SEBI AIF Amendment Regulations 2022: Empowering Investors at the Cost of Weakening Managers' Role?
[Aditya is a student at NALSAR University of Law, Hyderabad.]
Alternative investment funds (AIFs) are private pooled investment vehicles that maintain a highly diversified portfolio and lock-in funds for more extended periods, as opposed to other investments like mutual funds. AIFs incorporated or established in India are regulated by the Securities and Exchange Board of India (Alternative Investment Funds) Regulations 2012 (AIF Regulations) and are required to be registered with the Securities and Exchange Board of India (SEBI). Subject to these, AIFs raise capital by pooling large volume investments from Limited Partners, centrally managed by a General Partner— the Manager, who creates a risk profile and plans recurring investments.
AIFs cater to sophisticated investors like high-net-worth individuals and institutional investors. As AIFs invest in unlisted securities and unsecured obligations to derive maximum profit percentages for their partners, they are prone to frequent inadequacies of funds or illiquidity. All too often, this exposes investors to mismanagement, diversion of funds for unintended purposes, or even money laundering. Similar incidents include the SEBI Action against Peninsula Brookfield India Real Estate Fund in January 2022. The primary reason for this could be the leeway granted by the AIF Regulations to the Managers.
Identifying these lacunae, SEBI, through the SEBI (AIF) (Fourth Amendment) Regulations 2022 (Amendment Regulations), has imposed limits and penalties to curb the degree of imminent mismanagement of funds. This was followed by circulars clarifying the same, including the circular on AIF Guidelines for management dated 17 November 2022, and on Foreign Investment in AIFs dated 9 December 2022. This article discusses the Amendment Regulations and their implications, and makes suggestions that could better tackle the practical issues faced by AIFs.
IMPLICATIONS OF THE AMENDMENT REGULATIONS
At first glance, it is evident that the Amendment Regulations protect individual investors' rights by curbing the amount of leeway granted to Managers, which is welcome. However, a deeper analysis reveals that the bounds placed on Managers could adversely impact investment strategies and the commercial acumen of Managers.
Ring-Fencing of Assets
Under the AIF Regulations, an AIF was at liberty to exchange capital across multiple schemes set up by it and placed under the control of the same Manager. Therefore, investors were aggrieved by the maladministration of their investments, which were often used to cover losses in other schemes. The Amendment Regulations inserted Regulation 20(16), which requires Investment Managers to segregate AIF schemes from one another. The amendment seeks to ring-fence assets, liabilities, bank accounts, and securities accounts of distinct schemes by mandating a clear demarcation between the sub-funds so that investors have a clear understanding of allocations during the lock-in period.
This is a welcome move for foreign investors who wish to ensure they are not exposed to potential litigation in respect of the assets of the scheme in which they invest. Furthermore, the differentiation of fund accounts according to the scheme will also be beneficial from a taxation point of view to the Managers, investors, and authorities, as gains out of each fund account could be taxed proportionately, rather than managers diverting capital across funds to avoid taxes.
SEBI has also amended the AIF Regulations to curb timelines for the first close of funds, which must be done within one year. Earlier, funds were free to lock in large investments for years on end, resulting in enormous losses for the investors but profiting the Manager due to the fee-based services payment structure. Investors, therefore, had no control over when they could recover profits. The Amendment Regulations seek to rectify this loophole by mandating an ascertainable timeline, providing some transparency to investors and regulatory authorities.
While this amendment is aimed at safeguarding investments and providing clarity to investors regarding the tenure of the scheme, it could adversely affect small-time fund Managers who are just venturing into the market and adjusting to the recessionary market, many of whom occasionally have collapsed under pressure, as can be seen from the experience report by an early seed Venture Capital Founder. AIFs also try to defer the launch of their schemes to adhere to various compliances or conduct due diligence studies to assess risks. Putting a blanket timeline for all AIFs would erode investor confidence as risk assessment would be compromised to meet targets. Furthermore, credit assessments would fall, and AIFs would fail to obtain leverage through debt financing.
Where SEBI has erred in its analysis is placing AIFs at par with mutual funds, which are considerably more regulated and maintain lower risks by raising funds from multiple investors but in smaller chunks. AIFs, like hedge and venture capital funds, typically lock in their investors for a significant period so that risk profits are calculated efficiently. Mutual funds do not undertake such complex strategies and mostly peg the investments to indexes or stocks. Furthermore, it could be said that SEBI is committing a fatal mistake by implementing these timelines on existing funds as well, which will undoubtedly tumble under the pressure of extensive compliance requirements as opposed to the traditionally deregulated AIF marketplace with maximum managerial discretion in the control of fund capital and addition of new partners.
Restrictions on Managers from Withdrawal of Contributions
According to AIF Regulations, a fund must have a minimum corpus of INR 20 crores (INR 10 crores for angel funds). Earlier, it was usual practice for Sponsors and Managers to make investment commitments in order to inflate the holdings and project a portfolio that exceeds the minimum requirement. This would immediately be followed by their exit after the close. Through its circular, SEBI has constrained Managers from reducing, withdrawing, or transferring their commitments after the first close to ensure they do not inflate numbers during fundraising to meet the corpus criteria.
Again, this impacts ventures by small-scale Sponsors, who might need to make personal contributions to meet the stringent thresholds. There may not necessarily be any commercial viability in holding onto Manager's funds, and the discretion of deciding the same must be left to their commercial wisdom.
Change of Control
Through the amendments to Regulation 20(12) and (13) of the AIF Regulations, SEBI has effectively given a new meaning to 'change of control' in an AIF, requiring prior approval from SEBI and a separate application accompanied with fees. Earlier, when an AIF sought to change its Sponsor and Manager, a majority vote by investors facilitated a swift change of management. This was used to bypass registration requirements as prospective AIFs could acquire an inactive AIF and replace its management instead of undergoing the registration process themselves. However, it may be argued that just as the laws governing companies allow for a determining vote by its members, decisions regarding the administration of funds must be left to the investors and not curbed by regulatory oversight.
As per the amendment, a fund would have to re-register and pay the hefty fees of INR 5 lakhs, INR 10 lakhs, or INR 15 lakhs, depending on the fund. This levy is therefore concerning as it could detrimentally impact the Managers' performance and deter investors from voting to change control for better management.
COMMENTS AND SUGGESTIONS
The analysis undertaken above indicates that the Amendment Regulations could fail to achieve the ideals behind them while also unfairly impacting Managers who have yet to make themselves a name in the market. SEBI and the Hon'ble Supreme Court have emphasized in the Franklin Templeton Mutual Fund Case the fiduciary duty of a Manager owed to investors. The order also stated that only a free and fair manager could allocate funds and make profits for its investors. These amendments would then do little to nothing to remedy such situations. Therefore, the author proposes the following suggestions that could combat the inadequacies of the Amendment Regulations.
Instead of ring-fencing, SEBI could scrutinize fund documents, i.e., the Private Placement Memorandum, and disallow clauses that could contractually limit the operation of the regulations. This would ensure practical compliance. Furthermore, to ensure that there is no tax avoidance or evasion, PAN identifications based on individual fund accounts must be enforced.
Currently, SEBI considers an AIF to be a separate legal entity under which different schemes are formulated through separate memorandums. Separation of schemes from the umbrella fund could ensure that intra-fund diversion of capital is checked effectively.
Clamping down on the investment management skills of Managers would do more harm than good. Regulation on closing down dates could hamper performance to a large extent. It would discourage funds from making long-term investment strategies like credit swaps, which are capital-heavy and require a hedge fund's risk profile.
SEBI also needs to simplify the process for interested investors to request a change in management. In order to safeguard investors of acquired AIFs who have undergone a change of management, there must be stricter guidelines clarifying the position of earlier investors in the new AIF post-change.
While these revised amendments are undoubtedly a welcome move ensuring benefits and rights to the investors, the above-cited ambiguities, along with over-regulation, might render them counter-productive.