Vinod Kothari & Company
Below is a short snippet of the relaxed timelines issued by the securities market regulator in the wake of the disruption caused by COVID-19.
SEBI’s proposal–came late, came correct
-CS Nitu Poddar, Tanvi Rastogi
Financial assistance to related entities is a quite a regular transaction. Considering the transfer of obligations, such transactions are subject to certain regulation under the Companies Act, 2013 (Act, 2013) and SEBI (Listing Obligations and Disclosure Requirements) Regulations, 2015 (LODR). However, despite the prohibitions and restrictions, there are several areas within the periphery of transactions with related parties which remain out of the ambit of law and therefore is beyond required checks. Following the proposal of changes in the provisions of RPT vide the report of the working group, SEBI has floated a consultative paper on 06-03-2020 proposing certain changes to corporate guarantees being provided by a listed party on behalf of its promoter / promoter related entities, without deriving any economic benefit from such transaction.
In this article, we discuss the coverage of the current provisions, gap therein, need for the proposal and the proposed regime to bridge such gap.
Unrelated-related parties – remains unregulated
As compared to the Act, 2013, LODR has a wider definition of related party where it additionally covers related parties under AS-18 / IND AS-24 and also such member of promoter and promoter group which holds 20% of the total shareholding of the listed entity. Despite such wide definition, practically speaking, there may be several interested entities of the promoter which gets excluded from the technical criteria of being a related party due to absence of required shareholding and consequently transactions with them can easily sail through without being subject to required approvals. As such, currently, a listed entity can grant loan, give guarantee / security in connection of loan to / on behalf of an entity, which technically is not a related party, but either is a promoter or an entity in which the promoter has vested interest against the interest of stakeholders of the lending company.
Existing provisions regulating financial transactions
Currently, section 177, 185 and 186 of Act, 2013 are the major provisions governing any financial transactions. Section 188 of the Act, 2013, does not cover financial transaction within its coverage and therefore the same get ruled out anyway. Section 177 provides for scrutiny of inter-corporate loans as well as approval and modifications of all related party transactions. The challenge of this section are that firstly, transactions with interested unrelated party gets ruled out and consequently the committee is left with the duty of a post mortem scrutiny and not a prior scanning of the transaction. Sec 186 provides for limits of financial transaction i.e giving of loan, investment, guarantee, security in connection with loan and also keeps a check on minimum rates to be charged in case of loan. Transactions beyond the limits require approval by special majority of the shareholders. Sec 185 talks about granting of loan to directors and director-interested entities. While there is complete prohibition of granting of such loan to the director himself or his relative / firm, loan can be granted to interested-companies, subject to approval by special majority of shareholders of the lender company.
To get such approval is not a tough task in a company with high promoter-holding, and the promoters can easily get their transaction through. Unlike sections 188 and 184 where the voting rights of the interested parties are restricted in the general meeting and board meeting respectively, section 185 and 186 does not provide for any such restrictions.
As per Reg 23 of LODR, related party transactions, which includes financial transactions as well, requires approval of shareholders by majority. This approval is by the majority of the minority as all entities falling under the definition of related parties cannot vote to approve the relevant transaction irrespective of whether the entity is a party to the particular transaction or not.
Proposed amendment – need and proposal
It is to be noted that whenever there is a transaction with a promoter related entity, there may be a potential threat to the interest of the non-promoter group / minority shares. Accordingly, approval of the majority of such minority is to be essentially sought to ensure that the resources of the company are not been siphoned away / wrongly used / alienated by the promoters and that the interest of such minority is secured. As mentioned above, in the existing regime, question of approval from such majority of minority arise only for material RPTs under LODR.
Hence, all such transactions which does not fall under the category of “RPT” and / or “material” remains unguarded and thus putting the corporate governance of the company at stake. SEBI, in its report on working group of RPT, has clearly put forward its intent to curb such influential transactions by the promoter / promoter group and to revise the definition of related party itself. Once the said proposal is made effective, all transactions with promoter / promoter group will be a RPT. However, inspite of such revision in the definition of RPT, only material transactions will require approval of minority shareholders.
Through the proposal in the consultative paper, SEBI intends to move a step ahead of what the working group discussed. SEBI now proposes to require all guarantee transactions, irrespective of the materiality to be approved by the majority of minority shareholders. Additionally, the directors of lending company are required to establish and record “economic interest” in granting of such guarantee.
Essence of voting by majority of minority
It is no approval, if the person seeking approval and granting approval is the same. In corporate democracy, approval is essentially ought to be sought from the class of people whose rights seem to be prejudiced from transaction proposed in the interest of another class. Reg 23 of LODR and sec 188 of Act, 2013 already recognises such majority of minority approval wherein all the related parties of the company refrain from voting.
Significance of “economic interest”
Any prudent mind would require risk and reward, benefit and burden to be shared proportionately. It is absolutely irrational to say that a listed company is extending guarantee / security in connection with loan but has no benefit in return.
It is to be noted that charging of guarantee commission or charging of interest is not to be misunderstood as presence of economic interest. There are charged only to keep the transaction at arm’s length. However, the exposure of the lender company is the amount of loan / amount guaranteed.
Few examples of embedded economic interest in a transaction can be as follows:
- A holding company extending loan to its wholly-owned subsidiary for funding acquisition of land for building of plant may be benefitted by the figures of such subsidiary at consolidated level;
- A listed company guaranteeing on behalf of another unrelated-related entity which is the customised raw material provider of the lending company
Different scenarios of financial transaction considering the proposal of SEBI:
|S. No.||Transaction between||Existing provision||Proposed amendment||Analysis|
|Two unlisted companies||Section 186 / 185, if applicable||Unlisted companies are not covered||No Impact|
|2||Listed company with its related party – beyond materiality threshold||Section 186 / 185, if applicable and Reg 23- shareholders’ approval through resolution where no related party shall vote to approve||Ensuring the economic interest + Prior approval from the shareholders on a “majority of minority” basis||Irrespective of the materiality, where there is any transfer of financial obligation, prior approval of unrelated shareholders will be required|
|3||Listed company with related party not within materiality threshold||No requirement for shareholders’ approval||Ensuring the economic interest + Prior approval from the shareholders on a “majority of minority” basis||Irrespective of the materiality, where there is any transfer of financial obligation, prior approval of unrelated shareholders will be required|
|4||Listed company with unrelated related party||No requirement prescribed under law|
- While the proposed amendment is absolutely on-point and timely amendment in the wake of several corporate scams in the recent past being witnessed by the country, however, it will achieve its intent if the same is not kept limited to guarantee / security in connection with loan, but also extended for granting of loan to such unrelated-related entities;
- Also, the list of entities is kept vague in the Paper (promoter(s)/ promoter group/ director / directors relative / KMP etc) and may be better clarified in the amendments, however, the intent seems to be quite clear to include any promoter / promoter group / management related entity;
- Lastly, it is not clear as to who should refrain from voting for majority of minority voting – all promoter / promoter group entities / all related parties of the listed entity;
 SEBI Report on working group of RPT dated 27th January, 2020 ibid
 Includes promoters which may not fall under definition of related party – like promoter not holding any shareholding in the company
Read our article on proposed changes by working group of SEBI on Related Party Transactions here: http://vinodkothari.com/2020/01/expanding-the-web-of-control-over-related-party-transactions/
Read our articles on the topic of related party transactions here: http://vinodkothari.com/article-corner-on-related-party-transactions/
Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.
SEBI has vide circular dated 5th February, 2020 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 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 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:
- Angel Funds as defined in SEBI (Alternative Investment Funds), Regulations 2012.
- 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 –
- Mandatory bench-marking of the performance of AIFs (including Venture Capital Funds) and the AIF industry.
- 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.
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 –
Timothy Lopes, Executive, Vinod Kothari Consultants Pvt. Ltd.
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
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, 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.
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
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
(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.
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.