Fractional ownership schemes: Distinguishing between investment schemes and shared ownership of real assets

Vinod Kothari | vinod@vinodkothari.com

Schemes to crowdfund real assets (that is, assets other than financial assets) continue to proliferate. Known by various names as fractionalisation, tokenisation, fractional property shares, etc., these schemes invite multiple retail investors to become fractional owners of assets. The assets in question may consist of properties, solar assets, leased equipment, etc. The assets, in turn, are deployed by some asset manager, who produces returns from these assets. These returns are earned by the investors.

Money for money, or interest in assets for money:

A money-for-money transaction is essentially an investment contract. The meaning of money-for-money transaction is one where a person puts in money, and is promised money in return. That is to say, the essence of the activity is producing monetary returns by investing a certain sum of money. This is opposed to a shared property ownership or business where money is invested for acquiring stake in an asset. The asset, in turn, may be deployed for a common good, but the key question to ask is: have the investors been promised returns by the manager of the scheme? That is, do investors  acquire equity in the asset, exposing themselves to the risks/returns of the asset, or do investors have been promised, explicitly or implicitly, a fixed rate of return? In the latter case, it is clearly an investment transaction, and being a pooled investment vehicle, it may be termed as “collective investment scheme”.

There are stringent regulations in India for Collective Investment Schemes i.e. the SEBI (Collective Investment Scheme) Regulations, 1999, and India is not unique in this respect. We have earlier discussed the law regarding fractional ownership of properties, and the ingredients that distinguish between a participated ownership, versus a collective investment scheme.

What makes it a collective investment scheme:

We have also discussed international case laws on the matter, including the classic US ruling in the case of  Securities and Exchange Commission v. Howey,  as also the UK Supreme Court ruling of 2016, Asset Land Investment Plc v. Financial Conduct Authority which went at length on the distinction between an investment scheme and a fractional ownership scheme. Subsequent to the 2016 UK ruling, there have been several rulings in the UK itself, including one as recent as July 2023, Financial Conduct Authority v. Forster & Ors  on the same issue.

if it is a collective investment scheme ensuring fixed returns on the money and of the money, it may not only be flouting the CIS Regulations, but also state laws on depositors’ protection. Notably,  most states have enacted such laws to curb the malaise of unregulated deposit schemes. These states exist in several states, including Maharashtra,  Tamil Nadu, West Bengal, etc. Not to leave the matter to states, the centre also enacted the Banning of Unregulated Deposit Schemes Act, giving enforcement powers, of course, to the States. These laws have very sharp penal implications, mostly providing for imprisonment as well as monetary fines.

With so much law making, and with so much to scare, there are still schemes and schemes which are founded on either the promise or the prospect of a fixed return. There are reports of several websites which offer fractional property shares: in fact, a SEBI Consultation Paper itself (discussed later) has listed several of such fractional ownership schemes, and real estate service providers such as Knight Frank have projected a sharp growth in fractional property shares. More recently, there are schemes that offer fractional ownership interests in green assets, leased furniture, etc.

The issue is, is the law about what constitutes a collective investment scheme clear enough? SEBI’s FAQs on the matter seem merely restatement of the law, providing no effective guidance. There have been several SEBI adjudication orders on the matter. Most of the SEBI adjudication orders pertain to transactions by real estate developers. There are some, which represent continuing action against plantation companies and similar devices which sprang in 1990s. It the plantation scam that resulted in the SEBI Committee under the chairmanship of Dr S A Dave, and eventually, the regulations on CIS became a part of the law.

Most of the SEBI adjudication orders, or orders by SAT, literally reproduce the features of a CIS as given in Sec 11AA of the SEBI Act, and do not help to advance the understanding. The adjudication orders mostly refer to these conditions:

(i) whether there was pooling of contributions for purposes of a scheme;

(ii) whether contributions were made with a view to receive assured realisable value;

(iii) whether the contributions were managed on behalf of the investors; and

(iv) whether the investors did not have day to day control over the management of the scheme

SAT orders would either repeat these conditions, or do detailed extracts from the 2016 Supreme Court ruling in M/s PGF ltd Vs Union of India.

There are some adjudication orders that make reference to “high rates of return”, as that was the backdrop of the plantation companies scam and the Dave Committee report. However, it needs to be understood that high or low rate of return is a matter of perception. If it is a pure money-for-money transaction, every investor who walks into such schemes does so with the lure of relatively much higher returns than are available with regulated investments such as mutual funds, bank deposits or even company fixed deposits. If an unregulated scheme is able to mop up crores of rupees from retail individuals, the only appeal is returns, for the high risk that the investors are taking.

There is a school of thought which asserts that a CIS should end up mopping up Rs 100 crores or more. For example, in a Calcutta High Court order, such an impression appears. However, this view is clearly mistaken. The proviso below sec. 11AA (1) does not control the operation of the section – all it says is that if Rs 100 crores or above has been raised, and the scheme is not one of the exempt schemes, then there will be no need to do a factual examination of the intent or operation, and the scheme will be deemed a CIS. Practically, this deeming fiction has little value, because before the fiction may be applied, the scheme has to be demonstrated to be a CIS.

So, what are the features of a CIS?

Succinctly stated, the following features establish the existence of a CIS:

• It is an investment scheme, and not a scheme to own, manage or run real assets. Investment implies some person handing over money to another, for the latter to manage the money, and provide return of, and return on, such money to the former.
• There is a pooling and commingling of money.
• There is no earmarking of the assets owned by different investors. That is, the investors pool their money to buy a common property or properties, and it is not possible to decipher the share of each person by segregating the same.
• The money is managed by a person other than the contributor. Thus, there is a manager who manages the money. The management is not done by the investor himself. For instance, in a partnership, partners commingle the money but they manage it as well.
• The money is sourced from several persons. This is more like an optical feature- the wider the outreach of the manager, trying to source money from unconnected persons, the more the scheme takes the colour of a CIS.
• There is an assured return. Most of SEBI adjudication orders talk about assured return of the money. A note of caution – returns may not be contractually guaranteed, but it is the prospect of returns that is used to attract investors. For example, a manager may say – investors in the past have earned upwards of X% returns. The more clear the message to an investor that he will get back his money with incremental returns, the closer the scheme becomes to a CIS.

The tests are quite often subjective; therefore, like any enquiry into the substance of a scheme, the approach becomes subjective.

If these features are present, the fact that the scheme is organised in a particular form of entity does not make a difference. Trusts are most commonly used, but some managers use LLP structures too, proliferating LLPs once the number reaches close to 200. An LLP is a partnership, and if one partner or some partners promise exit to other partners with a fixed return, the partnership becomes a farce. For that matter, if it was corporate structure, and the shareholders were given a buyback at a fixed return by the promoter of the scheme, it will still have the character of a CIS.

If not a CIS, what is it?

A joint ownership of an asset or joint operation of a business is not a case of a CIS. There are cases of jointly owned properties, jointly run businesses, or joint investments in assets. If the participants in the property, business or assets are all exposed to the risks and returns of the respective property, business or asset, the very fact that there is a handing over of  management to an independent manager does not make it a case of a CIS. As mentioned above, the core feature of a CIS is “investment”, that is, what is in essence a money for money transaction.

Let us start with an extremely basic example. If there is a mango tree owned by 5 individuals, who decide to share the produce in a certain proportion, no one can contend that the scheme is one of “investment”, as the co-owners are exposed to the risks/returns of owning a mango tree. Does it make a difference if the tree is managed by a 6th person? Not really.

Does it make a difference if there are 100 trees, owned by 100 different individuals, and managed by the 101th person? Technically, the mere increase in number should not make a difference, but that is precisely where the plantation company scam starts popping its head. The moment there is a mass sourcing of money, the probability that these 100 individuals had nothing to do with mangoes, and were simply lured by the prospect of a certain return becomes compelling. This is why fractional ownership schemes, which are sold on open platforms, may attract the provisions of CIS regulations.

Why should regulators act?

There are multiple reasons why regulators need to act.

First, there are clearly plenty of such schemes around, and more evidently so in the world of tokenisation where almost any real asset may be converted into fractional interests.

Secondly, clarity in regulation may create a place for innovation. The idea of regulation is not to curb innovation; on the contrary, the absence of regulatory clarity breeds worries, and risk averse innovators are driven away by the spectre of incarceration. Some dare to contend that their scheme is different, and all that it sets in motion is a demonstration effect, where every other person gets encouraged by looking at every other person doing it. Eventually, if regulatory action follows, it is a long rope of litigation, with very unpleasant consequences. Those with inside knowledge will confirm that matters are still in different legal forums for more than 10 years.

Third, a regulated investment breeds investor confidence. Things may be more systematic, more compliance-prone, and therefore, less as enticing; however, the entire activity is reliable and disciplined. Everyone gains, excepting those with mischief in mind.

SEBI proposes REITs-type regulation

SEBI recently proposed a REITs-style regulation of fractional ownership platforms for real estate assets. This SEBI Consultation paper dated May 12, 2023 proposes a REITs-type registration and regulation, including listing, for what SEBI names as MSM REITs.

However, the scope of the SEBI CP does not extend to assets other than real estate. For example, there may be a bunch of solar assets, gold, or any other income-yielding property such as furniture leases; fractional ownership models continue to exist and proliferate in those spaces. Most of these offer attractive rates of return. The rates of return entice small investors, and therefore, the stakes continue to get high.

Our views on the matter are as follows:

• If the substance of the scheme is to offer fixed rates of return to investors, it is not a fractional ownership scheme, but a collective investment scheme, which is clearly violative of the existing provisions of the SEBI CIS Regulations. The key features of a CIS have been succinctly discussed in our article and reiterated above.
• If it is a fractional ownership scheme, not promising, explicitly or implicitly, any guaranteed return, then one needs to see whether the scheme was a private invitation, or invitation to the public. In the latter case, there is a very strong likelihood of it being taken as CIS.
• If it is not a CIS, from a taxation viewpoint, it will, in all likelihood, be an “association of persons”, and therefore, be exposed to tax at maximum marginal rate. Of course, the investors’ share will not be taxable.
• There may be a question as to whether the undivided interest in movable property is exigible to GST. However, one may contend that the definition of “actionable claims”, including a beneficial interest in property not in the possession, will take such fractional ownership interests out of the purview of GST law.

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Read our other related article

1. Law relating to collective investment schemes on shared ownership of real assets