Implementation Standards for Encumbrance Creation by AIFs issued by SFA

On April 25, 2024, Securities Exchange Board of India (“SEBI”) had amended the SEBI (Alternative Investment Funds Regulations), 2012 to permit Category I and II AIFs to create encumbrances on the equity of their investee companies for securing loans borrowed by the said investee company, provided the investee company is in the business of development, operation or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure issued by the Department of Economic Affairs, Ministry of Finance, Government of India (“SEBI April 2024 Amendment”).

Pursuant to the SEBI April 2024 Amendment, SEBI had issued a circular dated April 26, 2024 (“SEBI April 2024 Circular”) to prescribe a number of rules and compliances in relation to creation of an encumbrance by Category I and Category II AIFs on the securities of their investee companies, in order to secure any loan taken by such investee companies.

Paragraph 4 of the SEBI April 2024 Circular stated that “The pilot Standard Setting Forum for AIFs (SFA) in consultation with SEBI shall formulate implementation standards to ensure that the encumbrance created on equity of investee company by Category I or Category II AIFs, is only utilized for facilitation of debt raising at the infrastructure sector investee company as stated in para 2 above.”

Consequently, the two SFAs, namely the IVCA and the PEVCCFO Association have formulated “Operating guidelines on framework for Category I and II Alternative Investment Funds to create encumbrance on their holding of equity of investee companies” dated July 17, 2025 (“Implementation Standards for Encumbrance Creation”) and published the Implementation Standards for Encumbrance Creation on the websites.

The Implementation Standards for Encumbrance Creation provide for the following:

Identification of eligible investee companies

As per the SEBI April 2024 Amendment and the SEBI April 2024 Circular, “Category I and Category II AIFs are permitted to create encumbrances only on equity of investee company that are in the business of development, operation or management of projects in any of the infrastructure sub-sectors listed in the Harmonised Master List of Infrastructure (“HML”) issued by the Central Government”.Therefore, theImplementation Standards for Encumbrance Creation requires AIFs to collect necessary details from investee companies in order to ascertain whether the investee company is being covered under HML issued by the Central Government. AIFs shall ensure that at least one of the following conditions is satisfied for ensuring that the investee company falls under the HML:

1. a) An RBI regulated lender, such as a Bank or an NBFC, has categorised the loan extended / proposed to be extended to the investee company of AIF, towards the sector as covered under the HML; or
2. b) The investee company has obtained a clarification from the Central Government that its business is covered under the HML.

Implementation of end-use restrictions 

Para 3.4 of the SEBI April 2024 Circular states that “Category I or Category II AIFs shall ensure that the borrowings made by the investee company against the equity investments encumbered by the AIFs are utilised only for the purpose of development, operation or management of investee company”. The SEBI April 2024 Circular forbids the borrowings made by the investee company from being invested in another company or utilised in any other manner. Therefore, the Implementation Standards for Encumbrance Creation require the AIF to have a well-laid out policy to ensure the objectives contained in Para 3.4 of the SEBI April 2024 Circular.

Compliance with RBI rules for creating pledges by non-residents

Para 3.4 of the SEBI April 2024 Circular states that “Any Category I or Category II AIF with more than 50% foreign investment or with foreign sponsor/ manager or with persons other than resident Indian citizens as external members in its investment committee which is set up to approve its decisions, shall ensure compliance with para 7.11.2 of RBI Master Direction dated January 04, 2018 on ‘Foreign Investments in India’, as though the AIF is a person resident outside India”. The aforementioned para 7.11.2 of the RBI Master Direction dated January 04, 2018, permits persons resident outside India holding capital instruments in an Indian company or units, to pledge such capital instruments or units in favour of a bank in India or an NBFC regulated by the RBI to secure the credit facilities being extended to such Indian company for bona-fide purposes. It also allows a pledge of such capital instruments or units in favour of an overseas bank to secure the credit facilities being extended to the promoter of such Indian company or its overseas group company, provided the promoter is a non-resident. The aforementioned para 7.11.2 also prescribes a number of compliances for the permitted pledges.

Therefore, the Implementation Standards for Encumbrance Creation require the AIF to have a well-laid out policy to ensure compliance with the aforementioned para 7.11.2 of RBI Master Direction dated January 04, 2018.

Contractual limit on AIF’s liability in case of default by the borrower/investee company

The Implementation Standards for Encumbrance Creation require the contract between the AIF and the lender for creation of the encumbrance on the securities of the infrastructure company to provide that, in case of any default by the borrower/investee company, neither the AIF (including all , schemes of the AIF) nor its investors are subject to any liability over and above the equity of the borrower investee company encumbered by the AIF.

• The Implementation Standards for Encumbrance Creation state that if an RBI regulated lender has categorised the loan extended / proposed to be extended to the investee company of the AIF, as a loan towards the sector as covered under the HML, the AIF can rest assured that the investee company falls under the HML. The alternative is for the investee company to obtain a clarification from the Central Government that its business is covered under the HML. Since the latter may not be easy, any AIF which proposes to create an encumbrance on the securities of its investee company should obtain a letter from the lender confirming that the borrower has been suitably categorised (as a company involved in the business of development, operation or management of projects in any of the infrastructure sub-sectors listed in the HML) in the records of the lender.

• The Implementation Standards for Encumbrance Creation require the AIF to have a well-laid out policy to ensure that the monies borrowed by the investee company are utilised only for the purpose of development, operation or management of the investee company. The Implementation Standards for Encumbrance Creation do not spell out in what manner the AIF’s policy should ensure that the monies borrowed by the investee company are utilised only for the permitted end uses. It is submitted that such a policy could provide for the AIF to periodically inspect the borrower and the books of the borrower to ensure that investee company is in compliance with the end-use restrictions. The investment agreement between the AIF and the investee company is likely to provide such rights to the AIF. If it doesn’t, the policy should require the AIF to enter into a contract with the investee company to provide appropriate inspection rights for the AIF so that the AIF and the borrower are in compliance with the applicable rules in this regard.

• The Implementation Standards for Encumbrance Creation require the contract between the AIF and the lender for creation of the encumbrance on the securities of the infrastructure company to provide that in case of any default by the borrower/investee company, neither the AIF (including all , schemes of the AIF) nor its investors are subject to any liability over and above the equity of the borrower investee company encumbered by the AIF. It is an accepted principle of law that if a borrower directly provides security to the lender and such security is not sufficient to meet the amount due to the lender at the time of any default, the lender would have a recourse against the borrower for the balance amount. However, when the security for a loan is provided by a third party, such third party’s liability to the lender would be limited to the security offered. It can be argued that unless the contract between the AIF and the lender expressly states that the AIF’s liability would extend to the entire loan amount even if such amount is higher than the value of the security offered, the AIF would not have any liability to the lender over and above the value of the security provided. Further, under no circumstance can the investors in the AIF have any form of liability to the lender, since there is no privity of contract between the lender and the investors in the AIF. However, in order to comply with the Implementation Standards for Encumbrance Creation, the contract between the AIF and the lender should have an express statement to the effect that the AIF’s liability and that of its schemes and investors would not exceed the equity of the borrower (investee company) on which an encumbrance has been created by the AIF.

The SEBI April 2024 Amendment can be found here.

The SEBI April 2024 Circular can be found here.

TheImplementation Standards for Encumbrance Creation can be found here.

We hope you have found this information useful. For any queries/clarifications please write to us at insights@elp-in.comor write to our authors:

Vinod Joseph, Partner – Email – vinodjoseph@elp-in.com

Akhil Ganatra, Associate – Email – akhilganatra@elp-in.com