Alerts & Updates 16th Dec 2024

SEBI Reads the Riot Act on Pro-rata and Pari-Passu rights of AIF investors

Authors

Vinod Joseph Partner | Mumbai
Akhil Ganatara Advocate | Gift City
Zaynali Badami Advocate | Gift City

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  • The Securities and Exchange Board of India (SEBI) has issued a circular dated December 13, 2024 (“SEBI December Circular”) in order to implement the amendments made to the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 (“SEBI AIF Regulations”) on November 18, 2024 vide the Securities and Exchange Board of India (Alternative Investment Funds) (Fifth Amendment) Regulations, 2024 (November 2024 Amendments), which had inserted two new sub-regulations, 21 and 22, in Regulation 20 of the SEBI AIF Regulations.

  • Limited exceptions for the grant of rights that are not pro-rata to the investor’s commitment

    Pursuant to new sub-regulation 21 of Regulation 20 of the SEBI AIF Regulations, the SEBI December Circular lists the following exceptions to the general rule that each investor’s rights in an AIF’s scheme shall always be pro-rata to such investor’s commitment to the AIF scheme:

    • an investor has been excused or excluded from participating in one or more investments by the AIF scheme[1];
    • an investor has defaulted on providing his/her pro-rata contribution for the said investment; or
    • returns or profit on the investments are being shared by an investor with the investment manager or sponsor of the AIF, provided such sharing is in accordance with the contribution agreement executed between the AIF and the investment manager or sponsor. This exemption allows an AIF to offer carry shares to its investment manager and sponsor.

    The SEBI December Circular also allows the following classes of investors to accept returns lesser or to share losses other than in accordance with their pro-rata rights in the investments of an AIF:

    • The investment manager or sponsor of the AIF;
    • Multilateral or Bilateral Development Financial Institutions;
    • State Industrial Development Corporations;
    • Entities established or owned or controlled by the Indian central government or any Indian state government or any foreign government. These entities could be central banks or sovereign wealth funds.

    The aforementioned exception would permit the issue of units by an AIF that are subordinate to the other units issued by the same AIF (“Subordinate Units”) to the classes of investors mentioned above and would facilitate fund raising by AIFs. It is interesting to note that ordinary commercial banks (scheduled banks) are not covered by the above exception and cannot subscribe to Subordinate Units.

    If the investment manager or sponsor of an AIF subscribes to Subordinate Units of an AIF, investee companies of such AIF cannot use the money received from the AIF to repay any of the investee company’s obligations or liabilities towards such investment manager or sponsor of the AIF or the associates of such investment manager or sponsor.

  • Ban on fund raising and investing by violators

    Any AIF scheme that had in the past adopted a priority distribution model which does not fall under the limited exemption given by the SEBI December Circular to AIF to issue Subordinate Units to certain entities (that accept returns lesser or to share losses other than in accordance with their pro-rata rights in the investments of such AIF) cannot accept any fresh commitment or make investments in new investee companies, directly or indirectly.

  • Grant of differential rights to investors

    Pursuant to new sub-regulation 22 of Regulation 20 of the SEBI AIF Regulations, the SEBI December Circular permits differential rights (DR) to be offered by AIFs to select investors, without affecting the rights of other investors, based on the following guiding principles:

    • The investor receiving the DR should not have to bear the liabilities of other investors of the AIF scheme;
    • The DR should not give the investor holding the DR the power to make decisions pertaining to the AIF scheme, unless such investor is a member of the AIF’s investment committee;
    • Any DR granted by an AIF shall not alter the rights granted by the AIF to its other investors; and
    • Full details of the DRs and eligibility to hold DRs shall be transparently disclosed in the PPM of the AIF scheme. Any investor meeting the specified eligibility criteria for a DR may opt to avail such DR.
  • Implementation standards for issuance of DRs

    SEBI has tasked the Standard Setting Forum for AIFs (‘SFA’) with formulating the implementation standards for issuance of DRs by AIFs. The implementation standards are expected to provide a positive list of specific differential rights that may be offered by AIFs to their investors and are to be published  on the websites of the three industry associations which are part of SFA (namely, the IVCA[2], the PE VC CFO Association and the Trustee Association of India) on or before January 15, 2025.

  • Exemption for LVFs

    Regulation 20(22) of the SEBI AIF Regulations does not apply to Large Value Fund for Accredited Investors (LVF).  Therefore, LVFs whose PPMs are filed with SEBI for launch of LVF scheme post the date of issuance of the SEBI December Circular (December 13, 2024), may issue DRs provided appropriate disclosures are made in the PPM of the relevant AIF scheme and every investor in the LVF provides a waiver at the time of on-boarding. The waiver should state as follows:

    “The prospective investor is aware that LVFs may avail exemption from the requirement of maintaining pari-passu rights among investors and therefore, may offer differential rights to select investors which might affect interest of other investors of the LVF.”

  • Impact on AIFs that issued non-compliant DRs

    Vide its circular dated February 05, 2020, SEBI had prescribed standard templates for the private placement memorandums (“PPM”) of AIFs. As per such template, with effect from March 01, 2020, AIFs are required to disclose to investors through their PPMs that any differential right offered to an investor(s), through separate classes of units or side letters/agreements, shall not have any adverse impact on the economic rights or any other rights of other investors. If any AIF, which filed a PPM with SEBI on or after March 01, 2020 and granted DRs to its investors that do not fall under the folds of the implementation standards formulated by SFA, the investment manager of such AIF should email details of such DRs to SEBI on or before February 28, 2025. The format for such report is given in Annexure I of the SEBI December Circular. Further, out of the DRs that are required to be reported to SEBI as per the SEBI December Circular, the investment manager has to immediately terminate/discontinue those DRs which affect the rights of other investors.

  • ELP Comments
    • If any AIF has issued Carry units (that is, units which offer the equivalent of the performance fee in the form of a return on capital) to any investor other than its investment manager and sponsor, the holders of such carry units will not be entitled to receive any Carry or performance fee or other disproportionate return.
    • Interestingly, the SEBI December Circular does not extend to employee welfare trusts (“EWT”) the right to receive Carry units. It is very common for PE and VC funds to issue Carry units to EWTs whose beneficiaries are employees of the investment manager. Using an EWT to transfer Carry to the employees of the investment manager is a more tax efficient way to transfer Carry to such employees, as compared to giving Carry to the corporate investment manager. The SEBI AIF Regulations recognize EWTs and even provide a specific exemption to EWTs from the requirement to be registered as an AIF. It is hoped that SEBI will issue an amendment to the SEBI December Circular in order to extend to EWTs the right to receive returns or profit on the EWTs’ investments in the AIF which are not pro-rata to the EWTs’ commitment to the relevant AIF scheme.
    • The ban on fresh fundraising on AIFs whose schemes had in the past adopted a priority distribution model which is not covered by the exemption given by the SEBI December Circular does not seem to apply to AIFs which issued rights to investors that are not pro-rata to such investor’s commitment to the AIF scheme. The only impact on such AIFs is that such rights may not be valid or enforceable.
    • The SEBI December Circular states that if the investment manager or sponsor of an AIF subscribes to Subordinate Units of an AIF, investee companies of such AIF cannot use the money received from the AIF to repay any of the investee company’s obligations or liabilities towards such investment manager or sponsor of the AIF or the associates of such investment manager or sponsor. It is interesting to note that there is no blanket ban on an AIF’s investee company paying back its debt to investment manager or sponsor of the AIF which has invested in it. Therefore, if a company which has received an investment from an AIF that has issued Subordinate Units to its investment manager or sponsor, owes some money to such investment manager or sponsor, such company can repay its debt to investment manager or sponsor of the AIF only if it can demonstrate that the money used to repay the debt is not the same money which was invested in the company by the AIF.
    • SEBI has always insisted that AIFs should treat all investors alike and not offer special rights to any investors. The prohibition on fresh fundraising and investing imposed by the SEBI December Circular on AIFs that had in the past adopted a priority distribution model which does not fall under the limited exemption given by the SEBI December Circular to AIF to issue Subordinate Units confirms the interim prohibition imposed by  SEBI vide its circular dated November 23, 2022 which directed AIFs that had adopted priority distribution models to neither accept any fresh commitment nor make investment in a new investee company, until a view is taken by SEBI in this regard.

    The SEBI December Circular can be found here.

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

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

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

    Zaynali Badami, Advocate – Email – zaynalibadami@elp-in.com

  • References

    [1] SEBI has, vide its circular dated April 10, 2023, formulated guidelines for excusing or excluding an investor from investments by the AIF.

    [2] The Indian Venture and Alternate Capital Association

Disclaimer: The information contained in this document is intended for informational purposes only and does not constitute legal opinion or advice. This document is not intended to address the circumstances of any individual or corporate body. Readers should not act on the information provided herein without appropriate professional advice after a thorough examination of the facts and circumstances of a situation. There can be no assurance that the judicial/quasi-judicial authorities may not take a position contrary to the views mentioned herein.

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