Specific due diligence of investors and investments of AIFs to prevent circumvention of laws

SEBI’s notification dated April 25, 2024, had inserted a new sub-regulation in Regulation 20 of the Securities and Exchange Board of India (Alternative Investment Funds) Regulations, 2012 which requires every AIF, investment managers of AIFs and key management personnel of such investment managers and AIFs to exercise specific due diligence to ensure that investors in AIFs do not circumvent specified laws by investing through AIFs instead of investing directly. Further to the aforementioned notification, SEBI has issued a circular dated October 08, 2024 (“SEBI October Circular”) which spells out the specific laws that should not be circumvented and the due diligence that should be taken by AIFs and investment managers of AIFs to prevent such circumvention.

The specific laws are as follows:

• The SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (“ICDR Regulations”), and other regulations of SEBI and other regulations of SEBI wherein benefits or relaxations have been provided to entities designated as Qualified Institutional Buyers (QIBs).
• The Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (“SARFAESI Act”) wherein benefits are provided to entities designated as Qualified Buyers (QBs).
• Prudential norms specified by Reserve Bank of India (RBI) for regulated lenders with respect to income recognition, asset classification, provisioning and restructuring of stressed assets.
• Rule 6 of Foreign Exchange Management (Non-Debt Instruments) Rules, 2019 (“NDI Rules”) for investment from countries sharing land border with India (read with Press Note 3 dated April 17, 2020 of the FDI Policy 2020).

As provided in the SEBI October Circular, implementation standards dated October 9, 2024 (“Implementation Standards”) for the due diligence required to be carried out in terms of the SEBI October Circular have been formulated by the industry associations which are part of the Setting Forum for AIFs (SFA), namely the Indian Venture and Alternate Capital Association (IVCA), PE VC CFO Association and Trustee Association of India and published on their websites.

The SFA has prescribed a 50% test to prevent circumvention of the ICDR Regulations and the SARFAESI Act, which works as follows. The investment manager has to ensure that an investor (or investors of the same group), who contribute(s) 50 percent or more to the corpus of the scheme, is/are  either QIBs or QBs, as the case may be or entities established, owned or controlled by the Central Government or a State Government or the Government of a foreign country, including central banks and sovereign wealth funds. In case the investor(s) contributing 50 percent or more of the corpus is an AIF or a fund set up outside India or in International Financial Services Centres in India, the investment manager shall check whether the aforesaid condition is met on a look through basis.

For the prevention of any circumvention of the Prudential norms specified by Reserve Bank of India (RBI) for regulated lenders, the SFA has required the investment manager, before the AIF invests in any portfolio company, to identify if any investor of the scheme (who are lenders/entities regulated by the RBI or are funds having contribution from lenders regulated by the RBI) would be in breach of any prohibition or limit or RBI prudential norms in case the regulated investor were to directly lend to or invest in proposed investee company.

An AIF can proceed with an investment only after the aforementioned due diligence and  after obtaining 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 regulated investor that there is no restriction on the regulated investor to lend to or invest in the investee company directly, and all required disclosures have been made by the regulated investor as if it has a direct exposure to such portfolio company.

For the prevention of any circumvention of Press Note 3 dated April 17, 2020, the investment manager shall collect information on the investors of the scheme and their beneficial owners and verify if 50% or more of the corpus of the scheme is contributed by investors, who themselves or their beneficial owners, are citizens of/are from/are situated in a country which shares land border with India. If the 50% threshold is crossed, the investment manager of the AIF shall report the same to the AIF’s custodian, within 30 days of the said investment of the scheme, in the format provided in the  Implementation Standards.

It is interesting to note that SEBI (and the SFA) have applied three different yardsticks to prevent any circumvention of the four specific laws that are mentioned in the SEBI October Circular:

• In the case of the ICDR Regulations and the SARFAESI Act, it is sufficient if no investor (or investors of the same group), who contribute(s) 50 percent or more to the corpus of the scheme, circumvent the aforementioned laws. If they do, the AIF cannot make the investment.
• In the case of Press Note no. 3, even if 50% or more of the corpus of the scheme is contributed by investors, who themselves or their beneficial owners, are citizens of/are from/are situated in a country which shares land border with India, such investment has to be reported by the AIF to its custodian. Custodians shall compile such information received from AIFs on a monthly basis and report to SEBI within 10 working days from the end of the month. Neither the SEBI October Circular nor the Implementation Standards expressly prohibit the AIF from making the proposed investment.

In the case of prudential norms specified by Reserve Bank of India (RBI) for regulated lenders with respect to income recognition, asset classification, provisioning and restructuring of stressed assets, even if a single investor in an AIF would be in breach of the RBI’s prudential norms if it were to make the investment directly, either such investor or investors of the same group shall be excluded from the investment, subject to necessary disclosure in the PPM for exclusion of investors, or, the investment shall not be made.

SEBI’s notification dated April 25, 2024 can be found here

SEBI’s circular dated October 08, 2024 can be found here

The Implementation Standards dated October 9, 2024 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

Paridhi Jain, Associate – Email – paridhijain@elp-in.com