SEBI’s Due Diligence Framework for AIFS: Addressing Regulatory Arbitrage and Investment Transparency

Introduction: “Regulatory arbitrage” in the guise of AIFs

Investments made by alternative investment funds (AIF) that have domestically owned and controlled sponsor and manager are not classified as downstream investments or indirect foreign exchange but are considered as investments by persons resident in India [Explanation attached to Rule 23(7)(i) of the Foreign Exchange Management (Non-debt Instruments) Rules, 2019¹ (NDI Rules)]. However, investments made by AIF on a fully diluted basis (equity shares, mandatorily convertible preference shares, mandatorily convertible debentures) where either or both sponsor or manager is/are not Indian, such investments are classified as downstream investment, and consequently the exchange control norms apply, such as pricing guidelines, sectoral restrictions, etc. The rationale of allowing AIFs with Indian owned and controlled sponsor and manager was to facilitate such AIFs in raising investments from a large number of investors without being restricted by the exchange norms and attendant conditions. The root of the classification was domicile of AIF, which, owing to Indian sponsor and manager remain in India as investment decisions are effectively taken by them.

However, Securities and Exchange Board of India (SEBI) has been mulling over the cases of what it calls “regulatory arbitrage”. This can be traced back to SEBI’s consultation paper in January 2024 titled “Consultation Paper on Proposal to Enhance Trust in the Alternative Investment Funds (AIF) Ecosystem to Facilitate Ease of Doing Business Measures”,² where SEBI inter alia highlighted the attempts of exchange norm circumvention through AIFs. For example, as SEBI explained, AIFs have been set up with Indian owned and controlled sponsor/manager to aid the foreign investors in investing in restricted sectors or beyond the prescribed limits. At the cost of repetition, it needs to be again emphasised that since the characterisation of the investment by AIF is not that of a downstream investment, the foreign exchange norms will not be attracted, and where such investors could not have invested in such investee companies, or to that limit, if not through AIF.

Perhaps this change was long anticipated, with Reserve Bank of India (RBI) already recommending the Government to change the basis of determination of downstream investment with respect to AIF and that it should be the beneficial interest held by foreign investors rather than ownership and control of sponsor and manager.³ However, the recommendation is yet to see the light of day in the form of an amendment in the NDI Rules. Similarly, RBI had barred regulated entities from investing in AIFs that had invested in the debtor companies, as it amounted to evergreening of loans i.e. the money would be channeled through AIF to debtor companies to keep themselves alive.⁴ This problem also led to twin problems: first, that it prevented proper classification of such debtor companies in the books of the regulated entities; and second, by preventing proper classification, the creditworthiness of the debtor remained unaffected.

SEBI, through a Circular titled, Specific Due Diligence of Investors and Investments of AIFs⁵ (Circular), has laid down due diligence (DD) requirements to be carried out by the AIF, its manager, and their key management personnel (KMP). This article analyses the DD requirements laid down by the Circular in respect of the investment from countries sharing land border with India through AIFs.

Due diligence standards and reporting duties

In 25-4-2024 SEBI amended the Securities and Exchange Board of India (Alternative Investment Funds) (Second Amendment) Regulations, 2024 (AIF Regulations) which inter alia introduced an additional obligation incumbent upon an AIF, manager, and KMPs of the AIF and manager to exercise DD with respect to their investors and investments to prevent facilitation of circumvention of laws.⁶ Pursuant to this, SEBI has released the Circular titled dated 8-10-2024 delineating the DD requirements required to be carried out by AIFs, managers of AIFs and their KMPs.

For proposed investment

If in a scheme of an AIF, a citizen of land border country (LBC) with India or an investor whose beneficial owners are citizens of LBC contributes 50% or more to the corpus, necessary DD as per the implementation standards formulated by Standard Setting Forum for AIFs needs to be carried out prior to making any investment. Post such DD, the details of the investment need to be reported if it results in the scheme holding 10% or more of equity/equity-linked securities (on a fully diluted basis) issued by the investee company.

For existing investment

If scheme(s) of AIFs meet the corpus threshold (50% or more contribution by the investor from LBC) and the scheme holds 10% more of equity/equity-linked securities (on a fully diluted basis) issued by the investee company, then it must report the same to their custodians by 7-4-2025.

Outsourcing due diligence by AIFs: Balancing operational efficiency with regulatory accountability

The DD obligations incumbent upon AIF, its manager and their KMPs are of a continuing nature. As per the Circular, the compilation of the data needs to be made on a monthly basis. Thus, any indirect acquisition of beneficial interest by foreign investors from LBC from the last date of disclosure ought also to be reported. Therefore, it adds to the operational burden of the AIFs. To discharge such a burden, AIF may outsource the DD work to third parties. This outsourcing needs to be assessed on the cornerstone of the incumbent obligations on the AIFs.

Regulation 20(20) of the AIF Regulations⁷ read with the Circular mandate the DD requirement. Though the responsibility of carrying out DD is casted upon AIF, its manager and their KMPs, they may want to outsource it for ensuring operational efficiency and reducing burden. Perhaps outsourcing of DD obligations is a tenable and reasonable option; however, it is unequivocal that the burden solely remains on AIF, its manager, their KMP, and their responsibility for ensuring compliance cannot be evaded. And since SEBI has neither in the AIF Regulations nor in the Circular prescribed any penalty for the failure to perform DD, therefore, a clarity on penalty provision is awaited.

However, the AIFs outsourcing the work may want to sign an indemnity agreement with the third party in case of any inconsistency or default in the DD so outsourced and consequent penalty levied by SEBI. As the AIF industry will see outsourcing of DD to third parties, robust indemnification agreements will help maintain operational efficiency through outsourcing and indemnity against potential action by the regulator.

PN3 conundrum

Investments in units of investment vehicles such as AIFs are governed by Schedule 8⁸ of the NDI Rules. Schedule 8 does not have anything to do with Press Note 3⁹ (PN3) but allows investment in units of investment vehicles by non-residents other than citizens of Pakistan and Bangladesh or entities incorporated in such nations. On the other hand, PN3 conditions relate to Schedule 1¹⁰ investments, which govern the purchase or sale of equity instruments of an Indian company by non-residents. It needs to be emphasised that the ambit of Press Note 3 restriction is much wider than any restriction in Schedule 8 in the sense that investments from an entity of an LBC with India, or when the beneficial owner of any such investment is a citizen of LBC with India the investments will need Government approval.

Therefore, technically, PN3 restrictions do not apply to investments in units of AIF absent any such restriction in Schedule 8 of the NDI Rules. However, the funds have been hesitant to take this position and accept investment from entities from LBC due to much regulatory antagonism against investments flowing from LBC and fear of any regulatory action that may follow.

With respect to this Circular, SEBI has not outlawed the investment in units of AIF from LBC entities but has merely sought disclosure. It may be the case that SEBI may forward the collated data to the RBI, which may then deem it fit to warrant any regulatory action in certain cases with respect to such investment from LBC countries. However, as submitted above, technically PN3 restrictions do not apply to AIF units, and thus SEBI has merely sought disclosure and not crammed down on such investments.

Conclusion

While the PN3 restrictions technically do not apply to AIF investments, the emphasis on disclosure highlights SEBI’s intent to monitor and potentially address risks associated with investments from LBC. Moving forward, regulatory clarity on penalties for non-compliance and on RBI’s actions (if any) based on such disclosures will be critical in determining the course of raising capital from LBC by AIFs.