Tag Archives: SEBI

Post-Merger Corporate Governance

Corporate governance is an important aspect for the success and growth of any organisation. A well-structured corporate governance regime becomes even more important post a merger (strategic or otherwise). It might prove to be especially beneficial in the smooth transition and functioning of the business of the merged entity, especially during the early stages after the merger. At the same time, a weak corporate governance structure may be detrimental to the success of the merged entity.

In a merger, the merging entities commonly come together to work and operate as a single merged entity. This would mean the integration of different cultures, mindsets, viewpoints, work ethics, principles, etc. Therefore, post-merger corporate governance becomes important so that all discussions between the key stakeholders of the merged entity are seamlessly documented leaving zero scope for potential conflict in the future. This would also help the key stakeholders to run the business of the merged entity without having to worry about internal conflicts, mismanagement, etc. Also, depending on the end goal or the objectives of the merging entities, there has to be a clear understanding on the type of merger to be undertaken. Refer to our previous post on M & A: Different structures and a comparative to know more about different structures of M&A.

What is Corporate Governance?

Before moving on to the different aspects of corporate governance to be considered post a merger, let us try to understand the meaning of the term ‘corporate governance’. With respect to early-stage unlisted entities, corporate governance generally refers to the internal rules and policies of the organisation, the relationship between the shareholders, the roles and responsibilities of the directors and the top management and the decision-making structure, including the financial and operational decision making. In a nutshell, it includes all aspects which govern the organisation and basis which business is conducted and an organisation is run, both with respect to internal stakeholders, as well as external stakeholders.

Significance of Post-Merger Corporate Governance

Merger of entities, more often than not, would mean the integration of different cultures, mindsets, viewpoints, work ethics, principles, etc. Even though the end goal would be the same, that is, the success and growth of the merged entity, perspectives on the means to achieve the end goal may differ from person to person. However, since the merging entities would no longer be separate entities, it is important that the means to achieve the end goal is also aligned. Thus, while corporate governance is very important for every organisation, it gains even more significance post a merger.

There has to be a clear understanding on the structure of the corporate governance post-merger, which could primarily be recorded discussions and step plans to achieve the objectives of the merger. For example, if the main objective of a merger is market expansion of the business, it would be good to have a clear step plan detailing out the potential markets, key people to target the same, timelines and other operational parameters which could eventually determine achievement of results as agreed amongst the key stakeholders. If a merger involves employee movement, a clear plan for the transitioning of employees, in terms of location, identification, compensation plan, positive interactions across teams and often (in new age companies) regular counselling on challenges faced may prove to be tremendously beneficial in the long run.

Also, post the merger, it is always better to have each and every discussion documented. Such discussions (including the informal discussions) should also be conducted at the board level, which would help in ensuring that the important stakeholders are part of these discussions. The objective is not to increase bureaucracy but to ensure that the operations are seamless. This might not seem to be important especially during the initial stages after a merger. However, the importance of documenting every discussion comes into play when, at some point, the difference of opinion arises. In order to avoid tense and awkward situations at that point of time, if every decision or discussion in relation to the business and operations is documented and is taken with the knowledge of all the key stakeholders, it would to a large extent help in solving the issue at hand in a much more efficient and faster manner.

A merger would, in most circumstances, result in a change in the board composition and management. The board of the merged entity will play an important role in effective management and quick transition. The composition of the board (and the committees of the board) is usually determined prior to the closing of the transaction and is documented in the transaction documents. The composition of the board (and the committees of the board) will have to be properly thought through and well planned. Every member of the board/committee needs to understand their respective roles. It is important to ensure that there is equal representation for all the key stakeholders. The members of the board/committees have to be diverse, experienced and should have a clear understanding of the goals of the merger. Also, it is important to conduct review meetings to ensure that the goals or targets are being met and if not, analyse on the reasons and improve on the same. The board/committee meetings may be conducted on a regular basis.

It may be a good option to appoint an independent director to the board. This will help in situations where there is a difference of opinion between the various members of the board since the independent director will be a neutral party and would be able to give unbiased opinions. The independent directors bring objectivity and an independent opinion to the decisions made by the directors. They can also help in bringing more transparency to the proceedings of the board and also ensure that the interests of the shareholders are given due regard. However, an independent director can play a major role in ensuring good corporate governance only as long as he/she functions independently. His/her decisions should not be influenced by the other board members. Refer to our previous post on Independent Directors to know more about independent directors and their independence.

Conclusion

Even though there is no specific statute or law governing corporate governance as a whole in case of unlisted companies, there are various provisions under the Companies Act, 2013, SEBI guidelines, etc. which indirectly strives to have a good corporate governance system like provisions for appointment of independent directors and their roles and duties, appointment of audit committees, role of directors, etc.

To achieve the goals and objectives of the merged organisation and for a smooth transition, a well-structured corporate governance is vital.

 

Author: Paul Albert, Associate at NovoJuris Legal

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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

 

Significant Beneficial Owners Rules – Disclosures

SEBI vide its circular number SEBI/HO/CFD/CMD1/CIR/P/2018/0000000149 dated December 7, 2018 issued this circular in  exercise  of  the  powers  conferred  under  Section  11  and Section  11A  of  the  Securities  and  Exchange  Board  of  India  Act,  1992  read  with Regulation 31 and Regulation 101(2) of the Securities and Exchange Board of India (Listing Obligations and Disclosure Requirements) Regulations, 2015, in the in the interest of transparency.

This circular is in furtherance to the previous circulars and notifications (SEBI Circular No.  CIR/CFD/CMD/13/2015 and Companies (Significant Beneficial Owners) Rules, 2018 notified June 2018 by the Ministry of Corporate Affairs). SEBI clarified and laid down specific disclosures with respect to the shareholding pattern to determine the significant beneficial ownership.

Highlights:

  • Modification: The format specified in the Annexure to the circular shall be Table V  under clause  5 of  the format of  holding  of  specified  securities specified  in  the circular No. CIR/CFD/CMD/13/2015 dated November 30, 2015.
  • Disclosure: contents of the circular to be brought to notice of all listed entities and onus on stock exchange to disseminate this information though notice and publication in website
  • Annexure contains details of-
  • (i) Significant Beneficial Owner (Name, PAN, Nationality)
  • (ii) Registered Owner (Name, PAN, Nationality)
  • (iii) Particulars of shares held by significant beneficial owner which amount to significant beneficial ownership (the quantum of shares in the form of – exact number, percentage of the total number of shares)
  • (iv) Date of creation of Significant beneficial interest (/acquisition of the shares)

The manner of disclosure, as specified in the Annexure (tabular form) to the circular, will come to force from the quarter ending 31 March 2019.

LINK: https://www.sebi.gov.in/legal/circulars/dec-2018/disclosure-of-significant-beneficial-ownership-in-the-shareholding-pattern_41245.html

BSE Startup Platform and Revised Listing norms at National Stock Exchange

Many initiatives have been undertaken in the recent years for facilitating direct listing and consequent public trading of startup securities in India. In January 2010, Prime Minister’s Task Force recommended to set up a dedicated stock exchange for small and medium enterprises[2], which eventually led to the genesis of the SME Exchanges, NSE EMERGE and BSE SME platform. In our earlier Handbook on Initial Public Offering: SMEs, we have provided an overview of various SME platforms, benefits of SME listing and SME IPOs, list of documentation and comparatives of fees.

The rationale behind boosting SME listing could be manifold, from the perspective of all stakeholders in the ecosystem, i.e. the investors, growth stage companies, and the exchanges. The biggest impetus would be the greater access to sophisticated investors and wider portfolio base and investment opportunities for investors of both ‘Main Board’ and SME Exchange Platforms. This is also attractive from the perspective of providing exit opportunities to eligible existing investor base. As mentioned by the Managing Director of NSE, Mr. Vikram Limaye, “… a lot of money has been invested in start-ups and some investors in these companies may want to exit in the next 12-14 months…it is only appropriate for them to list in India and give an opportunity for the domestic investors to participate in their growth,”[3]

However, for various reasons, the SME platforms have not taken off or seen the traction that was envisaged during their formation. The eligibility criteria of companies with less than INR 25 crore in equity capital and those which have raised less than USD 4 million in external funding have been often cited to be the most crucial one of them. Many of the Startups[4] would have already raised large amounts of external funding from the now extensive venture capital and private equity fund base. Minimum promoter holding requirement is another set back as more often than not, a post Series B or Series C entity would have a diversified capital table where the initial subscribers’ holding could be much lesser than the required norms, with investors collectively or individually holding largest single block stakes in these companies. However, these companies might still not be matured enough to have met the eligibility criteria of the traditional IPO routes for accessing capital markets.

It is in this background that discussions around revising the listing criteria for Startups started at various levels. On 27 November and 28 November 2018, BSE and NSE, respectively, released the revised norms. We have provided the details of these below.

BSE Notice No. 20181127-23 dated 27 November 2018 on Introduction of BSE “StartUp Segment”.

The applicability seems to be for “Start-up Companies” in the identified sectors of “IT, ITES, Bio-technology and Life Science, 3D Printing, Space technology, E-Commerce, Hi- Tech Defense, Drones, Nano Technologies, Artificial Intelligence, Big data, Enhance/Virtual Reality, E-gaming, Exoskeleton, Robotics, Holographic Technology, Genetic Engineering, Variable Computers Inside body computer technology and other Hi-tech based companies”.

The criteria as notified by BSE are as follows:

  • Company should be registered as start-up with Ministry of Small and Medium Enterprises / Department of Industrial Policy and Promotion (MSME/DIPP). If not registered as Start-up with MSME/DIPP then the company’s paid-up capital should be minimum Rs. 1 crore.
  • Company should be in existence for a minimum period of 2 years on the date of filing the draft prospectus.
  • Preferably there should be an investment for a minimum of 2 years (at the time of filing draft prospectus) in the Company by:
    • Qualified Institutional Buyer or QIB[5]; or
    • Angel Investors/ Accredited Investors[6]
  • Company should have a positive net-worth.
  • Company should not have been referred to National Company Law Tribunal (NCLT) under Insolvency and Bankruptcy Code, 2016.
  • No winding-up petition must have been accepted against the Company by the NCLT.
  • None of the promoters/directors of the Company must have been debarred by any regulatory agency/agencies.

However, in addition to the above, compliance with LODR requirements and Chapter IX of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018 [SEBI (ICDR) Regulation] is also mandated, with respect to conditions applicable for listing of SME Companies, viz. minimum application size, number of allottees etc.

NSE Circular No. 2/2018 dated 28 November 2018 on Listing Criteria for the Technology Startups on the SME Platform.

As mentioned in the Circular, “In order to facilitate technology startups with potential growth business model, to raise equity and list on Stock Exchange, NSE has formulated a criteria for listing such technology startups. These listed companies shall be operating within the regulatory framework as specified under Chapter IX of SEBI ICDR Regulations, 2018 and LODR requirements as applicable to SME Exchange.”

The major criteria as listed in the Circular are as follows:

  • As conditions precedent adherence must have been made to the provisions of Securities Contract (Regulation) Act, 1956; Companies Act, 2013; SEBI Act, 1992 and regulations prescribed therein.
  • Company must be incorporated in India under the Companies Act.
  • The post issue paid up capital of the company (at face value) shall not be more than Rs. 25 crores.
  • There must be a 3 years of track record of either:
    • applicant seeking listing; or
    • promoters/promoting company, incorporated in or outside India with at least 3 years of experience in the same line of business and shall be holding at least 20% of the post issue equity share capital individually or severally; or
    • Proprietary / Partnership firm and subsequently converted into a Company
  • Annual revenue of at least Rs. 10 crores and the issuer must have shown growth of at least 20% in the past one year. (Annual growth may be exhibited in the form of number of users/revenue growth/customer base)
  • Net-worth of issuer must be positive.
  • Must meet one of the following criteria:
    • At least 10% of pre-issue capital to be held by QIBs as on the date of filing of draft offer document; or
    • At least 10% of its pre-issue capital should be held by a member of the angel investor network[7] or private equity firms and such angel investor network or Private Equity Firm should have had an investment in the start-up ecosystem in 25 or more start-ups their aggregate investment is more than 50 crores as on the date of filing of draft offer document.

The criteria of minimum QIB, angel network or private equity holding is interesting as this now could give a clear pathway to the Startups from very early stages on who to raise funds from. A diligence on the investors would also become necessary in such scenarios.

  • The Company must not have been referred to the erstwhile Board for Industrial and Financial Reconstruction (BIFR).
  • No petition for winding up must have been admitted by a court against the Company.
  • No material regulatory or disciplinary action by a stock exchange or regulatory authority in the past three years must have been brought against the Company.
  • Further the following disclosures will be required to be made:
    • Any material regulatory or disciplinary action by a stock exchange or regulatory authority in the past one year in respect of promoters/promoting company(ies), group companies, companies promoted by the promoters/promoting company(ies) of the applicant company.
    • Defaults in respect of payment of interest and/or principal to the debenture/bond/fixed deposit holders, banks, financial institutions by the applicant, promoters/promoting company(ies), group companies, companies promoted by the promoters/promoting company(ies) during the past three years. In this regard, an auditor’s certificate shall also have to be provided.
    • Litigation record, the nature of litigation, and status of litigation pending against the applicant company, promoters/promoting company(ies), group companies, or companies promoted by the promoters/promoting company(ies).
    • Status of criminal cases filed or nature of the investigation being undertaken with regard to alleged commission of any offence by any of the Company’s directors and its effect on the business of the company, where all or any of the directors of issuer have or has been charge-sheeted with serious crimes like murder, rape, forgery, economic offences etc.

As may be noted, both the BSE and NSE Notice and Circular refer to the applicability of the SEBI (ICDR) Regulations.

Under Chapter IX of the SEBI (ICDR) Regulations, 2018 certain common criteria, irrespective of the SME Exchange sought to be listed in must be met. These are:

  • the amount for general corporate purposes, as mentioned in objects of the issue in the draft offer document and the offer document should not exceed 25% of the amount being raised in the issue;
  • promoters must hold at least 20% of the post-issue capital of the Company. However, if the post-issue shareholding of promoter is less than 20% then alternative investment funds, foreign venture capital investors, banks, or public financial institutions may contribute to meet the shortfall in the minimum contribution. In any case, the promoter cannot hold less than 10% of the post-issue capital;

This brings back the concerns related to minimum promoter holding as discussed above.

  • the minimum promoters’ contribution as mentioned above shall be locked-in for 3 years; any promoter shareholding in excess of the above shall be locked in for 1 year;

This could be a major concern for QIBs given their internal constraints, for instance, fund exit requirements.

  • apart from promoters’ pre-issue capital, the entire pre-issue capital held by persons other than promoters shall be locked in for 1 year, however this lock in period will not apply to share allotted to employees, shares held in an ESOP trust, and equity shares held by a venture capital fund or alternative investment fund (categories I and II) or foreign venture capital investor, provided that such equity shares must be locked in for a period of at least 1 year from the date of purchase by such investor.
  • entering into an agreement with a depository for dematerialisation of its specifies securities already issued and proposed to be issued;
  • all existing equity share capital must be fully paid up or forfeited;
  • all securities held be promoters must be in dematerialised form;

SEBI’s intent to relax listing norms for Startups seems to be in the pipeline[8] and it remains to be seen whether the realities of the Startup ecosystem are considered and reflected in the revised norms.

Authors: Ms. Sohini Mandal and Mr. Avaneesh Satyang

[1]BSE Circular dated November 27, 2018: Available at https://www.bseindia.com/markets/MarketInfo/DispNewNoticesCirculars.aspx?page=20181127-23

NSE Circular dated November 28, 2018: Available at http://nseindia.com/content/circulars/SME39509.zip

[2] As defined and categorized under the Micro, Small & Medium Enterprises Development (MSMED) Act, 2006

[3] Yuvraj Malik, “NSE in talks with Sebi to tweak start-up listing norms”, as reported in https://www.livemint.com/Companies/giHdsfq86vtiPzngwlQSqL/NSE-in-talks-with-Sebi-to-tweak-startup-listing-norms.html on 2 March 2018

[4] As registered with DIPP under the Startup India Action Plan

[5] As defined in Regulation 2(ss) of the Securities and Exchange Board of India (Issue of Capital and Disclosure Requirements) Regulations, 2018: includes venture capital fund, alternative investment fund, scheduled commercial bank, foreign portfolio investor, et al.

[6] The concept of accredited investor is found in US securities law, which is similar to angel investors in India, only persons meeting the minimum net-worth criteria, professional experience and expertise requirements are recognised as accredited investors.

[7] By angel investor networks, the notice makes reference to angel funds, which are a sub-category of category-I alternative investment funds registered with SEBI, and angel investors are persons who propose to invest in angel funds and meet the net-worth, expertise, and experience criteria as specified under the SEBI (AIF) Regulations, 2012.

[8] PTI News, “SEBI To Relax Listing Norms For Startups, Rename it ‘Innovators Growth Platform’”, as reported in https://www.bloombergquint.com/markets/sebi-to-relax-listing-norms-for-start-ups-rename-it-innovators-growth-platform#gs.U99GjHQ on 9 December 2018

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

Enhanced disclosure requirements for Credit Rating Agencies

SEBI vide its circular dated 13 November 2018 has tightened the norms for Credit Rating Agencies (CRAs) by enhancing the levels of disclosures required to be made by the CRAs under the SEBI (Credit Rating Agencies) Regulations, 1999 (CRA Regulations). As per the recent circular, the following changes have been brought about:

  1. Under an earlier circular dated 1 November 2016, SEBI had prescribed the standard format for press releases put out by CRAs regarding rating action. Now, specific disclosures must be made in the press release;
    • with respect to rating factors where support from a parent/group/government entity is expected, the name of such entities and the rationale for such expectation to be mentioned.
    • when subsidiaries or group companies are consolidated to arrive at a rating, the names of all such companies, along with the extent of consolidation and rationale for the same to be disclosed.
  2. The above-mentioned press release must also contain a specific section on ‘Liquidity’ with parameters like liquid investments or cash balances, access to unutilised credit lines, liquidity coverage ratio, adequacy of cash flows for servicing maturing debt obligation, etc.
  3. Disclosure of any linkage to external-support for meeting near term maturing obligations must also be made by CRAs.
  4. CRAs may review their rating criteria with regard to assessment of holding companies and subsidiaries in terms of their inter-linkages, holding company’s liquidity, financial flexibility and support to the subsidiaries, etc.
  5. In monitoring of repayment schedules, CRAs to analyse the deterioration in the liquidity conditions of the issuer and also take into account any asset-liability mismatch.
  6. CRAs may treat sharp deviations in bond spreads of debt instruments vis-à-vis relevant benchmark yield as a material event.
  7. CRAs to publish their average one-year rating transition rate over a 5-year period, on their respective websites, calculated as the weighted average of transitions for each rating category, across all static pools in the 5-year period. This shall be adhered during the half-yearly internal audit of the CRAs under the CRA Regulations.
  8. CRAs to furnish data on sharp rating actions in investment grade rating category to Stock Exchanges and Depositories for disclosure on website on half-yearly basis, within 15 days from the end of the half-year (31st March/ 30th September).

Link to source:

https://www.sebi.gov.in/legal/circulars/nov-2018/guidelines-for-enhanced-disclosures-by-credit-rating-agencies-cras-_40988.html

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.