a big market for India-focused offshore feeder funds which are set-up outside India. Keeping in mind the premise offered by IFSC as fully capital account convertible, i.e. providing full exemption from FEMA norms for transactions from and to the IFSC, emerges as an important alternative to offshore feeder funds. For all transactional and regulatory aspects, an AIF operating from GIFT City, is an offshore AIF.

Thus, to assess the viability of setting up AIFs in GIFT City as opposed to an offshore fund will require an analysis on Regulatory (fund formation, registration, tax considerations, etc.) as well as Operational (ease of conducting business, etc.).

Regulatory Regime for AIFs in GIFT City

Soon after the introduction of GIFT City, SEBI promulgated its SEBI (International Financial Services Centres) Guidelines, 2015 (SEBI Guidelines) on March 27, 2015. The SEBI Guidelines permits only ‘recognized entities’ registered with SEBI or registered/recognized with foreign regulators, to set-up units in IFSC, in this regards AIFs operating in IFSCs are treated as recognized financial institutions.

Further operational and regulatory clarifications for stakeholders waiting to set up AIFs in GIFT City, the circular titled ‘Operating Guidelines for Alternative Investment Funds in International Financial Services Centres’ dated 26 November, 2018 (AIFs in IFSC Guidelines) by SEBI, provided much needed clarity on several aspects with respects to setting up and operation of AIFs in GIFT City.

  1. Continued applicability of the SEBI (AIF) Regulations, 2012 – the AIFs in IFSC Guidelines work under the broad ambit of the SEBI (AIF) Regulations, 2012 (the AIF Regulations). Thus, all provisions of the AIF Regulations and the circulars issued thereunder, will also apply to AIFs set-up in GIFT City, and also to the investment managers, sponsors, and investors. This would include periodic reporting, event-based reporting, adherence to disclosure norms to SEBI.
  2. AIFs in IFSC are considered offshore entities – RBI, in its Foreign Exchange Management (International Financial Services Centres) Regulations, 2015 dated 02 March, 2015 has stated that any financial institution or branch of a financial institution set up in the IFSC and permitted/recognised as such by a regulatory authority shall be treated as a person resident outside India. Therefore, under FEMA, the transactions with Indian residents or making investments in Indian securities would require compliance with FEMA norms.
  3. No separate registration process – The conditions as applicable to domestic AIFs for registration with SEBI, will continue to apply to AIFs in GIFT City as well.
  4. Operating Currency – AIFs operating in IFSCs can accept money only in foreign currency.
  5. Eligible Investors – A person resident outside India, NRIs, Indian institutional investor permitted under FEMA invest funds offshore, Indian resident having net worth of at-least USD 1 Million during the preceding financial year (subject to limits under Limited Remittance Scheme of RBI). It would be beneficial if the guidelines clarify, whether investment by Indian residents into the AIF set up in GIFT City, which further invests into Indian companies, is considered as round-tripping.
  6. Investible Securities – AIFs in GIFT City can only invest in securities that are; listed in IFSC; issued by companies incorporated in IFSCs; or issued by companies incorporated in India or companies belonging to a foreign jurisdiction.
  7. Investment Route – Earlier, such AIFs in IFSCs could only invest in India through the FPI route. Now, such AIFs may invest in India through the FDI or Foreign Venture Capital Investor (FVCI) route as well.

Following is an encapsulation of other conditions applicable to AIFs operating in IFSCs:

Minimum Corpus of AIF at least USD 3 Million.
Minimum investment value by any one investor at least USD 150,000 [for employees/directors of AIFs, minimum value of investment is USD 40,000].
Continuing interest of the Manager/Sponsor at least 2.5% of the corpus or USD 750,000, whichever is lower (such interest cannot be through waiver of management fees). For Cat-III AIFs, the continuing interest shall be at-least 5% of the corpus or USD 1.5 Million, whichever is lower.
Sponsor/Manager of an existing AIF in India may act as Sponsor/Manager of AIF operating in IFSC only by setting up a branch in the IFSC or incorporating a company or LLP in the IFSC.
Appointment of Custodian for Securities Sponsor/Manager of Cat-I and II AIFs are required to appoint a custodian registered with SEBI for safekeeping of securities, if the corpus of the AIF is more than USD 70 Million.

Appointment of custodian is mandatory for all Cat-III AIFs operating in IFSCs.

Application and Registration fees
Application Fee : USD 1,500
Registration fee for Cat-I AIF (other than Angel Funds) : USD 7,500
Registration fee for Cat-II AIF : USD 15,000
Registration fee for Cat-III AIF : USD 22,500
Registration fee for Angel Funds : USD 3,000
Scheme Fee for AIFs : USD 1,500

Following are the special conditions as applicable to Angel Funds operating in IFSCs:

Minimum Corpus USD 750,000
Criteria for becoming an ‘angel investor’ (a) Individual investor to have net tangible assets of at least USD 300,000 (excluding value of principle residence).

(b) body corporate to have net worth of at least USD 1.5 Million.

Minimum investment value for ‘angel investor’ Investment from an angel investor should not be less than USD 40,000 (up to a maximum period of 5 years)
Investible entities Angel funds to invest in Venture Capital Undertakings (VCUs) as defined in Reg. 19(F)(1)(a) of the SEBI (AIF) Regulations, 2012. Also;

– Turnover of venture capital undertaking (VCU, is the company which receives the investment by the AIF) must be less than USD 3.75 Million

– VCU must not be promoted/sponsored/related to industrial group with group turnover more than USD 45 Million

Investment caps on Angel Funds Minimum investment by Angel fund in VCU – USD 40,000. Maximum investment – USD 1.5 Million

 

Continuing interest of Manager/Sponsor 2.5% of the corpus of fund or USD 80,000 whichever is lower (such interest cannot be through waiver of management fees)

Key Takeaways from the Regulatory Perspective

Key Opportunities:

  • The regulatory provisions applicable to AIFs in IFSCs do offer a viable alternative to offshore feeder funds, and can act as a feeder fund for an Indian AIF.
  • Other offshore funds investing in India which traditionally operate out of other countries like Mauritius, Singapore, etc. may deliberate on the option.
  • Indian overseas fund managers looking to set up funds for investing outside India, may find it easier to raise capital from overseas investors and Indian investors simultaneously. Indian offshore fund managers can also use AIFs in GIFT City as feeder fund to invest funds offshore.
  • Costs for setting up the fund appear to be much lower in comparison to setting up an offshore fund.
  • As a deemed overseas fund, conditions on overseas investments by AIF prescribed by SEBI in October 2015 such as overall investment limit (USD 750 million), specific SEBI approvals, and other conditions shall not apply.

Key Challenges:

  • There is lack of clarity with respect to AIFs in IFSCs being able to invest in securities listed on overseas stock exchange.
  • Although, investment under FDI, FVCI or FPI route is allowed for AIFs in IFSCs, it has not been specified whether such AIFs would require separate licenses to invest as FPIs or FVCIs. Ideally, as a recognised AIF, they must be granted FPI/FVCI status as well.
  • New Investment managers of AIF in IFSCs must necessarily be incorporated in the IFSC, this might add to the cost of setting up the fund. Ideally, if the IFSC truly aims to attract global funds, management by offshore managers should also be allowed.
  • With respect to Angel Funds, it appears that angel funds in IFSCs can only invest in Indian entities.

Key Development: Proposed Unified Authority for regulating all financial services in IFSCs in India

Cognizant that the dynamic nature of the business conducted in IFSC requires immense inter-regulatory co-ordination, the Central Government has acted on the need for having a unified financial regulator for IFSCs in India to provide world class regulatory environment to financial market participants. Thus, the International Financial Services Centres Authority Bill, 2019 (the Bill) was introduced in the Rajya Sabha on 12 February 2019 by the Finance Minister providing for the establishment of an authority to develop and regulate the financial services market in the IFSCs. This is an important development, as the presence of a unified and dedicated International Financial Services Centres Authority (the Authority) is proposed to play a significant role towards the IFSCs ultimate goal of ease of doing business.

Under the Bill, all powers relating to regulation of financial products, services, and institutions in IFSCs, which were previously exercised by the respective regulators will be exercised by the Authority. As per the Government’s rationale, the Authority will be responsible for providing world-class regulatory environment to market participants from an ease of doing business perspective.

Tax and Operational Considerations for AIFs in GIFT City

Under Sections 10(23FBA) and 115UB of the Income Tax Act, 1961 (the IT Act), Category I and II AIFs are accorded tax pass-through status with respect to AIF’s income other than business income, thereby tax being chargeable in the hands of the investors. These provisions are extended to AIFs in IFSCs as well, as they continue to be tax residents in India despite being non-residents under FEMA.

There are several beneficial provisions available for IFSC units, however, since they are not AIF specific, which leads to ambiguities regarding the availability of such incentives to AIFs in IFSCs. Nevertheless, the beneficial provisions for IFSC units under the IT Act are as follows:

  1. Tax holiday under Section 80LA – Any unit set-up in an IFSC shall not be taxed in relation to income from business as follows in two blocks. First block of 5 years in which 100% of the income beginning with the year in which the permission or registration was obtained is exempt from income tax, and; Second block of 5 years in which 50% of income is exempt for the next 5 consecutive years.
  2. Lower rates of Minimum Alternate Tax (MAT) and Alternate Minimum Tax (AMT) – MAT and AMT in case of a unit located in an IFSC and deriving its income solely in convertible foreign exchange shall be charged at a lower rate of 9% as opposed to the general 18.5%.
  3. Exemption from Dividend Distribution Tax (DDT) – A unit located in an IFSC and deriving its income solely in convertible foreign exchange, being a company, is exempted from paying DDT at the time of distributing dividend.
  4. Gains from certain securities transferred by non-residents not considered as capital gains – Any transfer of derivatives, global depository receipts, or rupee denominated bonds of Indian companies by a non-resident on a stock-exchange in an IFSC is exempt from tax on capital gains.
  5. Exemption from Securities Transaction Tax (STT) – A transaction undertaken on recognised stock exchange in an IFSC shall be exempt from STT.
  6. Exemption from Goods and Services Tax (GST) – All supplies made to and made by units in SEZs are exempt from GST applicability.

Apart from the tax considerations, units in IFSCs also being subject to the Special Economic Zones Act, 2005 as SEZ Units might face other problems. This argument stems from the fact that the SEZs were originally conceived as special designated zones for manufacture and export-oriented industries, and thus SEZ Units are subject to certain conditions which might prove difficult for non-export-oriented business to satisfy. For example, in the recent Special Economic Zones (2nd Amendment) Rules, 2019 dated 07 March, 2019, Rule 53 of the Special Economic Zones Rules, 2006 was substituted to mandate a positive net foreign exchange earning by SEZ Units calculated cumulatively for a period of five years from the commencement of production. IFSC units specialize in financial services and products, might find it very difficult to meet the net foreign exchange earning criteria set by the government.

Key Opportunities

  • The tax holiday is a big benefit for investment managers established in the IFSC, management fee and other income will be exempt.
  • Other exemptions with respect to MAT and AMT for non-market players, and DDT and STT exemptions make GIFT City an attractive destination.

Key Challenges

  • There is dearth of clarity in taxation of income of AIFs in IFSCs on many fronts, such as will the tax holiday be available to AIFs in IFSCs with no business income, whether investors in AIFs will be required to obtain PAN and file tax returns in India in case of tax pass-through being available, etc.
  • There is a need to harmonize the provisions as applicable to SEZ Units with respect to IFSC Units requiring necessary carve outs and exemptions to be created.
  • Unless a unified regulator is in place, the problem of multiplicity and overlapping of authority will continue to diminish the growth of AIFs in IFSCs as viable alternatives to offshore funds.

Observations:

There certainly are numerous benefits for setting up an AIF in GIFT City. With the proposed unified regulator, ease of doing business, it holds many promises.

However, it is to be noted that many grey areas especially with respect to taxation of AIFs in IFSCs need to be clarified and resolved to understand the true effects of such provisions on AIFs as mentioned above. The determining criteria would be clarity to the tax incentives available for AIFs in IFSCs. How well does GIFT City perform, will determine the success of AIFs in IFSCs, too.

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The Head and Tail of Side Letters in Alternative Investment Funds

This article was first published by IAAFI – Indian Association of Alternative Investment Funds

A side letter is a document or a letter that is ancillary to another existing contract. In investment world, Side letter would mean something over and above your general terms and conditions that are binding under the investment product agreement i.e. PMS or AIF or any other investment vehicle.

Executing side letters with contributors has become an increasing phenomenon in the Alternative Investment Fund (AIF) documentation space. While the genesis of the practice seems to have stemmed from the need to have supplementary, clarificatory terms and sometimes preferential rights to large or strategic investors in a fund, the modality is now being used at a much higher frequency. The general dicta of avoiding side letters, however, prevail for various reasons of maintaining fairness, integrity and transparency, concerns around legality and enforceability. In this article we have explored the enforceability and regulatory nuances around the usage of side letters.

Enforceability of Side Letters in General.

  • From a contractual perspective, side letters could be said to be enforceable if they fulfil the basic tenets of a valid and binding contract under the Indian Contract Act, 1872, i.e. offer and acceptance, made by the free consent of the parties, for a lawful consideration with a lawful object, and not expressly declared to be void[1].
  • Enforceability could also flow from equity and relief under Chapter II of the Specific Relief Act, 1963. However, in a fund context that is structured as a trust, Section 11 of the Specific Relief Act, 1963 also comes into play that specifies that a contract made by a trustee in excess of his powers or in breach of trust cannot be specifically enforced. [Note: Enabling provisions in the indenture of trust need to be drafted carefully, as such.]
  • The principle of law as stated in Von Hatzfeldt – Wildenburg v. Alexander[2] is that:

“…… if the documents or letters relied on as constituting a contract contemplate the execution of a further contract between the parties, it is a question of construction whether the execution of the further contact is a condition or term of the bargain or whether it is a mere expression of the desire of the parties as to the manner in which the transaction already agreed to will in fact go through…… In the latter case there is a binding contract ……”

In the private equity/venture capital investment space, we often see side letters being sought for by seed stage or early stage institutional investors for grant of preferential or superior rights that provide better protection against future dilution of their existing voting or other rights in investee companies.

However, from an AIF documentation perspective, let us now look into the regulatory regime under the Securities and Exchange Board of India (Alternative Investment Fund) Regulations, 2012 (“AIF Regulations”).

Side Letters in AIFs – SEBI Perspective.

Chapter III and Chapter IV of the AIF Regulations talk about investment conditions and restrictions and general obligations and responsibilities of a sponsor or an investment manager, respectively. The relevant provisions put a lot of focus on adherence to placement memorandum terms, material changes only through consent of two-thirds of unitholders by value, the sponsor and manager acting in fiduciary capacity towards all investors. Through its Circular No. CIR/IMD/DF/7/2015 dated 1 October 2015 (“Circular”), the Securities and Exchange Board of India (SEBI), has further stressed upon the duty of all managers to carry out all the activities of the AIF in accordance with the placement memorandum circulated to all unit holders; and also, to act in the interest of unitholders and not take any action which is prejudicial to the interest of the unitholders. However, in the same Circular, AIF, manager, trustee and sponsor have also been mandated to exercise due diligence and independent professional judgment for the conduct of the business.

Therefore, the question that arises here is whether offering a preferential or special right to an investor through a side letter, affects the fiduciary responsibility of the sponsor or the manager towards the other investors. There seems to be 2 schools of thought here. One stressing upon the highest level of transparency and adherence to principles of avoidance of conflict of interest. The other thought, however, comes from the practical perspective of having to raise funds by the investment managers. Providing certain special rights which of course do not materially change the commercials terms of the applicable class of units, investment strategy, investment purpose and investment methodology of a fund, could sometimes be crucial for sealing the deal with a large or strategic investor. Side letters are also useful for providing contractual clarifications to even investors who want to join in late. The most frequent requests from the investors in this regard vary from limitations on time horizon and capping of indemnity and contributor giveback amounts to waiver of certain charges or fees, etc.

A constructive (or aggressive) interpretation of the AIF Regulations and the Circular could lead to the understanding that fund managers may exercise prudence and independent professional judgment for entering (if willing to take risk) into side letters, however, acting throughout in the interest of all unitholders and maintain highest standards of integrity and fairness and under an enabling provision captured in this respect in the placement memorandum.

One should remember that investment manager, holding a fiduciary role, merely has delegated powers from the trustee on the back of investment management agreement and typically can’t enter into contracts on the side-lines with investors without consent of the trustee or overriding/relaxing the main contract which the trustee has with investors. This could be construed as breach of trust and fiduciary duty depending on case circumstances and investment manager would need to indemnify the investors for any potential loss. Large number of side letters would also add to the administrative and legal burden on the fund/investment manager.

From an investor’s perspective, one should be careful on the enforceability, permissibility and workability of such letters and if they add any substantial value to the overall value proposition on manager selection vs. product selection.

From a Wealth Manager or Investment Advisor perspective, presence of side letters in their approved products might be construed as a red flag in due diligence process as limiting the transparency and fairness in treatment for their own investors.

Some much needed clarity from the Securities and Exchange Board of India (SEBI) on these lines could provide some color on the practice, one way or the other, and help in reduction of security and risk concerns amongst the investor base.

[1] Section 10 of the Indian Contract Act, 1872

[2] As quoted by the Hon’ble Supreme Court in Kollipara Sriramulu v. T. Ashwathanarayana & Ors. – 1968 SCR (3) 387

Authors: Ms. Sohini Mandal, Associate Partner, NovoJuris Legal and Mr. Biharilal Deora, Director, Abakkus Asset Manager LLP

 

Case Study: SEBI Settlement Order in the Matter of SREI Multiple Asset Investment Trust (a Category II AIF)

In this post, we look into the Adjudicating Officer’s (“AO”) Order dated November 29, 2017, in the matter of SREI Multiple Asset Investment Trust (“Fund”) and SREI Alternative Investment Managers Limited (“Investment Manager”) and the way the matter proceeded further, leading finally to a settlement on July 25, 2018 under the SEBI (Settlement of Administrative and Civil Proceedings) Regulations, 2014. The AO’s order cannot be considered to be conclusive because of the subsequent settlement order. However, a review of the entire saga provides some insight into how the Securities and Exchange Board of India (“SEBI”) interprets relevant provisions of the SEBI (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”).

Factual Matrix and Issues Raised before the AO:

The Fund had launched a scheme which was to primarily focus on financing brownfield assets which carries a lower execution risk as compared to greenfield assets. The following issues were dealt with in the proceedings before the AO;

  1. The Fund, instead of making investments of the amount raised from the investors, had gone on to grant loans to several entities, allegedly in breach of the AIF Regulations.
  2. Out of the investible corpus of the Fund, amounts in excess of 25% of the investible corpus were given to investee companies on two occasions, allegedly another breach of the investment conditions prescribed in the AIF Regulations.
  3. The Fund had acted in contravention of the decision of the investment committee of the Fund, and also had failed to follow the investment strategy as specified in their private placement memorandum.
  4. The Investment Manager failed in maintaining the minimum continuing interest of INR 5 crore in the Fund mandated in the AIF Regulations.

Summary of the AO’s order:

In the foregoing paragraphs the arguments on behalf of the Fund/Investment Manager and the reasoning adopted by the AO are summarized:

Issue 1: The defence taken by the Fund/Investment Manager was that the private placement memorandum of the Fund clearly stated that it was the Fund’s investment strategy to invest in forms of finance/loans to various companies. Further, the AO pointed out that the fund was registered as Category II AIF which included a “debt fund” that invests primarily in debt and debt securities. Thus, the Fund was not in contravention of Reg. 2(1)(b) of the AIF Regulations in giving loans as per its investment strategy.

Issue 2:  Reg. 15(1)(c) of the AIF Regulations require the investment commitment to not be more than 25% of the investible corpus of the Fund. According to the Fund, on the alleged date of investment (i.e. June 29, 2015), the investment commitment was indeed only 25%. However, post the investment (i.e. July 9, 2015), due to redemption of units of the Fund and distribution to investors, the total corpus of the Fund fell, and resultantly the investment commitment rose to about 28%. It was argued that since this was just an after-effect of the redemption of units, this was not an infringement of the said regulation. However, the AO ruled that the defence was inadmissible as they themselves had admitted to the investment being in excess of the 25% threshold post July 9, 2015.

Issue 3: According to the minutes of the investment committee of the Fund, and also as mentioned in the Fund’s private placement memorandum, the Fund had decided on the range of interest rates it would charge on their loans (14-16%), and also decided what the corpus of investment for each investee under the scheme would be (INR 50 crore–INR 200 crore). The Fund/Investment Manager took the defence that these ranges were only indicative in nature, and it was not intended that they would be strictly bound by them. However, the AO cited Paragraph 2(c) of SEBI’s Circular No. CIR/IMD/DF/7/2/2015 dated October 1, 2015 which prescribed that all managers shall carry out all the activities of the AIF in accordance with the placement memorandum circulated to all unit holders and amended from time to time in accordance with AIF Regulations and circulars issued by SEBI. It was decided that terms of the private placement memorandum must be complied with without any deviation, unless amended following the due process of law.

The AO here tried to propagate strict compliance of SEBI’s 2015 Circular to safeguard the interests of the investors. However, reference may be made to SEBI’s Circular No. CIR/IMD/DF/14/2014, dated June 19, 2014 which at Paragraph 2(b) states that only in cases of material deviations from the placement memorandum, the manager is bound to provide an exit to the investors. The investors are to be informed of any changes post-facto and are not bound to take prior approval. The strict compliance with placement memorandum that the AO’s order demands needs careful consideration, therefore.

Issue 4: Under Reg. 10(d) of the AIF Regulations, an Investment Manager is required to have a continuing interest in the Fund of not less than 2.5% or INR 5 crores (whichever is lower) in the form of investment. The defence taken was that the contribution of the Investment Manager reduced to INR 3.13 crore after some of its contribution was repaid to it as an investor of the Fund. The AO however decided that the continuing interest requirement had no exception and must be complied with at all times.

Developments after the AO’s order:

Interestingly, regarding the AO’s decision on whether the Fund could give out loans, the final settlement order dated July 25, 2018 published by SEBI indicates a different conclusion. The settlement order was prepared in consultation with the High-Powered Advisory Committee (HPAC) of SEBI. According to the said settlement order, a new show-cause notice dated February 2, 2018 was issued to the Fund for using the investible corpus for the purpose of giving loans.

Further, the Fund and Investment Manager were required to provide an undertaking by way of an affidavit, confirming that they would stop granting loans, the amounts given as loans shall be taken back and, in the future, there will be no loan activity. The reasoning for such conclusion is not captured in the settlement order.

Our Suggestions based out of the matter:

The AO’s order exhibits the strict nature of compliance demanded by SEBI with respect to AIFs in general. The following key suggestions are provided for all Funds and Investment Managers:

  1. It is highly advisable that appropriate protections through indemnities and limiting liabilities are provided in the fund documents for trustees, managers, or settlors. Furthermore, adequate insurance policies to protect the downside from such statutory penalties is also highly recommended.
  2. In light of the strict compliance demanded from the provisions of the private placement memorandum, it becomes increasingly important to draft them with extra attention to the investment strategies that will be adopted and to leave ample flexibility for the manager to execute the same.
  3. The order also reinforces focus and importance of regular monitoring of all regulatory compliances.

Sources:

  1. Order of the Adjudicating Officer, dated November 29, 2017: https://www.sebi.gov.in/sebi_data/attachdocs/nov-2017/1511951662889.pdf
  2. Order of the Securities Appellate Tribunal, dated May 4, 2018: http://sat.gov.in/english/pdf/E2018_JO2017373.PDF
  3. SEBI’s Settlement Order, dated July 25, 2018: https://www.sebi.gov.in/enforcement/orders/jul-2018/settlement-order-in-respect-of-srei-multiple-asset-investment-trust-and-srei-alternative-managers-limited-_39703.html
  4. SEBI’s Circular No. CIR/IMD/DF/14/2014, dated June 19, 2014: https://www.sebi.gov.in/legal/circulars/jun-2014/guidelines-on-disclosures-reporting-and-clarifications-under-aif-regulations_27118.html
  5. SEBI’s Circular No. CIR/IMD/DF/7/2/2015 dated October 1, 2015: https://www.sebi.gov.in/legal/circulars/oct-2015/guidelines-on-overseas-investments-and-other-issues-clarifications-for-aifs-vcfs_30772.html

Authors: Mr. Avaneesh Satyang and Ms. Sohini Mandal

Significant Beneficial Ownership: Who is the real owner of the shares?

The recent changes to Section 90 of Companies Act, 2013, is to determine the identity of the person behind the curtain who is having a significant ownership of the company and is essentially controlling the management and daily affairs of the company. The Ministry of Corporate Affairs notified the Companies (Significant Beneficial Owners) Rules, 2018 (“Rules”) on 13 June 2018. These Rules were made in exercise of powers provided under Section 90 of the Companies Act, 2013 (Act) which was notified on 6 June 2018.

At present, there are two separate definitions for the determination of a significant beneficial owner. The first, as per Section 90 of the Act, an individual who holds at least 25 (twenty-five) percent of beneficial interest in the company would be categorised as a significant beneficial owner. Such individual can hold beneficial interest either alone or together or through one or more persons, with such person or persons including person resident outside India, or a trust, with such trust including a trust outside India.

The second definition of significant beneficial ownership has been provided under the Rule 2(e) of the Rules, which ascribes the categorisation of a significant beneficial owner to an individual. However, a major deviation under the Rules from Section 90(1) is that the threshold provided for an individual being classified as a significant beneficial owner is 10 (ten) percent in contrast to the threshold of 25 (twenty-five) percent prescribed under the Act. Moreover, the definition as per the Rules provide for an additional condition that the name of such individual who is holding beneficial interest should not be entered in the register of members.

Both definitions have deemed a necessary condition that an individual must be holding beneficial interest in the company to be deemed as a significant beneficial owner. The term beneficial interest has been defined under Section 89(10) as the right of entitlement of a person alone or together with any other person, indirectly or directly, through any contract or arrangement, to exercise any or all rights attached to the shares; or to receive or participate in any dividend or any such distribution in respect to shares held.

Despite the contradiction in the threshold for determination of significant beneficial ownership in a company, the threshold specified in the Rules would be considered as the applicable threshold. This is because Section 90 of the Act provides that the beneficial interest should not be less than 25 (twenty-five) percent or any other percentage as may be prescribed. Therefore, the threshold of 10 (ten) percent as prescribed under the Rules would be the final threshold percentage to determine significant beneficial ownership.

The application of the Rules extends to companies which has shareholders apart from individuals and natural persons with such shareholders holding beneficial interest in the company as per prescribed limits. The application of these rules however, does not extend to holding of shares in instances of pooled investment vehicles or investment funds such as AIFs (Alternative Investment Funds), Real Estate Investment Trusts, Mutual Funds, Infrastructure Investment Trusts.

The Rules elucidate that a beneficial interest would include right of entitlement held either alone or jointly with another person, be it directly or indirectly under any contract or arrangement. The right of entitlement would include the right to exercise any or all rights attached to such shares and receive or participate in any dividend or other distribution. Beneficial owners would be such persons holding a beneficial interest.

The rules deem significant beneficial owners to be such individuals, who while acting alone or together or through one or more persons or through a trust, hold beneficial interest of not less than 10% of the shares in the company with the names of such owners not being entered in the register of members of the company as the holder of such shares.

In cases where the beneficial interest is possessed by persons other than individuals or natural persons, the significant beneficial ownership would be determined as follows:

  1. Where the member is a company – the significant beneficial owner would be the natural person who holds 10 (ten) percent of the share capital of the Company or who exercises significant influence or control in the company through other means.
  2. Where the member is a partnership firm – the significant beneficial owner would be the natural person who holds 10 (ten) percent of the share capital or has entitlement of not less than 10 (ten) percent of profits of the partnership.
  3. Where no natural person can be identified – where no natural person is identifiable for a company or a partnership firm, the senior management official of the entity would be deemed as the significant beneficial owner.
  4. Where the member is a trust through a trustee – for the purpose of identifying the significant beneficial owner, the process would include identification of the author of the trust, trustee, the beneficiaries with not less than ten per cent. interest in the trust and any other natural person exercising ultimate effective control over the trust through a chain of control or ownership.

The Rules explicitly exempt the applicability of certain funds and investment vehicles that are registered under the SEBI Act. The Rules however, do not deal with the funds that are foreign based and not registered under the SEBI Act. Therefore, if an Indian company has a foreign fund as an investor and has an ownership qualifying under the definition of a significant beneficial owner, it is not clear whether such foreign fund would be required to make a declaration.

The filing compliance under the rules are as follows:

  1. A declaration is required to be filed to the company in which significant beneficial ownership is held within 90 days of commencement of the rules and in case of any change in the significant beneficial ownership, declaration is to be made to the company within 30 days of such change under Form BEN-1.
  2. The company is required to file Form BEN-2 with respect to such declaration within 30 days of receipt of declaration under Form BEN-1.
  3. A company is required to maintain a register of significant beneficial owners under Form BEN-3.
  4. The company can serve a notice seeking information under Form BEN-4. The person on whom the notice has been served is required to revert to the company within 30 days of receipt of notice. Wherein the company is not satisfied with information provided or person fails to furnish required information, is entitled to apply to the Tribunal within 15 days of expiry of the period mentioned in the notice.

As per the Rules, the companies were required to make a filing of Form BEN-2 on receipt of Form BEN-1 within 30 days. However, the Ministry of Corporate Affairs (MCA) be way of a general circular no. 07/2018 dated 6 September 2018 have clarified that the 30-day time limit for filing Form BEN-2 would commence from the date of the e-form being available on the MCA-21 portal rather than with 30 days of receipt of declaration by the company under Form BEN-1. The MCA further clarified that no additional fee would be applicable subject to the case that the company makes the filing of Form BEN-2 within 30 days of the form being available on the MCA-21 portal.

Source: http://www.mca.gov.in/Ministry/pdf/CompaniesSignificantBeneficial1306_14062018.pdf

http://www.mca.gov.in/Ministry/pdf/GCCircularBen_10092018.pdf

Fund Formation: On-Shore and Off-Shore Structures

Global interest in the LP (Limited Partner) ecosystem, for investments in India focused businesses, is at an all-time high. According to recent surveys, about 108 India focused private equity firms are in the market looking to raise funds. The first half of the year 2018 has been characterized by large value deals as pension funds, sovereign funds and global buyout funds have increased their India exposure (Source: Economic Times).

The positive regulatory changes have influenced the investor preference for pooling of funds both on-shore and off-shore for investing in India focused businesses. Some of the significant statutory/legislative revisions/clarifications, brought in over the last couple of years, are as follows:-

  • Liberalization of foreign direct investment (FDI) in the home-grown alternative investment funds (AIFs) sector in 2015, which now allows 100% investment in AIFs through the automatic route, as opposed to the prior FIPB approval requirement.
  • Down-stream investments by AIFs with FDI is now deemed as foreign investment, only if neither the sponsor nor the manager nor the investment manager is Indian ‘owned and controlled’. This has led to an opening up of choices for many FDI taking AIFs and have also taken away the mandatory obligation of complying with the pricing guidelines for any downstream investment.
  • Clarification issued by the Central Board of Direct Taxes (CBDT) that dividend distribution by off-shore companies with respect to underlying Indian assets would not result in a tax liability since it does not result in indirect transfer of shares.
  • Clarification brought in through the Finance Act, 2017, that indirect transfer tax provisions would not be applicable for capital assets held directly or indirectly by way of investment in Category I or Category II FPIs.
  • Opening up of FDI in limited liability partnerships LLPs and taking away minimum capitalization requirements for investment advisory businesses in March 2017.

[Source: RBI Notifications, CBDT Circular No. 4/2015 and the Paragraph 4 of the Finance Act, 2017]

These changes have led us to consider and advise on various unified as well as co-investment fund structures. Each such structure requires evaluation from compliance and taxation perspective. A very high level overview of some of these structures are given below:-

Direct Investment by an Off-Shore Fund. Also known as a pure off-shore structure, this where an off-shore investment pooling vehicle can pool and directly invest into India portfolio companies, as FDI, FPI or FVCI investment. Few things to be kept in mind for this structure would be:-

  • Spread of LP appetite for India/non-India focused investment;
  • Permanent establishment connotation if the off-shore investment manager is being advised by an Indian investment advisor;
  • Advantage of not having to mirror every investment decision of Indian investment manager.

Indirect Investment through a Unified or Master-Feeder Structure.  The on-shore fund pools investments from Indian investors and the off-shore fund pools investments from global investors and the off-shore fund becomes one of the investors of the on-shore fund, by executing a contribution agreement. Advantages could be as follows:-

  • Indian investors can overcome liberalized remittance scheme (LRS) or overseas direct investment (ODI) or round tripping related restrictions;
  • For global investors, it is easy to invest through an off-shore structure as that helps in operational ease of not having to obtain PAN registration for each investor, not having to report each individual investment with RBI;
  • Global investors still get to benefit from the various Direct Tax Avoidance Agreements (DTAA). For example, continued tax benefits for sale of debentures, lower withholding tax rate of 7.5% for interest income, as available to Mauritius investors under the India-Mauritius DTAA.
  • The investment manager gets to pay on the management fee and carry allocation on the entire fund at the on-shore level.

Co-Investment Structure. This is where, typically, the investment management of the on-shore and the off-shore funds are handled by different entities, in the respective jurisdictions. Advantages would be as follows:-

  • The off-shore fund need not necessarily participate in every investment made by the on-shore AIF.
  • The investment spread between the 2 entities could be decided on a case to case basis, depending on availability of funds.

Taxation from an ‘Association of Persons’ perspective, in India, needs to be carefully thought through while adopting this structure and it is suggested to have completely separated investment committees and managements from this aspect.

Disclaimer: Fund structuring is complex matter that requires a case to case evaluation of investor-base, investor jurisdiction spread, taxation at each investor level, demonstration of level of substance and permanent establishment. The purpose of this article is to disseminate information only and readers are requested to seek profession advice shall for any individual requirement.

Post Formation Compliance Requirements for Alternative Investment Funds (AIFs)

AIFs are privately pooled investment funds in India, typically set up in the form of a trust or a company or a body corporate or a Limited Liability Partnership (LLP). Please see our previous post to read more on a brief introduction to AIFs.

As per the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (the ‘AIF Regulations’), an AIF can be registered in one of the following three categories:

Categories Particulars Type Tenure
Category I Mainly invests in start-ups, SME’s or any other sector which Govt. considers economically and socially viable. Close Ended Determined at the time of application which shall be minimum 3 years.
Category II Private equity funds or debt funds for which no specific incentives or concessions are given by the government or any other Regulator Close Ended Determined at the time of application which shall be minimum 3 years.
Category III Hedge funds or funds which trade with a view to making short-term returns or such other funds which are open-ended and for which no specific incentives or concessions are given by the government or any other Regulator. Open Ended or Close Ended No specific tenure

 

Reporting Mechanism

For proper adoption of the AIF regulations, 2012 the Securities and Exchange Board of India has issued the Operational, Prudential and Reporting Norms for Alternative Investment Funds vide its Circular No. CIR/IMD/DF/10/2013 dated 29 July 2013. Furthermore, in order to ensure conformity with the operational guidelines, the SEBI introduced the “Guidelines on disclosures, reporting and clarifications under AIF Regulations” vide its Circular No. CIR/IMD/DF/14/2014 dated 19 June 2014.

Following are the reporting obligations for all categories of AIF:

  1. As per Regulation 28 of the AIF Regulations, periodical reports (with respect to funds raised, net investments by the AIF, leverage undertaken if any, exposure, categories of investor, etc) shall be submitted by all AIFs to the SEBI with respect to their activity.
  2. Category I and II AIFs and Category III AIFs that do not undertake leverage shall submit a quarterly report with the SEBI as per the Annexure I.
  3. Category III AIFs undertaking leverage shall submit a monthly report with the SEBI as per Annexure II.
  4. As per the Circular No. CIRCULARSEBI/HO/IMD/DF1/CIR/P/2017/87 dated 31 July 2017 the aforementioned reports shall be submitted through the SEBI Intermediary Portal at https://siportal.sebi.gov.in
  5. Such reports shall be submitted within 7 calendar days from the end of the quarter/end of the month as the case maybe.

Further, all AIFs have to comply with the requirements of preparation of a Compliance Test Report (CTR) as laid down below:

  1. At end of financial year, the manager of an AIF shall prepare a compliance test report on compliance (an exhaustive reporting of the AIF’s activities) with AIF Regulations and circulars issued thereunder in the format as specified.
  2. In case of the AIF is a trust, the CTR shall be submitted to the trustee and sponsor within 30 days from the end of the financial year. In the case of other AIFs, the CTR shall be submitted to the sponsor within 30 days from the end of the financial year.
  3. In case of any observations/comments on the CTR, the trustee/sponsor shall intimate the same to the manager within 30 days from the receipt of the CTR. Within 15 days from the date of receipt of such observations/comments, the manager shall make necessary changes in the CTR, as may be required, and submit its reply to the trustee/sponsor.
  4. In case any violation of AIF Regulations or circulars issued thereunder is observed by the trustee/sponsor, the same shall be intimated to SEBI as soon as possible.

Apart from the aforementioned reporting requirements, Category III AIFs have to comply with certain other reporting and compliance norms.

Risk Management and Compliance requirements for Category III AIFs employing leverage

Category III AIFs that employ leverage have to comply with the following risk management requirements:

  1. The AIF should have a comprehensive risk management framework along with an independent risk management function which shall be appropriate to the size, complexity and risk profile of the fund.
  2. Presence of a strong and independent compliance function appropriate to the size, complexity and risk profile of the fund. The same shall be supported by sound and controlled operations and infrastructure, adequate resources and checks and balances in operations.
  3. Appropriate records of the trades/transactions performed shall be maintained and such information should be available to SEBI, whenever sought.
  4. Full disclosure and transparency about conflicts of interest should be made to the investors. Further, how such conflicts are managed from time to time shall also be disclosed in accordance with Regulation 21 of the AIF Regulations and any other guidelines as may be specified by SEBI from time to time. The details of such conflicts shall be disclosed to the investors in the placement memorandum and by separate correspondences as and when such conflicts arise. Such information shall also be disclosed to SEBI as and when required by SEBI.

Redemption Norms for open-ended Category III AIFs

  1. The Manager of these AIFs should ensure that there is a sufficient degree of liquidity of the scheme/ fund so that it meets redemption obligations and other liabilities.
  2. The Manager shall establish, implement and maintain a liquidity management policy and process so that the liquidity of the various underlying assets is consistent with the overall liquidity profile of the fund/scheme while making any investment.
  3. The Manager shall disclose any possibility of suspension of redemptions to the investors in the placement memorandum
  4. Suspension of redemptions shall be justified by the Manager only if such suspension is in the best interest of the investors of the AIF or if such suspension is required under the AIF regulations or SEBI
  5. Operational capability shall be built by the Managers of such AIF so that redemption can be suspended in an efficient manner. No new subscriptions shall be accepted during the suspension of redemptions.
  6. The Manager shall communicate to SEBI the decision of suspension along with the reason for such suspension and the same shall be appropriately documented.
  7. The Manager shall review the suspension regularly and take all necessary steps to resume operations in the best interest of the investors.
  8. It shall be the duty of the Manager to keep the SEBI informed about the actions undertaken throughout the suspension and also the decision to resume normal operations.

Category III AIFs undertaking leverage shall have to comply with the prudential requirements (calculation of leverage, total exposure, etc) as laid down in the Circular.

Compliance requirements in case of breach of leverage limits for Category III AIFs

Category III AIFs shall ensure that adequate systems are in place to monitor their exposure so that the leverage does not exceed at any time beyond the prescribed limits. The AIF shall report to the custodian on a daily basis the amount of leverage at the end of the day (based on closing prices) and whether there has been any breach of limit. Such reporting shall be done by the end of the next working day (as per Circular No. CIR/IMD/DF/14/2014 dated 19 June 2014).

Reporting requirements in case of breach of limit:

  1. AIF shall send a report to the custodian in case of any breach of limit. The custodian shall report to SEBI providing a name of the fund, the extent of breach and reasons for the same before 10 A.M. on the next working day.
  2. A report shall be sent to all the clients stating that there has been a breach in the limit along with reason, before 10 A.M. of the next working day
  3. The AIF shall square off the excess exposure and bring back the leverage within the prescribed limit by end of next working day. However, an action may be taken by SEBI against the AIF under SEBI (Alternative Investment Funds) Regulations, 2012 or the SEBI Act.
  4. A confirmation of squaring off of the excess exposure shall be sent to SEBI by the custodian by end of the day on which the exposure was squared off.

Author: Ms. Alivia Das

Regulatory update: SEBI – Overseas Investment by Alternate Investment Funds (AIFs)/ Venture Capital Funds (VCFs)

SEBI vide circular no. SEBI/HO/IMD/DF1/CIR/2018/103/2018 dated 3 July 2018 with the consultation of the Reserve Bank of India (RBI) has decided to enhance the limit from USD 500 (five hundred) million to USD 750 (Seven Hundred Fifty) million, in terms of the overseas investment by AIFs and VCFs. Further to monitor the utilization of the overseas investment limits, it has been notified that the AIFs/VCFs shall mandatorily disclose the following:

  • AIFs/VCFs shall report the utilization of the overseas investment limit within 5 (five) working days of such utilization on SEBI’s immediate portal at:

https://siportal.sebi.gov.in

  • The AIFs/VCFs shall also report the following on the immediate portal:
  1. If the AIF/ VCF has not utilised the overseas limit granted to them within a period of 6 (six) months from the date of approval by SEBI (“Validity Period”), the same shall be reported within 2 (two) working days after the expiry of the Validity Period;
  2. If the AIF/VCF has not utilized a part of the overseas limit within the Validity Period, then the same shall be reported within 2 (two) working days after the Validity Period;
  • If the AIF/ VCF wishes to surrender the overseas limit at any point of time within the Validity Period, then the same shall be reported within 2 (two) working days from the date of decision to surrender the limit.
  • The other requirements, and terms as specified vide SEBI circulars no. SEBI/VCF/Cir no. 1/ 98645 /2007 dated August 9, 2007 and CIR/IMD/DF/7/2015 dated October 01, 2015, shall remain unchanged.

Source:https://www.sebi.gov.in/legal/circulars/jul-2018/overseas-investment-by-alternative-investment-funds-aifs-venture-capital-funds-vcfs-_39424.html