Archive for category: Alternative investment Vehicles

-Vinod Kothari (finserv@vinodkothari.com)

The law relating to collective investment schemes has always been, and perhaps will remain, enigmatic, because these provisions were designed to ensure that enthusiastic operators do not source investors’ money with tall promises of profits or returns, and start running what is loosely referred to as Ponzi schemes of various shades. De facto collective investment schemes or schemes for raising money from investors may be run in elusive forms as well – as multi-level marketing schemes, schemes for shared ownership of property or resources, or in form of cancellable contracts for purchase of goods or services on a future date.

While regulations will always need to chase clever financial fraudsters, who are always a day ahead of the regulator, this article is focused on schemes of shared ownership of properties. Shared economy is the cult of the day; from houses to cars to other indivisible resources, the internet economy is making it possible for users to focus on experience and use rather than ownership and pride of possession. Our colleagues have written on the schemes for shared property ownership[1]. Our colleagues have also written about the law of collective investment schemes in relation to real estate financing[2]. Also, this author, along with a colleague, has written how the confusion among regulators continues to put investors in such schemes to prejudice and allows operators to make a fast buck[3].

This article focuses on the shared property devices and the sweep of the law relating to collective investment schemes in relation thereto.

Basis of the law relating to collective investment schemes

The legislative basis for collective investment scheme regulations is sec. 11AA (2) of the SEBI Act. The said section provides:

Any scheme or arrangement made or offered by any company under which,

• the contributions, or payments made by the investors, by whatever name called, are pooled and utilized solely for the purposes of the scheme or arrangement;
• the contributions or payments are made to such scheme or arrangement by the investors with a view to receive profits, income, produce or property, whether movable or immovable from such scheme or arrangement;
• the property, contribution or investment forming part of scheme or arrangement, whether identifiable or not, is managed on behalf of the investors;
• the investors do not have day to day control over the management and operation of the scheme or arrangement.

The major features of a CIS may be visible from the definition. These are:

1. A schematic for the operator to collect investors’ money: There must be a scheme or an arrangement. A scheme implies a well-structured arrangement whereby money is collected under the scheme. Usually, every such scheme provides for the entry as well as exit, and the scheme typically offers some rate of return or profit. Whether the profit is guaranteed or not, does not matter, at least looking at the definition. Since there is a scheme, there must be some operator of the scheme, and there must be some persons who put in their money into the scheme. These are called “investors”.
2. Pooling of contributions: The next important part of a CIS is the pooling of contributions. Pooling implies the contributions losing their individuality and becoming part of a single fungible hotchpot. If each investor’s money, and the investments therefrom, are identifiable and severable, there is no pooling. The whole stance of CIS is collective investment. If the investment is severable, then the scheme is no more a collective scheme.
3. Intent of receiving profits, produce, income or property: The intent of the investors contributing money is to receive results of the collective investment. The results may be in form of profits, produce, income or property. The usual feature of CIS is the operator tempting investors with guaranteed rate of return; however, that is not an essential feature of CISs.
4. Separation of management and investment: The management of the money is in the hands of a person, say, investment manager. If the investors manage their own investments, there is no question of a CIS. Typically, investor is someone who becomes a passive investor and does not have first level control (see next bullet). It does not matter whether the so-called manager is an investor himself, or may be the operator of the scheme as well. However, the essential feature is there being multiple “investors”, and one or some “manager”.
5. Investors not having regular control over the investments: As discussed above, the hiving off of the ownership and management of funds is the very genesis of the regulatory concern in a CIS, and therefore, that is a key feature.

The definition may be compared with section 235 of the UK Financial Services and Markets Act, which provides as follows:

• In this Part “collective investment scheme” means any arrangements with respect to property of any description, including money, the purpose or effect of which is to enable persons taking part in the arrangements (whether by becoming owners of the property or any part of it or otherwise) to participate in or receive profits or income arising from the acquisition, holding, management or disposal of the property or sums paid out of such profits or income.
• The arrangements must be such that the persons who are to participate (“participants”) do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions.
• The arrangements must also have either or both of the following characteristics—

• the contributions of the participants and the profits or income out of which payments are to be made to them are pooled;
• the property is managed as a whole by or on behalf of the operator of the scheme.
  • If arrangements provide for such pooling as is mentioned in subsection (3)(a) in relation to separate parts of the property, the arrangements are not to be regarded as constituting a single collective investment scheme unless the participants are entitled to exchange rights in one part for rights in another.

It is conspicuous that all the features of the definition in the Indian law are present in the UK law as well.

Hong Kong Securities and Futures Ordinance [Schedule 1] defines a collective investment scheme as follows:

collective investment scheme means—

• arrangements in respect of any property—
• under which the participating persons do not have day-to-day control over the management of the property, whether or not they have the right to be consulted or to give directions in respect of such management;
• under which—
• the property is managed as a whole by or on behalf of the person operating the arrangements;
• the contributions of the participating persons and the profits or income from which payments are made to them are pooled; or
• the property is managed as a whole by or on behalf of the person operating the arrangements, and the contributions of the participating persons and the profits or income from which payments are made to them are pooled; and
• the purpose or effect, or pretended purpose or effect, of which is to enable the participating persons, whether by acquiring any right, interest, title or benefit in the property or any part of the property or otherwise, to participate in or receive—
• profits, income or other returns represented to arise or to be likely to arise from the acquisition, holding, management or disposal of the property or any part of the property, or sums represented to be paid or to be likely to be paid out of any such profits, income or other returns; or
• a payment or other returns arising from the acquisition, holding or disposal of, the exercise of any right in, the redemption of, or the expiry of, any right, interest, title or benefit in the property or any part of the property; or
• arrangements which are arrangements, or are of a class or description of arrangements, prescribed by notice under section 393 of this Ordinance as being regarded as collective investment schemes in accordance with the terms of the notice.

One may notice that this definition as well has substantially the same features as the definition in the UK law.

Judicial analysis of the definition

Part (iii) of the definition in Indian law refers to management of the contribution, property or investment on behalf of the investors, and part (iv) lays down that the investors do not have day to day control over the operation or management. The same features, in UK law, are stated in sec. 235 (2) and (3), emphasizing on the management of the contributions as a whole, on behalf of the investors, and investors not doing individual management of their own money or property. The question has been discussed in multiple UK rulings. In Financial Conduct Authority vs Capital Alternatives and others,  [2015] EWCA Civ 284, [2015] 2 BCLC 502[4], UK Court of Appeal, on the issue whether any extent of individual management by investors will take the scheme of the definition of CIS, held as follows:  “The phrase “the property is managed as a whole” uses words of ordinary language. I do not regard it as appropriate to attach to the words some form of exclusionary test based on whether the elements of individual management were “substantial” – an adjective of some elasticity. The critical question is whether a characteristic feature of the arrangements under the scheme is that the property to which those arrangements relate is managed as a whole. Whether that condition is satisfied requires an overall assessment and evaluation of the relevant facts. For that purpose it is necessary to identify (i) what is “the property”, and (ii) what is the management thereof which is directed towards achieving the contemplated income or profit. It is not necessary that there should be no individual management activity – only that the nature of the scheme is that, in essence, the property is managed as a whole, to which question the amount of individual management of the property will plainly be relevant”.

UK Supreme Court considered a common collective land-related venture, viz., land bank structure, in Asset Land Investment Plc vs Financial Conduct Authority, [2016] UKSC 17[5]. Once again, on the issue of whether the property is collective managed, or managed by respective investors, the following paras from UK Financial Conduct Authority were cited with approval:

The purpose of the ‘day-to-day control’ test is to try to draw an important distinction about the nature of the investment that each investor is making. If the substance is that each investor is investing in a property whose management will be under his control, the arrangements should not be regarded as a collective investment scheme. On the other hand, if the substance is that each investor is getting rights under a scheme that provides for someone else to manage the property, the arrangements would be regarded as a collective investment scheme.

Day-to-day control is not defined and so must be given its ordinary meaning. In our view, this means you have the power, from day-to-day, to decide how the property is managed. You can delegate actual management so long as you still have day-to-day control over it.[6]’

The distancing of control over a real asset, even though owned by the investor, may put him in the position of a financial investor. This is a classic test used by US courts, in a test called Howey Test, coming from a 1946 ruling in SEC vs. Howey[7]. If an investment opportunity is open to many people, and if investors have little to no control or management of investment money or assets, then that investment is probably a security. If, on the other hand, an investment is made available only to a few close friends or associates, and if these investors have significant influence over how the investment is managed, then it is probably not a security.

The financial world and the real world

As is apparent, the definition in sec. 235 of the UK legislation has inspired the draft of the Indian law. It is intriguing to seek as to how the collective ownership or management of real properties has come within the sweep of the law. Evidently, CIS regulation is a part of regulation of financial services, whereas collective ownership or management of real assets is a part of the real world. There are myriad situations in real life where collective business pursuits,  or collective ownership or management of properties is done. A condominium is one of the commonest examples of shared residential space and services. People join together to own land, or build houses. In the good old traditional world, one would have expected people to come together based on some sort of “relationship” – families, friends, communities, joint venturers, or so on. In the interweb world, these relationships may be between people who are invisibly connected by technology. So the issue, why would a collective ownership or management of real assets be regarded as a financial instrument, to attract what is admittedly a  piece of financial law.

The origins of this lie in a 1984 Report[8] and a 1985 White Paper[9], by Prof LCB Gower, which eventually led to the enactment of the 1986 UK Financial Markets law. Gower has discussed the background as to why contracts for real assets may, in certain circumstances, be regarded as financial contracts. According to Gower, all forms of investment should be regulated “other than those in physical objects over which the investor will have exclusive control. That is to say, if there was investment in physical objects over which the investor had no exclusive control, it would be in the nature of an investment, and hence, ought to be regulated. However, the basis of regulating investment in real assets is the resemblance the same has with a financial instrument, as noted by UK Supreme Court in the Asset Land ruling: “..the draftsman resolved to deal with the regulation of collective investment schemes comprising physical assets as part of the broader system of statutory regulation governing unit trusts and open-ended investment companies, which they largely resembled.”

The wide sweep of the regulatory definition is obviously intended so as not to leave gaps open for hucksters to make the most. However, as the UK Supreme Court in Asset Land remarked: “The consequences of operating a collective investment scheme without authority are sufficiently grave to warrant a cautious approach to the construction of the extraordinarily vague concepts deployed in section 235.”

The intent of CIS regulation is to capture such real property ownership devices which are the functional equivalents of alternative investment funds or mutual funds. In essence, the scheme should be operating as a pooling of money, rather than pooling of physical assets. The following remarks in UK Asset Land ruling aptly capture the intent of CIS regulation: “The fundamental distinction which underlies the whole of section 235 is between (i) cases where the investor retains entire control of the property and simply employs the services of an investment professional (who may or may not be the person from whom he acquired it) to enhance value; and (ii) cases where he and other investors surrender control over their property to the operator of a scheme so that it can be either pooled or managed in common, in return for a share of the profits generated by the collective fund.”

Conclusion

While the intent and purport of CIS regulation world over is quite clear, but the provisions  have been described as “extraordinarily vague”. In the shared economy, there are numerous examples of ownership of property being given up for the right of enjoyment. As long as the intent is to enjoy the usufructs of a real property, there is evidently a pooling of resources, but the pooling is not to generate financial returns, but real returns. If the intent is not to create a functional equivalent of an investment fund, normally lure of a financial rate of return, the transaction should not be construed as a collective investment scheme.

[1] Vishes Kothari: Property Share Business Models in India, https://vinodkothari.com/blog/property-share-business-models-in-india/

[2] Nidhi Jain, Collective Investment Schemes for Real Estate Investments in India, at https://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/

[3] Vinod Kothari and Nidhi Jain article at: https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html

[4] http://www.bailii.org/ew/cases/EWCA/Civ/2015/284.html

[5] https://www.supremecourt.uk/cases/docs/uksc-2014-0150-judgment.pdf

[6] https://www.handbook.fca.org.uk/handbook/PERG/11/2.html

[7] 328 U.S. 293 (1946), at https://supreme.justia.com/cases/federal/us/328/293/

[8] Review of Investor Protection, Part I, Cmnd 9215 (1984)

[9] Financial Services in the United Kingdom: A New Framework for Investor Protection (Cmnd 9432) 1985

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Property Share Business Models in India,< https://vinodkothari.com/blog/property-share-business-models-in-india/>

Collective Investments Schemes: How gullible investors continue to lose money < https://www.moneylife.in/article/collective-investment-schemes-how-gullible-investors-continue-to-lose-money/18018.html>

Collective Investment Schemes for Real Estate Investments in India, < https://vinodkothari.com/blog/collective-investment-schemes-for-real-estate-investment-by-nidhi-jain/>