REIT, InvIT Subordinate Units: Examining SEBI’s Additional Proposals

On 10 January 2024, the Securities and Exchange Board of India (“SEBI”) released a consultation paper, titled “Additional Proposals Regarding Framework for Issuance of Subordinate Units–REITs and InvITs”.[i] This paper adds on to the proposals suggested by SEBI in its consultation paper on the same subject, issued last month (“2023 Proposals”).[ii] The latest consultation paper by SEBI suggests substantial changes to the regulatory framework regarding subordinate units issued by Real Estate Investment Trusts (“REITs”) or Infrastructure Investment Trusts (“InvITs”), which have been discussed in this article.

Background

The existing framework governing REITs and InvITs provides for all unit holders to have equal rights, as regards voting rights and right of distribution. However, it is permissible to issue “subordinate units” exclusively to sponsors or their associates. Sponsors under the SEBI (REIT) Regulations, 2014, are those persons who set up the REIT.[iii] The subordinate units issued to sponsors have inferior voting rights or any other rights compared to ordinary units.[iv] The consultation paper, thereby, proposes changes to three aspects linked to the issuance of subordinate rights by REITs and InvITs. These are (i) incorporating a ceiling on subordinate units which can be issued to sponsors or their associates; (ii) bringing uniformity in the nature of rights conferred by subordinate units; and (iii) dealing with changes in terms and conditions of the subordinate units after issuance.

Additional Proposals

The first proposal deals with the specification of a ceiling (in percentage) on subordinate units issued by REITs or InvITs. The paper acknowledges that subordinate units are primarily issued to bridge the difference in the valuation of an asset, as perceived by the sponsor and the REIT or InvIT. This point is explained with an illustration, wherein the sponsor’s asset valuation and the REIT’s asset valuation have a difference of INR 100 crores. In such a case, the REIT can issue subordinate units for this amount. The terms of issuance of such REITs may also provide for the conversion of the subordinate units into ordinary units after 5 years if specific pre-decided performance benchmarks are satisfied.

The problem identified by SEBI with the existing framework is two-fold. Firstly, if the performance benchmarks are met, the units will automatically be converted into ordinary units, resulting in the benefits of capital appreciation accruing only to the sponsor. Secondly, the conversion to ordinary units would necessarily dilute the holding of the existing unit holders of the REIT or InvIT. Keeping this in mind, the proposal seeks to limit the issuance of subordinate units at the time of acquisition to 10% of the price at which the asset is acquired.

The second aspect covered in the paper deals with bringing uniformity in the nature of rights that subordinate units confer on the sponsors or their affiliates. Owing to the lack of clarity on what kind of rights the subordinate units confer on the unit holders, it is proposed that the subordinate units shall only carry inferior voting rights, inferior distribution rights, or both. In addition to this, REITs will not be permitted to issue multiple classes of subordinate units. This means that an REIT would not be able to issue one class of subordinate units with 40% distribution rights and another class with 70% distribution rights.

The third aspect revolves around the permissibility of changing terms and conditions after the issuance of the units. The 2023 Proposals envisaged a one-time extension of the entitlement date, which is the date on which the subordinate units get converted into ordinary units if the required benchmarks are satisfied. However, this one-time extension of the entitlement date was subject to stringent conditions. Recognising the importance of the terms and conditions of the issuance of the subordinate units, which include inter-alia the performance benchmark agreed upon for conversion into ordinary units, SEBI proposes to prohibit any amendment to the terms and conditions of the subordinate units after their issuance. 

Conclusion

SEBI’s consultation paper seeks to expand on the 2023 Proposals and make it even more comprehensive and detailed. The proposals aim to prioritise the interests of the individual unit holders of the REITs and InvITs, especially retail investors. This is evident from the consultation paper, with many of the proposed changes being put forth with the intention of putting investors or unit holders on the same pedestal as the sponsor, a case in point being the capped limit proposed for issuance of subordinate units so that the holding of the investors is not diluted by a sizeable margin. Additionally, the proposals concerning the nature of rights emanating out of subordinate units, and prohibition on changing vital terms and conditions after the issuance of the units, are an effort to bring in much-needed uniformity and clarity to the framework for issuance of subordinate units by REITs and InvITs.

SEBI’s proposals aim to prioritise the interests of the individual unit holders of the REITs and InvITs, especially retail investors. This is evident from the consultation paper, with many of the proposed changes being put forth with the intention of putting investors or unit holders on the same pedestal as the sponsor, a case in point being the capped limit proposed for issuance of subordinate units so that the holding of the investors is not diluted by a sizeable margin. Additionally, the proposals concerning the nature of rights emanating out of subordinate units, and prohibition on changing vital terms and conditions after the issuance of the units, are an effort to bring in much-needed uniformity and clarity to the framework for issuance of subordinate units by REITs and InvITs.

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