SEBI introduces enhanced disclosure and standardized reporting for AIFs

Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.

finserv@vinodkothari.com

SEBI has vide circular dated 5th February, 2020[1] introduced a standard Private Placement Memorandum (PPM) and mandatory performance bench-marking for Alternative Investment Funds (AIF). The move is part of SEBI’s initiative to streamline disclosure standards in the growing AIF space. The changes are made based on the recommendations of the SEBI Consultation Paper[2] on ‘Introduction of Performance Bench-marking’ and ‘Standardization of Private Placement Memorandum for AIFs’.

Template for Private Placement Memorandum (PPM)

The SEBI (AIF) Regulations, 2012 specified broad areas of disclosures required to be made in the PPM. This led to a significant variation in the manner in which various clauses, explanations and illustrations are incorporated in the PPMs. Hence, this led to concerns that the investors receive a PPM which provides information in a manner which is too complex to easily comprehend or with too little information on important aspects of the AIF, e.g. potential conflicts of interests, risk factors specific to AIF or its investment strategy, etc.

Thus, SEBI has mandated a template[3] for the PPM providing certain minimum level of information in a simple and comparable format. The template for PPM consists of two parts –

Part A – Section for minimum disclosures, which includes the following –

  • Executive Summary –

This lays down the summary of the parties and terms of the transaction. In effect, it is a summary term sheet of the PPM, laying down essential features of the transaction.

  • Market opportunity / Indian Economy / Industry Outlook;

The theme of this section includes a general economic background followed by investment outlook and sector/ industry outlook. This section may include any additional information as well which may be relevant. An illustrative list of additional items which may be included has been specified in the template.

  • Investment Objective, Strategy and Process;

A tabular representation of the investment areas and strategy to be employed is laid down in under this head. Further, a flow chart depicting the investment decision making process and detailed description of the same is required to be specified. This will give investors a comprehensive idea of the ultimate investment objective and strategy.

  • Fund/Scheme Structure;

A diagrammatic structure of the Fund/ Scheme which discloses all the key constituents and a brief description of the activities of the Fund/ Scheme.

The diagrammatic representation shall specify, for instance, the sponsor, trustee, manager, custodian, investment advisor, offshore feeder, etc. 

  • Governance Structure; 

To enhance the governance disclosures to investors and ensure transparency this section mandates disclosures of all details of each person involved in the Fund/ Scheme structure, including details about the investment team, advisory committees, operating partners, etc.

  • Track Record of the Manager;

The track record of the Fund Manager is of great significance since investors would like to know the skill, experience and competence of the Manager before making an investment.

The template mandates disclosures about the manager including explicit disclosure of whether he is a first time manager or experienced manager.

  • Principal terms of the Fund/ Scheme;

Explicit disclosures about the principal terms such as minimum investment commitment, size of the scheme, target investors, expenses, fees and other charges, etc. are required to be disclosed as per the template.

Major terms and disclosures are covered under this section. 

  • Principles of Portfolio Valuation;

This section would broadly lay down the principles that will be used by the Manager for valuation of the portfolio company.

The investors would get a fair idea of the manner in which valuation of the portfolio would be undertaken, in this section.

  • Conflicts of interest;

All present and potential conflicts of interests that the manager would envisage during the operation of the Fund/ Scheme at various levels are to be disclosed under this section.

This would enable investors to factor in the conflicts of interests existing or which may arise in the future of the fund and make an informed decision.

  • Risk Factors;

All risk factors that investors should take into account such as specific risks of the portfolio investment or the fund structure are required to be disclosed in the PPM.

These risks would include operational risks, tax risks, regulatory risks, etc. among other risk factors. 

  • Legal, Regulatory, and Tax Consideration;

This section shall include standard language for legal, regulatory and tax considerations as applicable to the Fund/Scheme, including the SEBI (AIF) Regulations, 2012, Takeover Regulations, Insider Trading Regulations, Anti-Money Laundering, Companies Act, 2013. Taxation aspects of the fund are also to be disclosed.

  • Illustration of fees, expenses and other charges;

A tabular representation of the fees and other charges along with the expenses of the Fund are required to be disclosed for transparency of investors and no hidden charges. 

  • Distribution Waterfall;

The payment waterfall to different classes of investors is required to be disclosed in detail.

  • Disciplinary History.

Any prior disciplinary action taken against the sponsor, manager, etc. will be required to be disclosed for better informed decision making of investors.

Part B – Supplementary section to allow full flexibility to the Fund in order to provide any additional information, which it deems fit.

The template requires enhanced disclosures mandatorily required to be made by the AIF, such as risk factors, investment strategy, conflicts of interest and several other areas that may affect the interest of the investors of AIFs.

This will standardize disclosures across the AIF space and increase simplicity of information to investors in a standard reporting format. Enhancing disclosure requirements will increase investor understanding about AIF schemes.

Further there is a mandatory requirement to carry out an annual audit of the compliance of the PPM by either an internal or external auditor/ legal professional. The findings arising out of the audit are required to be communicated to the Trustee or Board or Designated Partners of the AI, Board of the Manager and SEBI.

Exemption has been provided from the above PPM and audit requirements to the following classes of funds:

  1. Angel Funds as defined in SEBI (Alternative Investment Funds), Regulations 2012.
  2. AIFs/Schemes in which each investor commits to a minimum capital contribution of Rs. 70 crores (USD 10 million or equivalent, in case of capital commitment in non-INR currency) and also provides a waiver to the fund from the requirement of PPM in the SEBI prescribed template and annual audit of terms of PPM, in the manner provided at Annexure 3 of the SEBI Circular.

These requirements are however applicable from 01st March, 2020.

Bench-marking for disclosure of performance

Considering that investments by AIFs have grown at a rate of 75% year on year in the past two years, a need was felt to introduce disclosures by AIFs indicating returns on their investments. Prior to the SEBI circular there was no disclosure requirement for AIFs on their investment performance.

There was no bench-marking of returns disclosed by AIFs to their prospective or existing investors. However, returns generated on investment is one of the most important factors taken into consideration by potential investors and is also important for existing investors in order to be informed about the performance of their investment in comparison to a benchmark.

Therefore, it is felt that there is a need to provide a framework to bench-marking the performance of AIFs to be available for the investors and to minimize potential misselling.

In this regard SEBI has introduced the following –

  1. Mandatory bench-marking of the performance of AIFs (including Venture Capital Funds) and the AIF industry.
  2. A framework for facilitating the use of data collected by Bench-marking Agencies to provide customized performance reports.

The new bench-marking framework prescribes that each AIF must enter into an agreement with a Bench-marking Agency (notified by an AIF association representing at least 51% of the number of AIFs) for carrying out the bench-marking process.

The agreement between the Bench-marking Agencies and AIFs shall cover the mode and manner of data reporting, specific data that needs to be reported, terms including confidentiality in the manner in which the data received by the Bench-marking Agencies may be used, etc.

Reporting to the Bench marking Agency –

AIFs are required to report all the necessary information including scheme-wise valuation and cash flow data to the Bench-marking Agencies in a timely manner for all schemes which have completed at least one year from the date of ‘First Close’. The form and format of reporting shall be mutually decided by the Association and the Benchmarking Agencies.

If an applicant claims a track-record on the basis of India performance of funds incorporated overseas, it shall also provide the data of the investments of the said funds in Indian companies to the Benchmarking Agencies, when they seek registration as AIF.

PPM and Marketing material –

In case past performance of the AIF is mentioned in the PPM or any marketing material the performance versus benchmark report provided by the benchmarking agencies for such AIF/Scheme is also required to be provided.

Operational Guidelines for the benchmarking criteria is placed in Annexure 4 to the SEBI Circular.

Further there is an exemption from the above requirements to Angel Funds registered under sub-category of Venture Capital Fund under Category-1 AIF.

Conclusion

These changes are likely to bring about higher disclosure and transparency in the AIF space, especially for existing as well as potential investors of AIFs. Standardization of PPM will eliminate any variance from the manner of disclosures made by various AIFs.

Links to related write ups –

http://vinodkothari.com/2018/03/can-aif-grant-loans/

http://vinodkothari.com/wp-content/uploads/2018/03/PPT-on-financial-and-capital-markets_27-02-18_final.pdf

http://vinodkothari.com/aifart/

[1] https://www.sebi.gov.in/legal/circulars/feb-2020/disclosure-standards-for-alternative-investment-funds-aifs-_45919.html

[2] https://www.sebi.gov.in/reports-and-statistics/reports/dec-2019/consultation-paper-on-introduction-of-performance-benchmarking-and-standardization-of-private-placement-memorandum-for-alternative-investment-funds_45215.html

[3] https://www.sebi.gov.in/sebi_data/commondocs/feb-2020/an_1_p.pdf

SEBI brings in revised norms for Portfolio Managers

Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.

finserv@vinodkothari.com

The securities market regulator has recently introduced the new SEBI (Portfolio Managers) Regulations, 2020 (PMS Regulations), bringing in several changes to the Portfolio Management industry, including doubling the ticket size for investments and increasing the net-worth requirement of Portfolio Managers.

The Portfolio Management Services (PMS) industry has witnessed substantial growth in its Assets Under Management (AUM) in the last 5 years as shown in the data below. There has also been a substantial increase in the number of clients, indicating that the PMS industry plays a significant role in managing funds of High Net-worth Individuals.

Source: SEBI PMS Data[1]

This growth called for a need to review the existing PMS Regulations and provide for enhanced regulations to protect investor interest and increase transparency and disclosure norms for the benefit of investors.

SEBI constituted a Working Group to identify the areas that required change in the PMS Regulations. Based on the Report of the Working Group[2], SEBI introduced the new PMS Regulations on 16th January, 2020 which is primarily aimed at reducing risk for investors by imposing certain investment caps and increasing transparency in the PMS industry. We discuss some of the major changes made and their impact on the industry.

Increase in ticket size of investment

The new regulations prescribe an increase in the minimum investment limit from earlier Rs. 25 Lakh to Rs. 50 Lakh in the new regulations. The rationale behind the increase is that Portfolio Management Services unlike mutual funds are more complicated and riskier products, meant for investors with higher risk taking capacity. So to avoid retail investors with limited understanding of volatility and risk entering this product, it is thought prudent to increase the minimum investment limit.

This increase is likely to deny the benefits of PMS to retail investors in the Rs. 25 – 50 Lakh investment bracket. Further the growth of PMS industry is likely to decline as there will be fewer new investors entering this product due to the increased limit. However with the sharp and rather rapid growth in the economy and stock markets, the increased investment limits seems justified considering that the last increase in the minimum limit was done 8 years ago in February, 2012.

Net-worth requirement increased to Rs. 5 crores

The new regulations prescribe an increase in the capital adequacy requirement of Portfolio Managers from the present Rs. 2 crores to Rs. 5 crores with a view to act as a deterrent to non-serious players in the PMS industry and also put pressure on fringe players co-existing with serious managers.

The limit was also increased considering several other factors such as inflation, rising income levels, increased compliance costs, IT costs, etc.

New Investment norms

Earlier the investment made by PMS was liberal as opposed to mutual funds where there existed several restrictions on investment and exposure norms. The new regulations have brought in investment restrictions for both discretionary and non-discretionary PMS.

Discretionary PMSs are those wherein the Portfolio Managers have some degree of discretion with respect to managing the funds of their clients. While non-discretionary PMS have no degree of discretion and require prior client consent each time a transaction is undertaken.

The PMS Regulations, 2020 introduce restrictions on investment in unlisted securities by mandating discretionary PMS to invest only in listed securities, while non-discretionary PMS can invest in unlisted securities up to 25% of their AUM.

This move is likely to reduce the risk for clients of PMS and disallow high exposure to investment in unlisted securities. It is important to note that similar restrictions on investment are also imposed on Mutual Funds in 2019. Investment in listed securities only brings in higher levels of disclosures and transparency to the clients investment portfolio.

Further investment in mutual funds may be done by Portfolio Managers only through ‘Direct Plans’. This is with a view to avoid charging any distributor’s fee from the clients.

Other investment norms are largely the same as 1993 PMS Regulations.

Nomenclature “Investment Approach”

The Working Group recommended the adoption of a standard nomenclature called the Investment Approach of Portfolio Managers, permitted to be used in reporting and disclosure documents of PMS as the same does not compromise the bi-laterality of the Portfolio Management Contract.

Adopting the nomenclature for reporting and disclosures by Portfolio Managers will allow them to easily compare performance of multiple investment approaches under the umbrella of one Portfolio Manager. There are concerns as to whether investors would then get confused between a Mutual Fund Scheme and the Investment Approach of a Portfolio Manager. This is unlikely as the Working Group addressed this issue by stating that the investors in PMS are highly sophisticated with higher understanding of the differences between Mutual fund schemes and Portfolio Managers.

Standardized Reporting

Performance reporting standards were revisited in light of the need for standardized & accurate reporting for all Portfolio Managers. Proposals were made by the Working Group for reporting at the client level, reporting to SEBI and reporting for marketing materials as well. Since, there was no standardized reporting in the earlier framework, several issues were pointed out by the Working Group such as –

  • Cherry picking certain portfolios by Portfolio Managers;
  • Performance calculation differed among several Portfolio Managers;
  • Portfolio managers showing model returns;
  • Portfolio managers inflating returns by annualizing partial periods;
  • Comparing the strategy’s returns with incorrect benchmark returns;
  • Not taking into account the cash component in computing returns
  • Ignoring withdrawn portfolios;
  • Not disclosing qualitative parameters such as a change in the identity of the fund manager, change in the investment strategy.

The PMS Regulations, 2020 address these issues by bringing in standard performance reporting for all Portfolio Managers. The Regulations prescribe calculation of performance of a Portfolio Manager using a standard ‘Time Weighted Rate of Return’ (TWRR) and has also increased the frequency of reporting to clients from the earlier half yearly reporting to quarterly reporting to clients.

Qualifying criteria for employees of a Portfolio Manager

Considering the importance of educational qualification as well as work experience in the PMS industry, the working group recommended a change in the qualifying criteria of the Principal Officer (PO) as well as employees of the PO. The new qualifying criteria is depicted hereunder –

Particulars PMS Regulations, 1993 Working Group Recommendation PMS Regulations, 2020
Definition of PO Reg 2(d) – “principal officer” means an employee of the portfolio manager who has been designated as such by the portfolio manager; Reg 2(l) – “Principal Officer” means an employee of the portfolio manager who is responsible for:-

(A) The decisions made by the portfolio manager for the management or administration of a portfolio of securities or the funds of the client, as the case may be.

(B) The overall supervision of the operations of the portfolio manager.

Reg 2(p) – “principal officer” means an employee of the portfolio manager who has been designated as such by the portfolio manager and is responsible for: –

(i) the decisions made by the portfolio manager for the management or administration of portfolio of securities or the funds of the client, as the case may be; and

(ii) all other operations of the portfolio manager.

Qualifying criteria for PO The principal officer of the applicant has either–

(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university; or

(ii) an experience of at least ten years in related activities in the securities market including in a portfolio manager, stock broker or as a fund manager;

(iii) a CFA charter from the CFA Institute.

Principal Officer of a Portfolio Manager shall have minimum qualification as given below:

1. a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university and relevant NISM certification

AND

2. an experience of at least Five years in related activities in the securities market including as a portfolio manager, stock broker, Investment Advisor or a fund manager.

 

the principal officer of the applicant has–

(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university or a CFA charter from the CFA institute;

(ii) experience of at least five years in related activities in the securities market including in a portfolio manager, stock broker, investment advisor, research analyst or as a fund manager; and

(iii) the relevant NISM certification as specified by the Board from time to time.

Provided that at least 2 years of relevant experience is in portfolio management or investment advisory services or in the areas related to fund management.

Qualifying criteria for employees of the PM The applicant has in its employment minimum of two persons who, between them, have at least five years’ experience in related activities in portfolio management or stock broking or investment management or in the areas related to fund management; Minimum two employees with –

(i) a professional qualification in finance, law, accountancy or business management from a university or an institution recognized by the Central Government or any State Government or a foreign university and relevant NISM certification

AND

(ii) an experience of at least two years in related activities in the securities market including as a portfolio manager, stock broker, Investment Advisor or a fund manager.

In addition, any employee of the Portfolio Manager who has decision making authority related to fund management shall have the same minimum qualifications as the Principal Officer.

In addition to the Principal Officer and Compliance Officer, the applicant has in its employment at least one person with the following qualifications :-

(i) graduation from a university or an institution recognized by the Central

Government or any State Government or a foreign university; and

(ii) an experience of at least two years in related activities in the securities market including in a portfolio manager, stock broker, investment advisor or as a fund manager:

Provided that any employee of the Portfolio Manager who has decision making authority related to fund management shall have the same minimum qualifications and experience as specified for the Principal Officer in clause (d) of sub-regulation (2) of regulation 7:

There are several legal and regulatory compliances required on part of a Portfolio Manager under the PMS Regulations. This called for the need to mandate appointment of a Compliance Officer, in addition to the Principal Officer, who shall be responsible for all legal and regulatory compliances.

Under Regulation 34 of the PMS Regulations, it is specifically stated that the role of the compliance officer shall not be assigned to the principal officer or employees of the Portfolio Manager. This was not stated under the PMS Regulations, 1993. This means that a person having the necessary legal background and qualifications will be required to be additionally appointed by each Portfolio Manager and it must be ensured that the role is not assigned to the principal officer or employees of the Portfolio Manager.

Conclusion

The changes in the PMS Regulations bring in enhanced disclosure and standardization for the PMS industry. Clients of PMS will be able to better understand and compare the terms of services offered by various Portfolio Managers.

Although the changes in the regulations are most welcome, the growth of the PMS industry will likely see a slowdown due to the increased investment minimum limit for clients of PMS of Rs. 50 Lakh.

[1] https://www.sebi.gov.in/statistics/assets-managed/assets-managed.html

[2] https://www.sebi.gov.in/sebi_data/commondocs/aug-2019/Report%20of%20Working%20Group%20on%20PMS_p.pdf

Relaxations to FPIs ahead of Budget, 2020

Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.

timothy@vinodkothari.com

As investors wait eagerly in anticipation of what changes Budget, 2020 could bring, the RBI has on 23rd January, 2020[1], provided a boost by revising the norms for investment in debt by Foreign Portfolio Investors (FPIs). This comes as a boost to FPIs as the revised norms allow more flexibility for investment in the Indian Bond Market.

Further the RBI has also amended the Voluntary Retention Route for FPIs extending its scope by increasing the investment cap limit to almost twice the previously stated amount. The amendments widen the benefits to FPIs who invest under the scheme.

This write up intends to cover the revised limits in brief.

Review of limits for investment in debt by FPIs

  1. Investment by FPIs in Government securities

As per Directions issued by RBI[2] with respect to investment in debt by FPIs, FPIs were allowed to make short term investments in either Central Government Securities or State Development Loans. However, the said short term investment was capped at 20% of the total investment of that FPI, i.e., the short term investment by an FPI in Government Securities earlier could not exceed 20% of their total investment.

The above limit of 20% has now been increased to 30% of the total investment of the FPI.

  1. Investment by FPIs in Corporate Bonds

Similar to the above restriction, FPIs were also restricted from making short term investments of more than 20% of their total investment in Corporate Bonds.

The above cap is also increased from 20% to 30% of the total investment of the FPI.

The above increase in investment limits provides more flexibility for making investment decisions by FPIs.

Exemptions from short term investment limit

As per the RBI directions, certain types of securities such as Security Receipts (SRs) were exempted from the above limit. Thus, the above short term investment limit were not applicable in case of investment by an FPI in SRs.

Now the above exemption is extended to the following securities as well –

  • Debt instruments issued by Asset Reconstruction Companies; and
  • Debt instruments issued by an entity under the Corporate Insolvency Resolution Process as per the resolution plan approved by the National Company Law Tribunal under the Insolvency and Bankruptcy Code, 2016

This widens the scope of investment by FPIs who wish to make short term investments in debt.

Further the requirements of single/group investor-wise limits in corporate bonds are not applicable to investments by Multilateral Financial Institutions and investments by FPIs in ‘Exempted Securities’.

Thus this amendment brings in more options for FPIs to invest without having to consider the single/group investor-wise limits.

Relaxations in “Voluntary Retention Route” for FPIs

The Voluntary Retention Route for FPIs was first introduced on March 01, 2019[3] with a view to enable FPIs to invest in debt markets in India. FPI investments through this route are free from the macro-prudential regulations and other regulatory norms applicable to FPI investment in debt markets subject to the condition that the FPIs voluntarily commit to retain a required minimum percentage of their investments in India for a specified period.

Subsequently the scheme was amended on 24th May, 2019[4].

On 23rd January, 2020[5] the RBI has brought in certain relaxations to the above VRR scheme. The changes made are most certainly welcome since it increases the scope of the scheme and provides relaxations to FPIs. The highlights are as under –

Increase in investment cap –

Investment through the VRR for FPIs was earlier subject to a cap of Rs. 75,000 crores. As on date around Rs. 54,300 crores has already been invested in the scheme. Thus based on feedback from the market and in consultation with the Government it was decided to increase the said investment limit to Rs. 1,50,000 crores.

Transfer of investments made under General Investment Limit to VRR –

‘General Investment Limit’, for any one of the three categories, viz., Central Government Securities, State Development Loans or Corporate Debt Instruments, means the FPI investment limits announced for these categories under the Medium Term Framework, in terms of RBI Circular dated April 6, 2018, as modified from time to time.

Now the RBI has allowed FPIs to transfer their investments made under the above mentioned limit to the VRR scheme.

Investment in ETFs that trade invest only in debt

Earlier under the VRR scheme, investments were allowed in the following –

  • Any Government Securities i.e., Central Government dated Securities (G-Secs), Treasury Bills (T-bills) as well as State Development Loans (SDLs);
  • Any instrument listed under Schedule 1 to Foreign Exchange Management (Debt Instruments) Regulations, 2019 notified, vide, Notification dated October 17, 2019, other than those specified at 1A(a) and 1A(d) of that schedule;
  • Repo transactions, and reverse repo transactions.

Pursuant to the amendment, the RBI has allowed FPIs to invest in Exchange Traded Funds (ETFs) investing only in debt instruments.

Further the following features are introduced for the fresh allotment opened by RBI under this route –

  1. The minimum retention period shall be three years.
  2. Investment limits shall be available ‘on tap’ and allotted on ‘first come, first served’ basis.
  3. The ‘tap’ shall be kept open till the limit is fully allotted.
  4. FPIs may apply for investment limits online to Clearing Corporation of India Ltd. (CCIL) through their respective custodians.
  5. CCIL will separately notify the operational details of application process and allotment.

Conclusion

The changes made by RBI certainly attract more FPIs to the Indian Bond Market and extends its scope. The relaxations come ahead of the Budget, 2020 wherein foreign investors have more expectations for new reforms to boost growth and investment in the Indian economy.

Links to our earlier write ups on the subject –

Recommendations to further liberalise FPI Regulations –

http://vinodkothari.com/2019/06/recommendations-to-further-liberalise-fpi-regulations/

RBI removes cap on investment in corporate bonds by FPIs –

http://vinodkothari.com/2019/02/rbi-removes-cap-on-investments-in-corporate-bonds-by-fpis/

RBI widens FPI’s avenue in corporate bonds –

http://vinodkothari.com/2018/05/rbi-widens-fpis-avenue-in-corporate-bonds/

Investment by FPIs in securitised debt instruments

http://vinodkothari.com/2018/06/investment-by-fpis-in-securitised-debt-instruments/

SEBI brings in liberalised framework for Foreign Portfolio Investors –

http://vinodkothari.com/2019/09/sebi-brings-in-liberalised-framework-for-foreign-portfolio-investors/

 

[1] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/APDIR18184461ABA6F14E2EA51DF0243B610CE6.PDF

[2] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11303&Mode=0

[3] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11492&Mode=0

[4] https://www.rbi.org.in/Scripts/NotificationUser.aspx?Id=11561&Mode=0

[5] https://rbidocs.rbi.org.in/rdocs/notification/PDFs/APDIR19FABE1903188142B9B669952C85D3DCEE.PDF

Sale assailed: NBFC crisis may put Indian securitisation transactions to trial

-By Vinod Kothari (vinod@vinodkothari.com)

Securitisation is all about bankruptcy remoteness, and the common saying about bankruptcy remoteness is that it works as long as the entities are not in bankruptcy! The fact that any major bankruptcy has put bankruptcy remoteness to challenge is known world-over. In fact, the Global Financial Crisis itself put several never-before questions to legality of securitisation, some of them going into the very basics of insolvency law[1]. There have been spate of rulings in the USA pertaining to transfer of mortgages, disclosures in offer documents, law suits against trustee, etc.

The Indian securitisation market has faced taxation challenges, regulatory changes, etc. However, it has so far been immune from any questions at the very basics of either securitisability of assets, or the structure of securitisation transactions, or issues such as commingling of cashflows, servicer transition, etc. However, sitting at the very doorstep of defaults by some major originators, and facing the spectrum of serious servicer downgrades, the Indian securitisation market clearly faces the risk of being shaken at its basics, in not too distant future.

Before we get into these challenges, it may be useful to note that the Indian securitisation market saw an over-100% growth in FY 2019 with volumes catapulting to INR 1000 billion. In terms of global market statistics, Indian market may now be regarded as 2nd largest in ex-Japan Asia, only after China.

Since the blowing up of the ILFS crisis in the month of September 2018, securitisation has been almost the only way of liquidity for NBFCs. Based on the Budget proposal, the Govt of India launched, in Partial Credit Guarantee Scheme, a scheme for partial sovereign guarantee for AA-rated NBFC pools. That scheme seems to be going very well as a liquidity breather for NBFCs. Excluding the volumes under the partial credit enhancement scheme, securitisation volumes in first half of the year have already crossed INR 1000 billion.

In the midst of these fast rising volumes, the challenges on the horizon seem multiple, and some of them really very very hard. This write up looks at some of these emerging developments.

Sale of assets to securitisation trusts questioned

In an interim order of the Bombay High court in Edelweiss AMC vs Dewan Housing Finance Corporation Limited[2], the Bombay High court has made certain observations that may hit at the very securitisability of receivables.  Based on an issue being raised by the plaintiff, the High Court has directed the company DHFL to provide under affidavit details of all those securitisation transactions where receivables subject to pari passu charge of the debentureholders have been assigned, whether with or without the sanction of the trustee for the debentureholders.

The practice of pari passu floating charge on receivables is quite commonly used for securing issuance of debentures. Usually, the charge of the trustees is on a blanket, unspecific common pool, based on which multiple issuances of debentures are covered. The charge is usually all pervasive, covering all the receivables of the company. In that sense, the charge is what is classically called a “floating charge”.

These are the very receivables that are sold or assigned when a securitisation transaction is done. The issue is, given the floating nature of the charge, a receivable originated automatically becomes subject to the floating charge, and a receivable realised or sold automatically goes out of the purview of the charge. The charge document typically requires a no-objection confirmation of the chargeholder for transactions which are not in ordinary course of business. But for an NBFC or an HFC, a securitisation transaction is a mode of take-out and very much a part of ordinary course of business, as realisation of receivables is.

If the chargeholder’s asset cover is still sufficient, is it open for the chargeholder to refuse to give the no-objection confirmation to another mode of financing? If that was the case, any chargeholder may just bring the business of an NBFC to a grinding halt by refusing to give a no-objection.

The whole concept of a floating charge and its priority in the event of bankruptcy has been subject matter of intensive discussion in several UK rulings[3]. There have been discussions on whether the floating charge concept, a judge-made product of UK courts, can be eliminated altogether from the insolvency law[4].

In India, the so-called security interest on receivables is not really intended to be a security device – it is merely a regulatory compliance with company law rules under which unsecured debentures are treated as “deposits”[5]. The real intent of the so-called debenture trust document is maintenance of an asset cover, which may be expressed as a covenant, even otherwise, in case of an unsecured debenture issuance. The fact is that over the years, the Indian bond issuance market has not been able to come out of the clutches of this practice of secured debenture issuance.

While bond issuance practices surely need re-examination, the burning issue for securitisation transactions is – if the DHFL interim ruling results into some final observations of the court about need for the bond trustee’s NOC for every securitisation transaction, all existing securitisation transactions may also face similar challenges.

Servicer-related downgrades

Rating agencies have recently downgraded two notches from AAA ratings several pass-through certificate transactions of a leading NBFC. The rationale given in the downgrade action, among other things, cites servicer risks, on the ground that the originator has not been able to obtain continuous funding support from banks. While absence of continuing funding support may affect new business by an NBFC, how does it affect servicing capabilities of existing transactions, is a curious question. However, it seems that in addition to the liquidity issue, which is all pervasive, the rating action in the present case may have been inspired by some internal scheme of arrangement proposed by the NBFC in question.

This particular downgrades may, therefore, not have a sectoral relevance. However, what is important is that the downgrades are muddying the transition history of securitisation ratings. From the classic notion that securitisation ratings are not susceptible to originator-ratings, the dependence of securitisation transactions to pure originator entity risks such as internal funding strengths or scheme of arrangement puts a risk which is usually not considered by securitisation investors. In fact, the flight to securitisation and direct assignments after ILFS crisis was based on the general notion that entity risks are escaped by securitisation transactions.

Servicer transitions

The biggest jolt may be a forced servicer transition. In something like RMBS transactions, outsourcing of collection function is still easy, and, in many cases, several activities are indeed outsourced. However, if it comes to more complicated assets requiring country-wide presence, borrower franchise and regular interaction, if servicer transition has to be forced, the transaction will be worse than originator bankruptcy.

Questions on true sale

The market has been leaning substantially on the “direct assignment” route. Most of the direct assignments are seen by the investors are look-alikes and feel-alikes of a loan to the originator, save and except for the true-sale opinion. Investors have been linking their rates of return to their MCLR. Investors have been viewing the excess spread as a virtual credit support, which is actually not allowed as per RBI regulations. Pari-passu sharing of principal and interest is rarely followed by the market transactions.

If the truth of the sale in most of the direct assignment transactions is questioned in cases such as those before the Bombay High court, it will not be surprising to see the court recharacterise the so-called direct assignments as nothing but disguised loans. If that was to happen in one case of a failed NBFC, not only will the investors lose the very bankruptcy-remoteness they were hoping for, the RBI will be chasing the originators for flouting the norms of direct assignment which may have hitherto been ignored by the supervisor. The irony is – supervisors become super stringent in stressful times, which is exactly where supervisor’s understanding is required more than reprimand.

Conclusion

NBFCs are passing through a very strenuous time. Delicate handling of the situation with deep understanding and sense of support is required from all stakeholders. Any abrupt strong action may exacerbate the problem beyond proportion and make it completely out of control. As for securitisation practitioners, it is high time to strengthen practices and realise that the truth of the sale is not in merely getting a true sale opinion.

Other Related Articles:


[1] For example, in a Lehman-related UK litigation called Perpetual Trustees vs BNY Corporate Trustee Services, the typical clause in a synthetic securitisation diverting the benefit of funding from the protection buyer (originator – who is now in bankruptcy) to the investors, was challenged under the anti-deprivation rule of insolvency law. Ultimately, UK Supreme Court ruled in favour of securitisation transactions.

[2] https://www.livelaw.in/pdf_upload/pdf_upload-365465.pdf. Similar observations have been made by the same court in Reliance Nippon Life AMC vs  DHFL.

[3] One of the leading UK rulings is Spectrum Plus Limited, https://www.bailii.org/uk/cases/UKHL/2005/41.html. This ruling reviews whole lot of UK rulings on floating charges and their priorities.

[4] See, for example, R M Goode, The Case for Abolition of the Floating Charge, in Fundamental Concepts of Commercial Law (50 years of Reflection, by Goode)

[5] Or partly, the device may involve creation of a mortgage on a queer inconsequential piece of land to qualify as “mortgage debentures” and therefore, avail of stamp duty relaxation.

Indian Securitisation Market opens big in FY 20 – A performance review and a diagnosis of the inherent problems in the market

By Abhirup Ghosh , (abhirup@vinodkothari.com)(finserv@vinodkothari.com)

Ever since the liquidity crisis crept in the financial sector, securitisation and direct assignment transactions have become the main stay fund raising methods for the financial sector entities. This is mainly because of the growing reluctance of the banks in taking direct exposure on the NBFCs, especially after the episodes of IL&FS, DHFL etc.

Resultantly, the transactions have witnessed unprecedented growth. For instance, the volume of transactions in the first quarter of the current financial year stood at a record ₹ 50,300 crores[1] which grew at 56% on y-o-y basis from ₹ 32,300 crores. Segment-wise, the securitisation transactions grew by whooping 95% to ₹ 22,000 crores as against ₹ 11,300 crores a year back. The volume of direct assignments also grew by 35% to ₹ 28,300 crores as against ₹ 21,000 crores a year back.

The chart below show the performance of the industry in the past few years:

Direct Assignments have been dominating market with the majority share. During Q1 FY 20, DAs constituted roughly 56% of the total market and PTCs filled up the rest. The chart below shows historical statistics about the share of DA and PTCs:

In terms of asset classes, non-mortgage asset classes continue to dominate the market, especially vehicle loans. The table below shows the share of the different asset classes of PTCs:

Asset class

Q1 FY 20 share Q1 FY 19 share FY 19 share
Vehicle (CV, CE, Car) 51% 57% 49%
Mortgages (Home Loan & LAP) 20% 0% 10%
Tractor 6% 0% 10%
MSME 5% 1% 4%
Micro Loans 4% 23% 16%
Lease Rentals 0% 13% 17%
Others 14% 6% 1%

Asset class wise share of PTCs

Source: ICRA

Shortcomings in the current securitisation structures

Having talked about the exemplary performance, let us now focus on the potential threats in the market. A securitisation transaction becomes fool proof only when the transaction achieves bankruptcy-remoteness, that is, when all the originator’s bankruptcy related risks are detached from the securitised assets. However, the way the current transactions are structured, the very bankruptcy-remoteness of the transactions has become questionable. Each of the problems have been discussed separately below:

Commingling risk

In most of the current structures, the servicing of the cash flows is carried out of the originator itself. The collections are made as per either of the following methods:

  1. Cash Collection – This is the most common method of repayment in case of micro finance and small ticket size loans, where the instalments are paid in cash. Either the collection agent of the lender goes to the borrower for collecting the cash repayments or the borrower deposits the cash directly into the bank account of the lender or at the registered office or branch of the lender.
  2. Encashment of post-dated cheques (PDCs) – The PDCs are taken from the borrower at the inception of the credit facility for the EMIs and as security.
  3. Transfer through RTGS/NEFT by the customer to the originator’s bank account.
  4. NACH debit mandate or standing instructions.

 

In all of the aforesaid cases, the payment flows into the current/ business account of the originator. The moment the cash flows fall in the originator’s current account, they get exposed to commingling risk. In such a case, if the originator goes into bankruptcy, there could be serious concerns regarding the recoverability of the cash flows collected by the originator but not paid to the investors. Also, because redirection of cash flows upon such an event will be extremely difficult to implement. Therefore, in case of exigencies like the bankruptcy of the originator, even an AAA-rated security can become trash overnight. This brings up a very important question on whether AAA-PTCs are truly AAA or not.

 

This issue can be addressed if, going forward, the originators originate only such transactions in which repayments are to happen through NACH mandates. NACH mandates are executed in favour of third party service providers which triggers direct debit from the bank account of the customers every month against the instalments due. Upon receipt of the money from the customer, the third party service providers then transfer the amount received to the originators. Since, the mandates are originally executed in the name of the third party service providers and not on the originators, the payments can easily be redirected in favour of the securitisation trusts in case the originator goes into bankruptcy. The ease of redirection of cash flows NACH mechanism provides is not available in any other ways of fund transfer, referred above.

Will the assets form part of the liquidation estate of the lessor, since under IndAS the assets continue to get reflected on Balance Sheet of the originator?

With the implementation of Ind AS in financial sector, most of the securitisation transactions are failing to fulfil the complex de-recognition criteria laid down in Ind AS 109. Resultantly, the receivables continue to stay on the books of the originator despite a legal true sale of the same. Due to this a new concern has surfaced in the industry that is, whether the assets, despite being on the books of the originator, be absolved from the liquidation estate of the originator in case the same goes into liquidation.

Under the current framework for bankruptcy of corporates in India, the confines of liquidation estate are laid in section 36 of the IBC. Section 36 (3) lays what all will be included therein. Primarily, section 36 (3) (a) is the relevant provision, saying “any assets over which the corporate debtor has ownership rights” will be included in the estate. There is a reference to the balance sheet, but the balance sheet is merely an evidence of the ownership rights. The ownership rights are a matter of contract and in case of receivables securitised, the ownership is transferred to the SPV.

The bounds of liquidation estate are fixed by the contractual rights over the asset. Contractually, the originator has transferred, by way of true sale, the receivables. The continuing balance sheet recognition has no bearing on the transfer of the receivables. Therefore, even if the originator goes into liquidation, the securitised assets will remain unaffected.

Conclusion

Despite the shortcomings in the current structures, the Indian market has opened big. After the market posted its highest volumes in the year before, several industry experts doubted whether the market will be able to out-do its previous record or for that matter even reach closer to what it has achieved. But after a brilliant start this year, it seems the dream run of the Indian securitisation industry has not ended yet.


[1] https://www.icra.in/Media/OpenMedia?Key=94261612-a1ce-467b-9e5d-4bc758367220

Distinguishing between Options and Forwards

By Falak Dutta (rajeev@vinodkothari.com)

Ruling of Bombay High Court

The Bombay High Court on March 27, 2019, in the case of Edelweiss Financial Services v. Percept Finserve Pvt. Ltd.[1], ruled out an award passed by a sole arbitrator with respect to a share purchase agreement (SPA). The High Court allowed enforcing of a put option clause to be exercised by Edelweiss, the appellant, to sell back the shares it had acquired from Percept Group, the respondent.

Before delving into the proceedings of the aforesaid case, it is important to understand certain basic concepts, to appreciate the ‘option clause’ in the case. An option is a derivative contract which gives the holder the right but not the obligation to buy (call) or sell (put) the underlying within a stipulated time in exchange for a premium. Options are not just traded on exchanges but are also used in debt instruments (eg. callable and puttable bonds), private equity and venture capital investment covenants. Even insurance is a type of option contract where the insured pays monthly premium in exchange of a monetary claim upon the future occurrence of a contingent event (accident, disease, damage to property etc.).

 

Facts of the case

Edelweiss Financial Services Pvt. Ltd. entered into a share purchase agreement (SPA) dated 8, December, 2007 with the Percept Group where it invested in the shares of Percept Group subject to a condition that the latter shall restructure itself as agreed between the parties followed by an IPO. Under the terms of the SPA, the appellant (Edelweiss) purchased 228,374 shares for a consideration of Rs. 20 crores. One of the conditions in the agreement, required Percept to entirely restructure by 31st December, 2007 and to provide proof of such restructuring. Upon failure of compliance by the respondent, the date was further extended to 30 June, 2008 with obligation to provide documentary evidence of completion by 15th, July 2008. Upon non-fulfillment within the extended date, Edelweiss had the option to re-sell the shares to Percept, where Percept was obligated to purchase the shares at a price which gave the appellant an internal rate of return of 10% on the original purchase price.

As was the case, Percept failed to restructure itself within the stipulated time. Subsequently in view of this breach Edelweiss exercised the put option and Percept was required to buy back the shares for a total consideration of Rs. 22 crores. Since the respondent refused to comply the appellant invoked the arbitration clause in the SPA and a sole arbitrator was appointed to adjudicate the dispute. The arbitrator submitted that despite Percept being in breach of the conditions in the SPA, the petitioner’s claim to exercise the put option was illegal and unenforceable, being in conflict with the Securities Contracts regulation Act (SCRA), 1956. The unenforceability was proposed on two grounds. First, for the clause being a forward contract prohibited under Section 16 of SCRA read with SEBI March 2000 notification, which recognizes only spot delivery transactions to be valid. Secondly these clauses were illegal because they contained an option concerning a future purchase of shares and were thus a derivatives contract not traded on a recognized stock exchange and thus were illegal under Section 18 of SCRA, which deals with derivative trading.

Aggrieved by the arbitrator’s order, Edelweiss challenged it before the Bombay High Court under section 34 of the Arbitration & Conciliation Act, 1996.

 

The Judgement

The Bombay High Court observed the reasoning of the order by the arbitrator and the contentions made by Percept. The said order confirmed the breach caused by Percept, but found the particular clauses of put option in the SPA to be illegal under two grounds as mentioned earlier. The Court divided the judgement along the sections involved.

The first of the arbitrator’s conclusion was found untenable when referred to the judgement in the case of MCX Stock Exchange Ltd. vs. SEBI [2]which deals with such a purchase option as in the present case. The Court observed that the put option clause contained in the SPA cannot be a derivatives contract prohibited by SCRA, because there was no present obligation at all and the obligation arose by reason of a contingency occurring in the future. The contract only came into being upon the following two conditions being met: (i) failure of the condition attributable to Percept (ii) exercise of the option by Edelweiss upon such failure. Whereas a forward contract is an unconditional obligation, the option in the SPA only comes into being when the aforesaid conditions are met. Thus, the arbitrator’s claim of the clause being a forward contract disregards the law stated by the Court in MCX Stock (supra).

Subsequently, respondent (Percept Group) challenged the relevance of the MCX Stock case to the present one. In the MCX Stock Exchange case, upon the exercise of the option the contract would be fulfilled by means of a spot delivery, that is, by immediate settlement. Whereas Edelweiss’s letter by which it exercised the put option required the shares to be re-purchased with immediate effect or before 12 Jan, 2009. This deferral of repurchase upon exercise of the option was not part of the MCX Stock Exchange case’s option clause and hence is not comparable to the present case.

This too was disregarded by the Court on the ground:

“It is submitted that in as much as this exercise of options demands repurchase on or before a future date, it is not a contract excepted by the circular of the SEBI dated 1 March, 2000.

Just because the original vendor of securities is given an option to complete repurchase of securities by a particular date it cannot be said that the contract for repurchase is on any basis other than spot delivery.

There is nothing to suggest that there is any time lag between payment of price and delivery of shares.”

Now, this brings us to the second leg of the arbitrator’s award regarding the illegality and unenforceability of the SPA option on account of breach of Section 18A of SCRA, which deals in derivative trading. The following is an excerpt from Section 18A:

Contracts in derivative. — Notwithstanding anything contained in any other law for the time being in force, contracts in derivative shall be legal and valid if such contracts are—

(a)Traded on a recognized stock exchange;

(b) Settled on the clearing house of the recognized stock exchange. In accordance with the rules and bye-laws of such stock exchange.

The respondent appeals that as the put option was not of a recognized stock exchange, it stands unenforceable and illegal. In response, the court submitted that the contract does contain a put option in securities which the holder may or may not exercise. But the real question is whether such option or its exercise is illegal? The presence of the option does not make it bad or impermissible.

“What the law prohibits is not entering into a call or put option per se; what it prohibits is trading or dealing in such option treating it as a security. Only when it is traded or dealt with, it attracts the embargo of law as a derivative, that is to say, a security derived from an underlying debt or equity instrument.”

There was further cross objections filed by the respondent but it was ruled out under Section 34 of the Arbitration & Conciliation Act, which deals with the application for setting aside arbitral award. Since the provisions of Civil Procedure Code, 1908 are not applicable to the proceedings under Section 34 and the section itself does not make any provision for filing of cross objections, the appeal was ruled out.

Conclusion

This Bombay High Court ruling in favor of Edelweiss provides an important distinction of options, from forward contracts. It highlighted that although both options and forwards are commonly categorized as derivatives, they share an important difference. On one hand, a forward contract contains a contractual obligation to buy or sell, on the other hand, the option gives the holder the right or choice but not the obligation to do the same. Options have always been integral to finance, routinely appearing in corporate covenants and contracts. Options are widely observed in mezzanine financing, private equity, start-up and venture funding among others. Given the Court’s distinction of forwards from options in their very essence and nature, the author believes this ruling is likely to be useful and a point of reference in future derivative litigations.

 

[1]https://bombayhighcourt.nic.in/generatenewauth.php?auth=cGF0aD0uL2RhdGEvanVkZ2VtZW50cy8yMDE5LyZmbmFtZT1PU0FSQlAxNDgxMTMucGRmJnNtZmxhZz1OJnJqdWRkYXRlPSZ1cGxvYWRkdD0wMi8wNC8yMDE5JnNwYXNzcGhyYXNlPTA0MDYxOTEwMDAyOQ==

[2] https://indiankanoon.org/doc/101113552/

Union Budget 2019-20: Impact on Corporate and Financial sector