SEBI Circular

SEBI Mandates Due Diligence of AIF Investors

The Securities and Exchange Board of India (SEBI) published a thorough master directive for Alternative Investment Funds (AIFs) on May 7, 2024, which included important rules and operating recommendations.

The circular emphasises openness and simplicity of compliance while introducing a simplified online filing mechanism for reports and applications about the AIF. Additionally, it requires that a Private Placement Memorandum (PPM) with fee schedules and compliance requirements be filed through a merchant banker registered with SEBI. It also provides a strong foundation for AIF operations within India by making clear the investment standards, registration procedures, and responsibilities of sponsors, managers, and trustees.

Shedding Light on SEBI

As the primary regulator of the Indian securities market, the Securities and Exchange Board of India (SEBI) is responsible for upholding investor trust, preserving market integrity, and encouraging the capital markets’ orderly expansion. For India’s financial ecosystem to operate effectively and transparently, it must adopt a proactive regulatory strategy and priority investor protection.

To guarantee transparency and investor protection, as well as to implement extensive changes in the capital market, the securities industry saw a major turning point with the founding of SEBI.

Before SEBI’s establishment, the Controller of Capital Issues (CCI) was principally in charge of regulating the Indian securities market. However, SEBI was established in response to the evolving financial sector and the demand for a more specialised and independent regulatory organisation.

The SEBI Act of 1992 gave SEBI independent authority over the securities market, enabling it to oversee and control it extensively. Over time, it has seen several improvements and adjustments to suit the changing needs of the financial sector. To strengthen investor trust, avoid market manipulation, and encourage good governance, it has implemented several rules and recommendations.

What are the Objectives of SEBI?

The primary objectives of SEBI are:

• Investor protection: Protecting the interests of shareholders in the securities industry is SEBI’s top priority. It aims to safeguard investors from dishonest and unfair commercial practices and to guarantee that they get current and precise details about the securities that they purchase.
• Securities market development and regulation: SEBI has been given the task of overseeing and advancing the securities industry. To support equitable and open practices, it creates rules and regulations that control different market players, including stock exchanges, brokers, and publicly traded companies.
• Insider trading prevention: The goal of SEBI is to stop insider trading, which is the practice of those who have access to confidential information using it to their advantage to influence prices unfairly. The goal of SEBI’s insider trading rules is to keep the playing field level for all traders.
• Code of conduct and fair practices promotion: SEBI encourages the securities market to operate with a high degree of integrity and fair practices. It creates an atmosphere where market operations are carried out ethically and openly by enforcing a code of conduct for all market participants.
• Prohibition of unfair and deceptive business practices: SEBI has the authority to take action against deceptive and deceptive business practices in the securities industry. To preserve market integrity and shield investors from market manipulations, it conducts investigations and implements remedial actions.
• Creation of a secondary market: Through the introduction of initiatives and reforms aimed at improving trading efficiency, transparency, and liquidity, SEBI has played a pivotal role in the growth of the secondary market in India. Its goal is to foster an atmosphere that will support the expansion of the capital market.

Functions of SEBI

To accomplish its main goals of protecting investors, regulating the market, and fostering the growth of the securities industry, the SEBI carries out a wide range of tasks. The principal roles consist of:

• Defending Indian investors’ interests in the securities industry.
• Promoting the expansion and smooth operation of the securities market.
• Controlling transactions in the securities market.
• Giving market players like investment counsellors, stockbrokers, and portfolio managers a platform.
• Monitoring the operations of foreign investors, securities custodians, credit rating agencies, depositors, and other market participants.
• Imparting knowledge to investors about the intermediaries involved in the securities markets.
• Stopping unfair and dishonest behaviours in the securities industry.
• Supervising share purchases and corporate takeovers.
• Using research and development to maintain the securities market’s efficiency and relevance.

What is an Alternative Investment Fund (AIF)?

A private pooled investment vehicle known as an Alternative Investment Fund, or AIF, makes investments in alternative asset classes such as derivatives, real estate, commodities, hedge funds, private equity, and hedge funds. Because the investment amount in AIFs is significantly bigger, HNIs (high net-worth individuals) and institutions typically invest in them.

The Securities and Exchange Board of India, or SEBI, oversees AIFs. An alternative investment fund (AIF) may be established as a trust, corporation, limited liability partnership, or corporate entity by the SEBI (Alternative Investment Funds) Regulations, 2012. On the other hand, a large number of AIFs that were recently incorporated with SEBI are trusted.

Categories of Alternative Investment Funds (AIFs)

According to SEBI rules, AIFs (Alternative investing Funds) are divided into three groups according to their investing approach and goals.

• Category I AIFs: These funds mainly make investments in infrastructure, SMEs, start-ups, early-stage businesses, social initiatives, and other economically or socially beneficial areas. The government provides incentives for these monies.
• Category II AIFs: Invested in funds that do not fit into either Category I or III are Category II AIFs, which include debt funds and private equity funds. Other than financing daily operations, these funds usually make loans and invest in a variety of instruments.
• Category III AIFs: To provide short-term returns, these funds use sophisticated trading techniques including hedging and leverage. This group includes hedge funds and private investment in public equity (PIPE) funds.

For high-net-worth people seeking alternatives to traditional assets, AIFs provide a variety of investing options.

Mandatory Due Diligence for AIF Investors

The Securities and Exchanges Board of India (SEBI), the official sectoral regulator for AIFs, provides and administers the SEBI (Alternative Investment Funds) Regulations, 2012, which govern the establishment and incorporation of alternative investment funds (AIFs), which are funds functioning as privately pooled investment vehicles.

The goal of AIFs is to aggregate assets from different investor types and use those funds to invest by the specific AIF’s predetermined policy. According to recent studies, interest in AIFs as an investment vehicle has grown, with forecasts showing a more than 40% increase in AIF financing year over year from 2021 and a rise in the number of AIFs registered in the nation. To make sure that the regulatory system can handle this additional burden and safeguard investors’ interests, SEBI has implemented many amendments to the legislation about AIFs in recognition of the growing popularity of these financial instruments in India.

Furthermore, SEBI established a specialised class of funds called Large Value Funds for Accredited Investors (LVF) in recognition of the fact that more established investors do not need strict regulatory oversight, particularly regarding governance practices. According to the SEBI guidelines regarding LVFs dated June 24, 2022, accredited investors can pool their money up to INR 70,00,00,000, to provide a light-touch regulatory regime for investors who meet the requirements. The SEBI recommendations of June 24, 2022, allow the following important relaxations:

• Exemption from using a merchant banker to file a PPM with SEBI. Following notification to SEBI in the form of an undertaking, LVFs may begin schemes;
• Duration extensions beyond two years are contingent upon the provisions of the contribution agreement, other fund papers, and any additional requirements that SEBI may sometimes specify.

An Explanation of SEBI’s New Due Diligence Rules

Using a circular dated November 17, 2022 (Circular), SEBI has established applicable regulatory fees for any change in control or the manager or sponsor of an AIF, as well as guidelines for amending specific AIF Regulations provisions regarding the declaration of the first close of an AIF scheme.

The Circular stipulates that the AIF schemes must announce their first close or the moment at which the scheme receives the initial investor commitments, within 12 (twelve) months of the date on which SEBI communicated the scheme’s Private Placement Memorandum (PPM) for the scheme’s records.

The first closing of existing AIFs must be announced by November 16, 2023, unless it has already been accomplished. Additionally, according to the standards, the first closure for Category III open-ended AIFs is the conclusion of their first offer period. Existing AIF schemes that haven’t declared their first closure and whose PPMs were submitted 12 months before the Circular are obliged to submit the updated PPM to SEBI within the prescribed format.

Furthermore, the AIF will have to submit a fresh application before the plan may be launched if the initial closure is not notified in the allotted period. The Circular further stipulates that the first LVF closure must be announced within a year of the AIF’s registration being granted or the scheme’s PPM being filed with SEBI, whichever comes first. The first closure for existing LVF projects must be announced within a year after this circular’s date.

What’s More in the Circular?

The Circular also required that the tenure be determined starting on the day the first closure is announced in the event of close-ended projects. Additionally, before the announcement of its corresponding first closure, an AIF has the right to change a close-ended scheme’s term at any point. Investors have the option to withdraw their commitment to the plan or change their commitment before the announcement of the first closure.

Existing closed-ended schemes that have not yet announced their first close are required under the rules to adhere to the schedule specified in their PPMs. In certain situations, the scheme managers are not free to change the timetable from what is previously specified in the PPM.

To make sure that only legitimate parties come forward, the Circular further stipulates that an application fee would be assessed based on the category and subcategory of the relevant AIF in the event of a change in management or sponsor. The fee must not be transferred in any way to the AIF’s investors.

The corresponding amount of a single administrative charge must be assessed when there is a concurrent change in management or sponsorship and control. In the following situations, the fee will not be assessed if the sponsor changes or their control changes:

When the management takes over or replaces the sponsor; if AIF has more than one sponsor, the sponsor(s) may leave.

According to SEBI, this fee must be paid within 15 (fifteen) days of the proposed manager/sponsor change or change in control of the manager/sponsor taking effect. Fees will only need to be paid in cases where the relevant scheme has not announced the first close for pending applications for changes in management, sponsorship, or control. The rules further provide that prior SEBI clearance for changes in management, sponsorship, or control described by this guideline shall be valid for six months after the date of SEBI approval notification.

SEBI FAQs on Registration of AIFs

To provide a uniform guide to the registration process, SEBI introduced frequently asked questions (FAQs) on the registration of AIFs on November 3, 2022. The FAQs specify that to register an AIF, an applicant must apply through the SEBI portal (“http://www.siportal.sebi.gov.in/”) and submit an application for registration, which can be tracked through the portal after submission to determine its status.

The FAQs also specify the necessary application fees that must be paid for registration purposes, depending on the category of the AIF; once accepted, the AIF is registered and the applicant receives a certificate of registration.

In addition to the other details listed in the FAQ, the papers listed in the First Schedule of SEBI (AIF) Regulations, 2012 are necessary for a successful application. These include:

1. application in the format of Form A;
2. Depending on the legal structure of the AIF, an undertaking must be made by the applicant’s trustee, board of directors, or designated partners (name of the proposed AIF) in the manner specified in Annexure A of the FAQ;
3. evidence of incorporation and the applicant’s address;
4. information about the AIF’s investment manager, sponsor, and trustee;
5. financial details of the sponsor or investment manager;
6. scheme papers and a certificate of due diligence in the format specified in the PPM and FAQ’s Annexure B;
7. information about the sponsor’s and investment manager’s partners and shareholders
8. Whether the relevant authorities have registered sponsors and investment managers with more than 20% of the partnership interest or voting rights
9. Information must be supplied on important managerial personnel, controlling entities, or individuals;
10. details about the applicant’s and sponsor’s or investment manager’s group firms; important investment team members;
11. The applicant must provide disclosures by the SEBI (AIF) Regulations, 2012.

Key Takeaways for Investors

When onboarding investors to an AIF, managers are expected to “ensure” the following, according to the Circular:

1. AIF investors are citizens of a nation whose securities market regulator has either signed an international Memorandum of Understanding with SEBI or a multilateral Memorandum of Understanding with the International Organisation of Securities Commissions (the “IOSCO Condition”). As it happens, the majority of jurisdictions that invest in India comply with the IOSCO Condition.

2. No one listed on the Sanctions List, which is periodically updated by the UN Security Council, is a resident of a nation listed in the Financial Action Task Force’s (“FATF”) public statement and has none of its underneath investors that contribute 25% or more to the shareholder corpus (or recognised on the assumption of control):

• A country with strategic shortcomings in “Combating the Financing of Terrorism” or “Anti-Money Laundering” that call for countermeasures; or

• A jurisdiction that has not committed to an action plan created in collaboration with the FATF to rectify the flaws or that has not made enough progress in doing so (the “FATF List Condition” and, in conjunction with the IOSCO Condition, the “Twin Diligence Conditions”).

The definition of “control” in the Circular includes the authority to choose the majority of the directors or to direct management or policy decisions.

These powers can be exercised by an individual or group of individuals acting alone or in concert, directly or indirectly, including through voting agreements, shareholder agreements, management rights, or shareholding.

In addition, the eligibility requirements outlined in Regulations 4(d) and 4(f) of the SEBI (Foreign Portfolio Investors) Regulations, 2019 (“FPI Regulations”) are equivalent to these diligence requirements. The definition of “foreign jurisdiction” in the International Financial Services Centres Authority (Fund Management) Regulations, 2022 (“Fund Management Regulations”) also includes the Twin Diligence Conditions, but funds established in IFSCs do not appear to be prohibited from accepting commitments from investors who would not have met the Twin Diligence Conditions.

Impact of Due Diligence Requirements on AIF

Both new and existing AIFs are expected to face a variety of operational challenges as a result of the Circular. An excellent place to start when looking at these challenges is by figuring out what sort of shareholders the Circular is going to affect. Furthermore, we expect the following five problems to surface in the upcoming weeks and months:

Exercise of Due Diligence

The Circular makes it apparent that managers are required to “ensure” that investors in an AIF fulfil the Twin Diligence Requirements. It’s unclear if the Circular requires managers to do due diligence or if it may be satisfied based just on investor warranties and representations. The term ‘ensure’ tends to suggest a greater level of care on the part of the manager, which might lead to issues with the amount of paperwork needed and investor resistance to sharing it.

Turning on the Carve-out

As previously stated, the Circular aims to prevent AIFs from taking on commitments from investors who live in countries whose securities authorities have not ratified either a bilateral memorandum of understanding with SEBI or the IOSCO Multilateral Memorandum of Understanding. However, it seems that SEBI has a clear intention to exempt sovereign wealth funds and affiliated organisations from this limitation.

It is unclear, though, if this carve-out will happen on its own. According to the Circular, nations whose governments or investors with ties to them are permitted to invest in an AIF require the consent of the Indian government. This might be an investment in an AIF or a separate government announcement. A different government announcement, which is currently pending, might be the form of this.

Deal Completion Risk

The management should stop taking on new capital from an investor if the AIF has already onboarded them and they later fail to meet any of the diligence requirements. From the standpoint of closing the deal, this may be problematic.

 Given that they could include investors that don’t meet the diligence requirements, AIFs that have executed term sheets and/or obtained investment council authorisation for agreements would not be able to finish them. Deals may eventually need to be cancelled or financed from other means, both of which might have an impact on AIFs’ bottom lines. To fulfil the promised money, affected investors would also need to find other structures and realign their investing strategy.

Restructuring/Withdrawal

Fund managers will need to strike a delicate balance between the conflicting interests of different investor constituencies. On the one hand, these investors would be prohibited from contributing capital due to the Circular, while on the other hand, they would be required to “over-contribute” to deals.

Investors may be able to use a restructuring exercise in certain situations, which would enable them to invest the remaining portion of their commitment in a country that is not prohibited by the Twin Diligence Conditions. This might not, however, address a situation when an underlying investor resides in a country that is prohibited by the Twin Diligence Conditions.

It might not be optimal for the underlying investor to stay invested in the AIF and continue to pay fees and other costs without taking advantage of the returns on the investments made by the AIF if the “freeze” on drawdowns lasts for a long period. Under these conditions, the underlying investor could want to negotiate its exit from the AIF or, at the absolute least, a release from its commitment to continue contributing to the AIF.

Customised Conditions of Continuation

Because the FATF lists are reviewed regularly, a jurisdiction that has been placed now on the list may eventually be removed. Even if a prolonged “freeze” on drawdowns would make it more difficult for investors who are affected by the Circular and the AIF to implement their investment plans, it might not be in their best interests to seek an early exit from the AIF.

In these situations, the investor may be compelled to keep their investment in the AIF, although in suspended animation, until it meets the Twin Diligence Requirements. Other than paying fees and expenditures, the manager is not allowed to take money out of the investment during this time.

In practice, when the drawdown ‘freeze’ is removed, there may be two methods that might be used. First, the investor is considered an “excused” investor for any transactions in which it was unable to participate due to the Circular.

The investor would, of course, not share in any profits from the investments because it has been “excused” in this case. Two, the investor participates in investments made during the drawdown “freeze” after the fact by paying an equalisation contribution, which includes a premium, to the shareholders who took part in those investments. There could be further questions about how the cost of the premium ought to be determined (for example, as a fixed proportion depending on the hurdle/preferred return rate or a custom process that better reflects the increase in investment value).

Wrapping Up

Due to periodic updates to the lists cited in the Circular, certain countries may occasionally find themselves on and off the list, which might cause disruptions to AIF operations. The question of whether a special exception should be made to let investments from investors who do not fulfil the FATF List requirement with prior government clearance, as in the case of the IOSCO requirement, may also come up in the days ahead.

In closing, it is important to reiterate that comparable diligence requirements are outlined in the Fund Management Regulations’ definition of “foreign jurisdiction”. Therefore, it is reasonable to wonder if the IFSCA would now provide guidelines for the type of due diligence that fund managers need to perform on investors who enter funds established in GIFT City.

To ger expert assistance in SEBI regulatory support or insights on other regulations, visit https://enterslice.com/.

Frequently Asked Questions