SEBI's Proposals to Plug Loopholes in AIF Regime

On January 19, 2024, the Securities and Exchange Board of India (“SEBI”) published a consultation paper[i] which sets out proposals aimed at enhancing trust and promoting ease of doing business in the Alternative Investment Fund (“AIF”) ecosystem.

SEBI, in the consultation paper, noted that there have been several instances of AIFs being structured to circumvent existing financial sector regulations. The paper records that a majority of the instances of circumvention involved either a single investor or investors of the same group. Instances in which such circumvention occurred were flagged in the consultation paper and are summarised below:

  1. Practice of evergreening of loans

    The subject of a recent notification of the Reserve Bank of India (“RBI“)[ii], finds mention in the consultation paper as well. The RBI noted that certain AIFs systematically funded a regulated lender’s borrower, and in return, the lender would subscribe to the units of an AIF. This would have the effect of lenders avoiding appropriate disclosures and regulatory requirements under RBI’s regulations. The paper acknowledges the steps taken by the RBI in this regard but points to the importance of ensuring that such practices do not recur in other forms.

  1. Setting up of AIF to circumvent FEMA rules

    SEBI noted that certain AIFs were set up for the sole purpose of circumventing the provisions relating to downstream investment as stated in the Foreign Exchange Management (Non-Debt Instruments) Rules, 2019.[iii] Attention was drawn to cases involving the appointment of Indian managers or sponsors by AIFs set up by foreign investors, wherein the AIFs were used to invest in an industry sector beyond the limit prescribed or in sectors prohibited for foreign direct investment.

  1. AIFs with single or very few investors availing benefits under QIB regulations

    SEBI noted that certain AIFs with a single or very few investors invested in multiple initial public offerings under the Qualified Institutional Buyer (“QIB”) quota, and thus were able to avail benefits available to QIBs under the SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018. These AIFs would otherwise have been ineligible for QIB status on their own.

Proposed Approach

SEBI seeks to approach these issues pragmatically. At the outset, SEBI notes in the consultation paper that the regulatory concerns ought to be addressed in a proportionate and risk-based manner. Secondly, this must be done simultaneously while facilitating ease of doing business and ease of compliance. It is essential to note that any proposed intervention on SEBI’s end does not seek to take away the AIFs’ flexibility to carry out genuine and legitimate investments. Some of the significant proposals are summarised below:

  • Setting up a Standards Forum for AIFs (“SFA”) for implementing the AIF regulations by formulating relevant standards.
  • Introducing a general obligation for AIFs, and their managers and key managerial personnel, to ensure that they do not operate in any way which would circumvent the regulations of any regulator.
  • SEBI has proposed moving forward in line with the “trust, but verify” principle to ensure compliance and adherence to the AIF regulations. This will be done by the standards set by the industry, in consultation with SEBI.
  • In furtherance of a previous SEBI circular[iv], the paper notes that managers of AIFs have the ability to either not make the investment or exclude the investment of an investor if the participation of such an investor leads to a violation of any regulation.

Keeping in mind the above, SEBI proposes to insert a new provision in Chapter IV of the SEBI (AIF) Regulations, 2012.[v] The said Chapter deals with the general obligations and responsibilities of an AIF. The proposed provision essentially places an obligation on the manager and key managerial personnel of an AIF to undertake necessary due diligence on their investors and investments, to prevent any circumvention of the regulations of any financial sector regulator. A proviso is also sought to be added, which states that the manager of an AIF shall either not make an investment or exclude the particular investor from the investment if it is found that the investment leads to circumvention of any existing regulations.

Conclusion

Following RBI’s clampdown on lenders and AIFs bypassing its regulations, SEBI’s proposal seeks to further prevent industry participants from circumventing the regulations of any regulator through novel modi operandi. The proposal marks a positive step in the regulatory environment governing AIFs, as it seeks to balance the interests of legitimate investments in the industry, with proper compliance with all regulations. Additionally, with the proposal putting forth the idea of “trust, but verify”, industry participants will themselves be responsible for setting up suitable standards of reporting and operating, as may be formulated by the SFA.

Following RBI’s clampdown on lenders and AIFs bypassing its regulations, SEBI’s proposal seeks to further prevent industry participants from circumventing the regulations of any regulator through novel modi operandi. The proposal marks a positive step in the regulatory environment governing AIFs, as it seeks to balance the interests of legitimate investments in the industry, with proper compliance with all regulations. Additionally, with the proposal putting forth the idea of “trust, but verify”, industry participants will themselves be responsible for setting up suitable standards of reporting and operating, as may be formulated by the SFA.

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