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  • Ayush Kumar, Vanshika Manglani

SEBI’s Consultation Paper on Unliquidated Investments- A Step in the Right Direction?

[Ayush and Vanshika are students at Hidayatullah National Law University.]


Recently, the Securities Exchange Board of India (SEBI) released a consultation paper dated 12 January 2024, exploring the possibilities of doing away with the liquidation scheme and allowing the AIFs to enter into a ‘dissolution period’ to deal with unliquidated investments. Moreover, the paper also suggests extending this option to the venture capital funds (VCFs) by way of facilitating their migration to the AIF regime.


This article aims to evaluate the potential benefits and drawbacks of the proposed framework while delving into the procedural intricacies, disclosure requirements and impact on the financial market.


Background


The introduction of alternate investment funds (AIFs) in the Indian landscape has been very instrumental in streamlining the challenges faced by investors like low returns, high volatility, suboptimal risk management and market stagnation. However, SEBI, in one of the orders, highlighted that its lack of authority to extend the tenure of the schemes has resulted in bypassing of the regulations at many occasions, owing to which SEBI’s recent amendment to the SEBI (AIF) Regulations 2012 dated 15 June 2023 introduced the concept of ‘liquidation scheme’ aiming to resolve the problem of regulatory defaults. Though the amendment seemed pragmatic and welcoming at first, the investors had a hard time dealing with the tedious process of winding up the original scheme let alone launching a new scheme.


Overview of the Consultation Paper


In a nutshell, the consultation paper suggests three amendments. These are as follows:


First, the paper seeks to replace Regulation 29A (liquidation scheme) of the SEBI (AIF) Regulations 2012 with a framework consisting of a dissolution process, which would be a tenure beyond the liquidation period for fully liquidating the unliquidated investments. The proposal mandates a positive consent of 75% of the investors by value for opting the dissolution process. Moreover, bids are to be arranged for a minimum of 25% of the value of the unliquidated investments. The dissenting investors are to be provided an exit option out of the 25% bid arranged by the AIF manager. The tenure of the dissolution period is restricted to that of the original scheme. Moreover, the AIF is also prohibited from indulging in further new investments.


Second, the proposal aims to safeguard the schemes which have already expired or would be expiring within one month from the date of notification relating to this subject matter. It suggests a one-time liquidation period (one year) beginning from the date of aforementioned notification. In this period, AIFs are to either fully liquidate their investments, make an in-specie distribution, or avail the option of dissolution process.


Third, the consultation paper proposes facilitating the migration of VCFs to the AIF regime thereby providing them with the benefit of the dissolution process. Prior to this, VCFs were given the option to re-register under the AIF regulations subject to two-third approval of their investors. Moreover, SEBI received several representations for extending the tenure of VCFs. However, there exists no provisions in the VCF regulations for extension of tenure. As a result, the VCFs functioning beyond the tenure is in violation of the VCF regulations. In view of these issues, there existed a need for a smoother migration of VCFs to AIFs. On this account, the consultation paper proposes a separate sub-category under category I- VCFs called ‘migrated VCFs’. The proposed framework facilitates smooth and cost-effective migration and also prescribes for additional benefits which shall be made available to the migrated VCFs.


Critical Analysis


The consultation paper aims to provide flexibility to AIFs with respect to their unliquidated investments by allowing it to opt for a dissolution process as against launching a new liquidation scheme solely for the purpose of liquidation. The consultation paper has both positive and negative aspects. The following are discussed hereunder:


Potential benefits


Saving costs


When an AIF launches a liquidation scheme, it would be required to pay a certain amount. Additionally, there will be some compliance burdens. This will cast additional burden on the fund which is currently suffering due to lack of liquidity. Thus, dissolution process can prove to be a good alternative and help in saving the time, effort and cost incurred on launching a new scheme.


Already expired schemes


The amendment to the AIF regulations which introduced the liquidation scheme clearly stipulated that the same shall not be applicable to the schemes which have already expired. However, the consultation paper extends the flexibility to the schemes which have expired before 15 June 2023 or would be expiring within a month of the notification in this regard. This is a step in the right direction as many schemes that expired with unliquidated investments during the COVID-19 pandemic now have an option to liquidate them.


Tax implications


The transfer of unliquidated investments into a liquidation scheme would come within the ambit of capital gains and thus liable to taxation. However, the dissolution process involves no such transfer and hence would not be subjected to tax payment.


Extending flexibility to VCFs


The consultation paper stipulates that the dissolution process shall be applicable on VCFs as well. In the opinion of the authors, this is a welcome step as it aims to encourage funding in the early-stage companies. It is pertinent to note that previously the option to avail liquidation scheme was not extended to these VCFs. As a result, they had to fully liquidate the investment during their liquidation period which is only 3 months as compared to AIFs which have a duration of 12 months. Thus, the new framework put forth by SEBI is commendable as it provides for a smooth and simple migration of VCFs to AIF regulations so that they can avail the benefit of dissolution process.


Drawbacks


Mandatory in-specie distribution


The consultation paper clearly stipulates that in case the AIF scheme fails to sell the unliquidated assets until the expiry of the dissolution period then they have to mandatorily distribute the investments in-specie to the investors. Now, the problem with in-specie distribution is that it does not take into account the practical challenges while making such a distribution. This will be even more difficult in the case of foreign investors as the same would require prior approval from RBI thus increasing the compliance burden. Furthermore, a foreign investor is not entitled to hold every type of security which an AIF holds and thus would make the distribution illegal. The authors, therefore, recommend doing away with this mandate as it casts an additional burden upon the fund managers, and they can be penalized for the same.


Securing bids for dissenting investors


The paper stipulates that the AIF must provide an exit to the dissenting investors by arranging a bid for a minimum 25% of the value of unliquidated investment. This could prove to be challenging. The time period for the same is before the expiry of the liquidation period and the same could prove to be too less a time for arranging a bid. It is also possible that the amount generated from a bid is not sufficient to provide an exit to the dissenting shareholders. Moreover, if the investors feel that they are getting more value on bid, they might choose to exit and make it unviable to secure a 75% consent. In the opinion of the authors, there should be certain clarity and relaxations with respect to the securing of bid as it poses a lot of risks.


Compliance burden on fund managers


The managers are required to manage the whole of unliquidated investments and undertake all the activities incidental thereto. If they fail to comply with the same, the penalties shall be imposed upon them. Chapter IV of the regulations prescribe for general obligations and disclosures for an AIF. Regulation 20(5) clearly stipulates that the decisions taken with respect to an AIF are in compliance with the applicable laws. In the adjudication order in the matter of Ingrowth Capital Fund I, SEBI imposed penalties on the manager of the fund for non-compliance with the aforesaid regulation. The authors, therefore, recommend giving certain relaxations to the fund managers during the dissolution process so that they can sell off the unliquidated investment at their best value.


Conclusion


The framework for dissolution process has certain benefits in terms of providing greater flexibility and saving costs but there are certain aspects which demand clarity. SEBI must provide directions with respect to securing a bid and the potential risks associated with the same. The mandate of in-specie distribution should also be relooked to be in compliance with the other foreign exchange laws.

The consultation paper is a step in the right direction in so far as it promotes investor protection. The new framework introduced by the SEBI is a suitable alternative to the liquidation scheme which suffered from certain drawbacks, but the true potential can only be assessed after due implementation by the concerned authorities.

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