India – SEBI Prescribes Due Diligence Norms For AIFs To Curb Regulatory Circumvention.

Introduction 

A new set of regulations has been implemented for Alternative Investment Funds (“AIFs”) to exercise “specific due diligence”,[1] with respect to their investors. The aim is to prevent investors from circumventing the extant norms administered by the financial sector regulators. These include: 

1. Investors availing benefits designated for Qualified Institutional Buyers (“QIBs”); 

2. Investors availing benefits designated for Qualified Buyers (“QBs”) under the SARFAESI Act, 2002;[2] 

3. RBI-regulated lenders/entities ever-greening their stressed loans/assets; and 

4. Residents of/are from/situated in countries sharing land border with India. 

Importantly, if a scheme’s proposed investment does not satisfy the due diligence checks (under A, B and C above) as given in the SEBI Circular, then proposed investment should either not be made, or such investor or investors of same group must be excluded from the said investment, subject to necessary disclosure in the PPM for exclusion of investors. 

As the Reserve Bank of India (“RBI”) has already addressed[3] the issue of evergreening of loans by regulated entities by mandating provisioning for all overlapping investments made by the AIFs in their debtor entities (excluding the investments in equity shares of the debtor company), these new requirements can be viewed as an overkill. 

We have analysed the specific due diligence requirements and implementation standards below: 

A. Investors availing benefits designated for QIBs through AIFs 

1.  

Regulation 22(1)(ss) of the ICDR Regulations designate the AIFs as QIBs. To prevent AIFs from facilitating investors, who would otherwise be ineligible for QIB status on their own, to avail benefits designated for QIBs, necessary due diligence will be carried out in line with the implementation standards formulated by SFA. This due diligence will apply to every impacted AIF before they can avail benefits available to QIBs under SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”) and other SEBI Regulations. The implementation standards are provided below: 

1. The manager will check whether an investor or investors of the same group contribute(s) fifty per cent (50%) or more of the scheme corpus either qualify as (i) QIBs themselves or they are entities owned or (ii) controlled by government of India or foreign governments including central banks or sovereign wealth funds. 

2. In case the investor is an AIF or a fund set-up outside India or in IFSC, the manager will check if the condition is met on a look-through basis. 

3. If the above conditions are met, the scheme may avail the benefits of a QIB provided that, the manager of the AIF independently verifies and provides an appropriate confirmation to the stock exchange and other relevant parties. 

Analysis 

QIBs enjoy certain benefits under the ICDR Regulations[4] such as certain number of shares in an IPO are allocated to QIBs only, exempting them from the 200-person limit during the private placement of securities, option to become an anchor investor, etc. 

Alternative Investment Policy Advisory Committee in its second report[5] had concluded that since AIFs cater to mature and sophisticated investors, their QIB status would reduce price volatility of IPOs. However, this QIB status may be used as a loophole when group entities who are small and individually not qualified as QIBs, start pooling their capital and establishing AIFs solely to obtain a QIB status in IPOs to make quick profits, in turn increasing the price volatility. 

The new due diligence standards by SFA provide a safeguard against such practices while protecting the interests of institutional investors like mutual funds, scheduled commercial banks, multilateral financial institutions, systematically important NBFCs, FVCIs, etc., who independently qualify as QIBs and are not affected by such standards. 

B. Investors availing QB benefits through AIFs under SARFAESI 

AIFs enjoy the benefits as QBs under the SARFAESI Act[6], and therefore, are eligible to subscribe to Security Receipts (“SRs”) issued by Asset Reconstruction Companies (“ARCs”). 

Similar to the QIB benefits discussed above, in order to prevent AIFs from facilitating investors who are otherwise ineligible for QB status on their own, in availing benefits designated for QBs, SEBI has prescribed due diligence for every scheme of AIFs having an investor, or investors belonging to the same group, who contribute(s) fifty percent (50%) or more to the corpus of the scheme prior to making any investments in SRs issued by ARCs or availing benefits designated for QBs under the SARFAESI Act. 

The implementation standards are as given below: 

1. The manager will check whether an investor or investors of the same group contribute(s) fifty per cent (50%) or more of the scheme corpus either qualify as (i) QIBs themselves or (ii) they are entities owned or controlled by government of India or foreign governments including central banks or sovereign wealth funds. 

2. In case the investor is an AIF or a fund set up outside India or in IFSC, the manager will check if the condition is met on a look-through basis. 

3. If the above conditions are met, the scheme may make investments in SRs issued by an ARC or avail benefits designated for QBs under the SARFAESI Act, 2002. 

Analysis 

Primarily, AIFs having an investor, or investors belonging to ‘same group’, who contribute 50% or more to the corpus of scheme will get impacted by these requirements where ‘same group’ shall mean ‘related parties’[7] and ‘relatives’[8] as defined under SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (“LODR Regulations”). 

This is to prevent group entities from establishing AIFs to solely for the purpose of availing the benefits extended to QIBs and QBs under the ICDR Regulations and SARFAESI respectively. 

QB under SARFAESI can avail certain special privileges, as they are permitted to subscribe to SRs, and the QBs holding SRs of not less than 75% of the total value of the SRs issued, in the event of non-realisation of financial assets, can call a meeting of all the QBs and every resolution passed in such meeting shall be binding on the company.[9] 

These new due diligence standards by SFA provide a safeguard against such practices while protecting the interests of genuine QBs like AMCs (on behalf of their mutual funds), banks, financial institutions, insurance companies, ARCs, FPIs (registered with SEBI), etc., who are independently qualified as QIBs, as they would not be affected by such standards. 

C. RBI-regulated investors evergreening their loans/assets through AIFs: 

To address the issue of evergreening of stressed loans/assets of RBI-regulated lenders/entities through AIFs and to prevent circumvention of RBI norms concerning income recognition, asset classification, provisioning and restructuring of stressed loans/assets, necessary due diligence will be conducted as per the implementation standards established by SFA for every AIF scheme: 

• whose manager or sponsor is an entity regulated by RBI; or 

• that has investor(s) regulated by RBI who:  

• individually or along with investors of the same group contribute(s) twenty-five percent or more to the corpus of the scheme; or 

• is an associate of the manager/sponsor of the AIF; or 

• by itself, or through its representative(s)/nominee(s), has majority or veto power in voting over decisions of the investment committee set up by the manager to approve investment decisions of the scheme; 

If an investor of the scheme is an AIF, or a fund set up outside India or in IFSC, then the criteria check for investor(s) regulated by RBI must be carried out on a look-through basis. 

For schemes falling under the ambit of the above provisions, the manager shall ensure that the scheme does not make any investment that would lead to the RBI-regulated lender/entity to indirectly acquiring or holding an interest/exposure in the investee compan(that is, through investment in a scheme of an AIF), that they are not permitted to acquire or hold directly. 

The due diligence implementation standards for the AIFs/managers/KMPs in relation to the above can be summarised as follows: 

1. The manager shall identify investors of the scheme who are lenders/entities regulated by RBI (“RBI Regulated Investor”) or investors that are funds having contribution from lenders regulated by RBI and collect details along with details of its outstanding financial obligations of these RBI Regulated Investors against the proposed investee entity. 

2. If the RBI Regulated Investor of the scheme is a lender or investor of the proposed investee company, the manager shall collect details of the financial credit/loan/investment from the books of such RBI Regulated Investor. 

3. Upon examining the information collected from the RBI-regulated Investor as above, the manager shall check whether the RBI Regulated Investor would be in breach of any prohibition or limit or prudential norms with respect to Income Recognition, Asset Classification and Provisioning and Restructuring of stressed assets/loans under following circulars/directions, in case the RBI Regulated Investor were to directly lend to/invest in proposed investee company –  

1. RBI’s Master Circular – Prudential norms on income recognition, asset classification and provisioning pertaining to advances; 

2. Master Circular – income recognition, asset classification, provisioning and other related matters – UCBs; and, 

3. Master Direction – Reserve Bank of India (Non-Banking Financial Company – Scale Based Regulation) Directions, 2023. 

If the answer to the due diligence check at stated at para 3 above is ‘No’, then the scheme may proceed with the investment opportunity, after the manager obtains a confirmation from Chief Compliance Officer or a person of the rank of Chair of the Audit Committee or Chairman of the Board or Executive Director of the RBI Regulated Investor that: 

a. there is no restriction on the RBI Regulated Investor to lend to or invest in the investee company directly, and 

b. if such investment in the proposed investee company through the scheme of AIF, would have required the RBI Regulated Investor to make any disclosure in terms of circulars provided at para 3 above, had it been a direct exposure, the necessary disclosures shall be made to this effect as per the applicable timelines in terms of circulars provided at para 3 above. 

Analysis 

Evergreening of loans by RBI Regulated Investors through AIF route has already come under a lot of regulatory scrutiny recently. RBI Regulated Investors are required to maintain provisioning for sub-standard assets and non-performing assets and to avoid such provisioning, RBI Regulated Investors subscribe to subordinate class of units of AIFs that have that absorbs the losses over other classes of units, this converts the RBI Regulated Investor’s sub-standard or non-performing assets into investments. While SEBI has already put blanket ban raising investments by AIFs who have priority distribution among investors[10] some of the AIFs and RBI Regulated Investors have found a way around it by categorising the RBI Regulated Investor as Sponsor. Therefore, RBI in its series of notifications[11] restricted these RBI Regulated Investors from circumventing these requirements even as a sponsor and make investments into such debtor portfolio entities, unless they make 100% provisions for such investments (existing investments in AIFs) in which the regulated investor also has an exposure as a direct lender/investor. Further, such investors are not permitted to make any new investments in the AIF scheme which has downstream investments either directly or indirectly in a debtor company of the regulated investor. This had practically solved the main contention of evergreening of loans by AIF route.  

D. Investments from land bordering countries through AIFs 

Under the Foreign Exchange Management Act (Non-Debt Instruments) Rules, 2019 (“NDI Rules”)[12] a person resident outside India, being from a country that shares land borders with India or whose beneficial owner[13] is situated or is a citizen of any such country, shall invest in equity instruments of an Indian company, only with the approval of the government. 

Specific due diligence check must be done for the schemes where 50% or more of the corpus is contributed by investors who themselves are or whose beneficial owners are Citizens of or are situated in a land bordering country. If so, then the manager must report the details of such investors and scheme as specified in the due diligence standards prescribed by the SFA within 30 days of the said investments of the scheme. Custodians shall compile such information received from AIFs on a monthly basis and report to SEBI within 10 working days from the end of each month. 

For investments that have already been made by such entities into schemes where the schemes hold 10% or more of equity or equity-linked securities issued by an investee company (on a fully diluted basis), the manager of such schemes must report to their custodians about the same by April 07, 2025 in the format prescribed by the SFA. 

Analysis: 

While these are just reporting requirements, the SEBI Circular is silent on the treatment of such investments which do not satisfy the due diligent criteria, presumably implying that necessary government approvals will be required.   

Conclusion 

While these new due diligence standards seem necessary to prevent circumvention of extant norms as prescribed by different financial sector regulators, they also put a heavy onus on the AIFs and their managers to perform these checks diligently, which, in turn will increase the cost of managing the fund, affecting the ease of doing business factor for the fund managers. 

[1] Regulation 20(20) of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“AIF Regulations”) read with SEBI Circular titled “Specific due diligence of investors and investments of AIFs” dated October 08, 2024 (“SEBI Circular”) read with “Implementation standards for specific due diligence of investors and investments of AIFs to prevent facilitation of circumvention through AIFs” by Standard Setting Forum for AIFs (“SFA”) dated October 09, 2024 (“due diligence standards”). 

[2] Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI”) 

[3] RBI Notifications dated December 19, 2023 and March 27, 2024 accessible here <https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0> and here <https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12639&Mode=0>. 

[4] under Regulation 6, Regulation 32 of ICDR Regulations and Section 42 of Companies Act, 2013. 

[5] The Alternative Investment Policy Advisory Committee Second Report submitted on November 1, 2016; accessible at <https://www.ivca.in/resources/aipac-reports>. 

[6] Section 2(1)(u) of SARFAESI Act read with Reserve Bank of India’s notification no. DNBR (PD-ARC) No. 07/ED (SS)-2018 dated May 16, 2018 which specified Category II and category III AIFs registered with SEBI as QBs. Also read: SEBIs informal guidance in response to a request from SREI Multiple Asset Investment Trust, dated October 26, 2020 accessible at <https://www.sebi.gov.in/sebi_data/commondocs/oct-2020/Inf%20Guid%20SREI_p.pdf>.  

[7] Regulation 2(zb) of LODR Regulations read with sub-section 76 of section 2 of Companies act 2013 define related parties. Such persons include: (i) director or his relatives; (ii) key managerial personnel or his relative; (iii) a firm, in which a director, manager or his relative is a partner; (iv) private company in which director is a member or director; (v) public company in which a director is a director and holds along with his relatives, more than 2% of paid-up capital; (vi) body corporate which is a: (x) holding, subsidiary or associate company of such company; (y) subsidiary of holding company to which it is also a subsidiary; or (z) an investing company or venturer of the company; (vii) any body corporate whose board of directors are accustomed to act in accordance with the instructions of a director or person on whose advice or instructions, director is accustomed to act. Additionally, any person or any entity, holding equity shares: (i) of 20% or more; or (ii) of 10% or more, in the listed entity either directly or on a beneficial interest basis as provided under the Companies Act, 2013, at any time, during the immediate preceding financial year; shall be deemed to be a related party. 

[8] Regulation (zd) od LODR regulations read with sub-section 77 of section 2 of Companies act 2013 and attendant rules define relatives. Such persons include: (i) members of Hindu undivided family; (ii) husband and wife; and (iii) one person related to the other as provided in the attendant rules such as father, mother, son’s wife, daughter’s wife. 

[9] Section 7(3) and 7(4) SARFAESI Act. 

[10] Circular – Schemes of AIFs which have adopted priority in distribution among investors, dated November 23^rd, 2022; accessible at <https://www.sebi.gov.in/legal/circulars/nov-2022/circular-schemes-of-aifs-which-have-adopted-priority-in-distribution-among-investors_65393.html> 

[11] RBI Notifications dated December 19, 2023 and March 27, 2024 accessible here <https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0> and here <https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=12639&Mode=0> 

[12] Rule 6 of NDI Rules for investment from countries sharing land border with India (read with Press Note 3 dated April 17, 2020 of FDI Policy 2020). 

[13] As defined under Rule 9(3) of the Prevention of Money-laundering (Maintenance of Records) Rules, 2005.