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Trust, but verify: AIFs cannot be used as regulatory arbitrage

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SEBI mandates ongoing due diligence for investors and investments made by AIFs

-Vinita Nair, Senior Partner and Lavanya Tandon, Executive | corplaw@vinodkothari.com

May 03, 2024 (updated on October 9, 2024)

Background

SEBI had raised concerns relating to evergreening of loans, circumvention of FEMA norms, QIB regulations and other concerns on regulatory arbitrage by Alternative Investment Funds (‘AIFs’) in its Consultation Paper issued in January, 2024. SEBI also recorded 40+ cases wherein the structure of AIF had been abused and used to circumvent extant financial sector regulations. Read our analysis in the article ‘AIFs ail SEBI: Cannot be used for regulatory breach’ dated January 31, 2024. Further, RBI had also barred all regulated entities (REs) with respect to their investments in AIFs, discussed in our article.

Subsequent to receipt of public comments, the proposal to mandate due-diligence (‘DD’) of investors and each of the investments made by the AIF was approved in the SEBI Board meeting held on March 15, 2024. SEBI notified SEBI (Alternative Investment Funds) (Second Amendment) Regulations, 2024 effective from April 25, 2024 amending Reg. 20 of the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’) dealing with general obligations thereby requiring every a. AIF, b. investment manager of the AIF, c. KMP of the AIF, and d. KMP of the investment manager, to exercise specific DD with respect to their investors and investments in order to prevent facilitation of circumvention of such laws as may be specified by SEBI from time to time. 

The list of laws, thresholds and conditions for DD, reporting requirements etc. has been provided in  SEBI circular dated Oct 8, 2024 (‘SEBI Circular’). DD is required to be carried out prior to making of investments as per implementation standards formulated by Standard Setting Forum for AIFs (‘SFA’)  and published on websites of the industry associations which are part of the SFA, i.e., Indian Venture  and  Alternate  Capital  Association (‘IVCA’), PE VC CFO Association and Trustee Association of India. 

Scope of laws covered under the ambit of due diligence

The list of laws provided in the SEBI Circular comprises of the following: 

  • Provisions of SEBI (Issue of Capital and Disclosure Requirements) Regulations, 2018 (‘ICDR Regulations’), and other regulations of SEBI wherein benefits or relaxations have been provided to entities designated as Qualified Institutional Buyers (‘QIBs’).
  • Provisions of the Securitisation and Reconstruction of Financial Assets and Enforcement of Security Interest Act, 2002 (‘SARFAESI Act’) wherein benefits are provided to entities designated as Qualified Buyers (‘QBs’).
  • Prudential norms specified by RBI for regulated lenders with respect to Income Recognition, Asset Classification, Provisioning and restructuring of stressed assets;
  • Rule 6 of FEMA (Non-Debt Instruments) Rules, 2019 (NDI Rules) for investment from countries sharing land border with India ( read with Press Note 3 dated April 17, 2020 of FDI Policy 2020)

Timing, thresholds for DD, reporting requirements

Pursuant to the SEBI Circular, the due diligence for various investors and investments is required to be carried out by a. AIF, b. investment manager of the AIF, c. KMP of the AIF, and d. KMP of the investment manager in accordance with the Implementation Standards. The table below indicates in brief the criteria, checkpoints and timelines for conducting due diligence along with the consequences of the outcome. 

Sr. NoObjective intended to be achieved by investors  through investments in AIF schemeRegulations/ Directions/ Norms applicableApplicability of requirement of DD for every scheme of AIF (refer Note 1)Checkpoints for manager for specific DD Timing of DD Consequence of outcome of DD & reporting requirements, if any
1Benefits designated for QIBs ICDR and other SEBI RegulationsIf an investor, or investors belonging  to the same group, contribute(s)50% or more to the corpus of the scheme.Manager to check if such if investor/ investors of the same group is/are:(i) QIBs themselves or,(ii) Entities established, owned or controlled by the Central Government or a State Government or the Government of a foreign country, including central banks and sovereign wealth funds.Note: Where such investor is an AIF or fund set up in IFSC or outside India, above check to be carried out on a look through basis.Prior to availing benefits available to QIBs 
Refer Note 2 below for existing investments & Note 3 for proposed investments.Manager to provide confirmation to SE or lead manager or merchant banker on this.
2Benefits designated for QBsUnder SARFAESI ActIf an investor, or investors belonging  to the same group, contribute(s)50% or more to the corpus of the scheme.Same as abovePrior to making any investments or availing benefits Refer Note 2 below for existing investments & Note 3 for proposed investments.
3RBI regulated lenders/ entities ever-greening their stressed loans/ assets & circumventing RBI normsRBI norms on Income    Recognition,    Asset    Classification, Provisioning and Restructuring of stressed loans/ assets(a)whose manager or sponsor is an entity regulated by RBI; or,(b)that has investor(s)regulated by RBI who:(i)individually or   along   with   investors   of the same   group contribute(s) 25% or more to the corpus of the scheme; or(ii) is an associate of the manager/ sponsor of the AIF;(iii) has majority or veto power [by itself, or through its representatives/ nominees] in voting over  decisions of the investment  committee  set up  by   the manager to approve investment decisions of the scheme.Note: where investor is an AIF or fund set up in IFSC or outside India, criteria check to be carried out on a look through basis.Refer Note 4.Prior to making any investments, to avoid indirect investment by RBI regulated lender/ entity.Refer Note 2 below for existing investments & Note 3 for proposed investments.
4Investment from countries sharing land border with IndiaFEMA (NDI) Rules, 2019Where 50% or more of the corpus of the scheme is contributed by investors (a)who are citizens of/are from/are situated in a country which shares land border with India; or(b)whose beneficial owners, as determined  in  terms  of  Rule  9 (3)  of  the  PMLA (Maintenance  of Records)  Rules,  2005, are citizens  of/are from/are situated in a country which shares a land border with India.If the proposed investment would result in the scheme holding           10 % or more of equity/equity-linked securities issued by the company (on a fully-diluted basis), the manager to check details stated in the previous column, by collecting information on the country of investors and their beneficial owners.Prior to making any investmentRefer Note 2 below for existing investments & Note 5 for proposed investments.

Note 1: same group’ shall mean ‘related parties’  and  ‘relatives’ as  defined  in  SEBI  (Listing  Obligations  and  Disclosure Requirements) Regulations, 2015.

Note 2: 

For Sr nos 1 to 3: DD requirement is applicable for existing investments too, held by AIF schemes as on October 8, 2024:

  • If DD check not satisfactory – details of investment to be reported to AIF’s custodian on or before April 07, 2025, in the format as per Annexure 1 of the circular;
  • If DD check satisfactory – AIF manager to submit an undertaking to AIF’s custodian on or before April 07, 2025.

For Sr no. 4: Reporting is required to be made for existing investments held by AIF schemes as on October 8, 2024 if the scheme holds 10% or more of equity/ equity-linked securities on a fully-diluted basis,  to AIF’s custodian on or before April 07, 2025 in the format prescribed by SFA.

Note 3: 

Consequence of not satisfying requirements of DD checks specified by SFA for proposed investments in case of Sr nos 1 to 3:

  • Such investor or investor group to be excluded along with necessary disclosure in the private placement memorandum (PPM); or 
  • Investment cannot be made.

Note 4: 

Note 5: Details of investment, which would result in the scheme holding 10% or more of equity/ equity-linked securities on a fully-diluted basis, to be reported to the custodian within 30 days of investment, in the below format specified by SFA.

DD requirement – one-time or ongoing?

As discussed in the SEBI BM Agenda, the  purpose  of  the  due-diligence  check  is  to  prevent  facilitation of any circumvention of provisions of financial sector regulators, which cannot be a time specific check. An entity who intends to circumvent can design the structure in such a way that, at a later date post investment, it acquires the units  of  AIFs  post  investment,  such  as  buying  the  units  of  an  existing investor or by acquiring control over the existing investor entity, as per prior arrangement.  Accordingly, it has been indicated that due diligence around investors and investments will be an ongoing one.

Applicability of DD – prospective or retrospective?

As per the SEBI circular this is applicable for existing and prospective investments. Refer Note 2 above.

Obligations of Custodian to the AIF

  • Information received from AIFs under Note 2 to be furnished to SEBI on or before May 7, 2025.
  • Information received from AIFs in terms of Note 4 above on a monthly basis to be compiled and reported to SEBI within 10 working days from month end.

Power of AIF to exclude an investor

As per SEBI Circular, in cases where the outcome of DD is not satisfactory, in that case the AIF will either have to exclude the investor or investor group or abstain from making the proposed investment. 

Dealing with power to exclude an investor, in April  2023 SEBI had issued ‘Guidelines with respect to excusing or excluding an investor from an investment of AIF that empowered an AIF to excuse its investor from participating in a particular investment in the following circumstances:

Figure 1: Circumstances to excuse an investor of AIF

Conclusion

The present amendment and SEBI Circular lays an onerous burden on the AIF, manager and KMP of the AIF and the manager. The DD requirement has become effective from October 8, 2024 and applies to existing investments as well. The AIFs have an actionable of evaluating the existing investments in the scheme in the light of the present amendment and ensure reporting in next 6 months. The obligation of on-going due diligence will result in a compliance burden, but is justified given the intent of law as “quando aliquid prohibetur ex directo, prohibetur et per obliquum” i.e. things that cannot be done directly should not be done indirectly either. AIFs will continue ‘trust, but verify’ using the DD standards for due diligence. The trustee/ sponsor of the AIF is required to ensure that compliance status of this amendment is reported to SEBI in the ‘Compliance Test Report’ prepared by the manager in terms of Chapter 15 of Master Circular for AIFs.

Our other resources:

  1. FAQs on Specific Due Diligence of investors & investments of AIFs
  2. AIFs ail SEBI: Cannot be used for regulatory breach
  3. RBI bars lenders’ investments in AIFs investing in their borrowers
  4. Some relief in RBI stance on lenders’ round tripping investments in AIFs

Some relief in RBI stance on lenders’ round tripping investments in AIFs

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– Team Finserv | finserv@vinodkothari.com

The Reserve Bank of India on 19th December 2023 issued a notification[1] imposing a bar on all regulated entities[2] (REs) with respect to their investments in AIFs. We had covered the same in our earlier write-up. The Circular has already created some bloodshed as several banks took a hit in their Q3 results. Though late, yet welcome, the RBI has now come with some relief by a March 27 2023 circular.  The following Highlights are based on the original circular, as amended by the March 27th circular :-

What has the RBI done?

  • Prohibited all regulated entities (REs), including banks, cooperative banks, NBFCs and All India Financial Institutions from making investments in Alternative Investment funds (AIFs), if the AIF has made any investment in a “debtor company”, other than by way of equity shares of the debtor company. Hence, if the AIF has made investment by way of bonds, structured capital instruments, etc., issued by a debtor company, the bar as above will apply.
  • Debtor company means a company in which the RE currently has or previously had a loan or investment exposure anytime during the preceding 12 months
  • The bar applies immediately, that is, effective 19th Dec 2023. No further investments to be made.
  • If investments already exist, the RE shall exit within 30 days, that is, by 18th Jan., 2024. Hindsight clearly shows that for most regulated entities, there was no way to cause exit, as AIF investments are evidently illiquid. Hence, most regulated entities took a hit on their P/L.
  • Further, if an RE has made an investment in an AIF, and the AIF invests in a debtor company, the RE shall make an exit within 30 days.
  • Investment by REs in the subordinated units of any AIF scheme with a ‘priority distribution model’ subject to full deduction from RE’s capital funds. See further discussion on priority distribution model below.

What was the intent?

  • Since several REs have affiliated AIFs, routing the money through AIFs to borrowers might have led to ever greening. That is, the AIF would invest the money into a debtor company, and consequently, the debtor company would keep its account as a performing asset. In essence, the AIF was acting as a stopover in the process of round tripping of the money back to a debtor company, from where it will be used to pay off the lender.

What will be the impact of the Circular?

  • Most of the larger REs have affiliated AIFs. Flow of funds to them from the RE would stop completely.
  • The sweep of the circular is wide and non-discriminatory. Not only affiliated AIFs, but any AIF in general will be dried of funding from REs. While the bar is only for those AIFs which have invested in “debtor companies”, it will be practically tough for REs to avoid overlapping investments. Given the severe implications of a breach, compliance-sensitive REs will avoid investing in AIFs.
  • There is an immediate disinvestment pressure on AIFs, as there may be overlapped investments. AIFs’ assets are mostly illiquid – ensuring exit to RE investors may be tough. In many cases, there are lock-in restrictions as well.
  • Not only has the RBI expressed concerns, SEBI also issued a consultation paper for enhancement of trust in the AIF ecosystem, citing use of AIFs for regulatory arbitrage. See our write up on the SEBI proposals.

Direct or indirect investments:

  • As the Circular is driven by concerns of round-tripping, widening the circuit by creating more stop-overs does not help. For example, if a lender invests in an AIF, which invests in an intermediate entity, which in turn invests in a debtor entity, the trail of the money is clear. Likewise, the lender may be making an indirect investment in an AIF.
  • However, where there is no round-tripping of the money to a “debtor company”, there should be no concern. For example, if a lender makes a loan to an entity, where an AIF of the group has also made investments, there is no flow of money from the lender to the AIF, for the purpose of the downstream investment by the AIF into the debtor company.

Investments through mutual funds and FOFs exempt:

  • The 27th March circular exempts instances where investments are made by lenders into mutual funds or FoFs, and those in turn have some exposure in either an AIF or in a debtor entity.

Priority distribution model or structured AIFs

  • In addition to the concerns on downstream investments by AIFs in debtor companies, the RBI also had concerns on the so-called structured AIFs or AIFs with a distribution waterfall. Whether AIFs can at all have a priority distribution waterfall is currently under SEBI examination and SEBI has stopped AIFs from using structured distribution schemes (by way of accepting fresh commitment or making investment in a new investee company) . However, several existing schemes have such models.
  • If a lender makes an investment in the subordinated units of a structured AIF scheme such investments will get deducted from the regulatory capital of the lender. The March 27 circular now clarifies that the deduction will be equally from Tier 1 and Tier 2 capital. Further, it also clarifies that the subordinated exposures in the AIF schemes could be in the form of subordinated exposures, including investment in the nature of sponsor units.

Concern areas

  • Ideally, the bar should have been limited to affiliated AIFs. Affiliated AIFs could have been defined appropriately – for example, a related party, or where the investment manager, or sponsor is a related party of the RE. Extending the bar to all AIFs is quite far from the intent of the circular – which is, admittedly, to curb evergreening. It is difficult to see how unrelated AIFs can be used by an RE to evergreen, as investment decisions of these AIFs are not exercised by the investors.
  • Ideally, the bar should have been limited only to Cat 1 and Cat 2 AIFs. Cat 3 AIFs, widely known as hedge funds, typically play in equity long/short strategies, or do other leveraged trades. REs find such investment a useful way to diversify their funds into hedge funds. Hedge fund investments are common by institutional investors all over the world; an outright curb on these investments by REs is, once again, beyond the stated intent. Notably, given the wide range of investments that Cat 3 AIFs make, avoiding an overlap with the RE’s borrowers will be quite impractical.
  • Practical implementation of this circular, if at all a RE invests in an AIF, will be quite tough. AIFs will have to share their potential investment list, which will be against any investment manager’s choice. Assuming there is an overlapped investment, the RE will have to exit within 30 days, which will create liquidity issues for AIFs, in addition to challenging the lock-in restrictions.
  • Most of the regulated entities took a provision in the 3rd quarter. The 27th March circular of the RBI gives some relief by saying that the provision will be required only to the extent of the downstream investment in a debtor entity.

In our view, there is a need to review the regulatory mechanism for AIFs, as currently, AIFs are being used as instruments of regulatory arbitrage.

[1] https://rbi.org.in/Scripts/NotificationUser.aspx?Id=12572&Mode=0

[2] Commercial Banks (including Small Finance Banks, Local Area Banks and Regional Rural Banks), Primary (Urban) Co-operative Banks/State Co-operative Banks/ Central Co-operative Banks, All-India Financial Institutions, Non-Banking Financial Companies (including Housing Finance Companies)

Other articles related to the topic:

  1. Trust, but verify: AIFs cannot be used as regulatory arbitrage (updated on October 9, 2024)
  2. FAQs on Specific Due Diligence of investors & investments of AIF
  3. RBI bars lenders’ investments in AIFs investing in their borrowers
  4. AIFs ail SEBI: Cannot be used for regulatory breach
  5. SEBI’s standard approach, standardising valuation for AIFs
  6. Comparison between non-deposit accepting NBFC – Investment and Credit Company (NBFC-ND-ICC), Core Investment Company (CIC) and an Alternative Investment Fund (AIF)
  7. Snippet on credit of existing & issue of new units of AIFs in demat form
  8. SEBI amends framework for Large Value Funds

AIFs ail SEBI: Cannot be used for regulatory breach

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Vinod Kothari | corplaw@vinodkothari.com

The alternative investment management industry in India works in the form alternative investment funds (AIFs), a SEBI-regulated vehicle. Most of the PE, VC funds, and hedge funds in India work in this mode.

AIFs have recently been at the receiving end of regulatory flak. RBI had expressed concerns on use of AIFs by regulated lenders for evergreening, and prohibited regulated entities from making any investment in such AIFs as have investments in their borrowers.

Now, SEBI, vide a Consultation Paper dated 19th January heaped a bunch of similar concerns, and required AIFs to affirm that the AIF or investments therein are not being used for regulatory breaches. These concerns, SEBI says, are a result of an ongoing thematic check on the AIF industry, and SEBI says it has already detected at least 40 cases, involving AUM over Rs 30000 crores, where the structure was used to create dents in existing financial regulations.

Based on Data relating to activities of Alternative Investment Funds (AIFs)

The AIF industry has demonstrated steady growth in recent years. As of September 2023, the assets under management (AUM) of AIFs have surged to 3.88 lakh crores, a substantial increase from the 13,000 crores recorded in September 2015. [See Graph above].   

Read more →

Snippet on credit of existing & issue of new units of AIFs in demat form

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Sanya Agrawal | corplaw@vinodkothari.com

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2020 – Year of changes for AIFs

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Timothy Lopes – Senior Executive                                                                             CS Harshil Matalia – Assistant Manager

finserv@vinodkothari.com

The year 2020 – ‘Year of pandemic’, rather we can say the year of astonishing events for everyone over the globe. Without any doubt, this year has also been a roller coaster ride for Alternative Investment Funds (‘AIFs’) with several changes in the regulatory framework governing AIFs in India.

Recent Regulatory Changes for AIFs

In continuation to the stream of changes, Securities Exchange Board of India (‘SEBI’), in its board meeting dated September 29, 2020, has approved certain amendments to the SEBI (Alternative Investment Funds) Regulations, 2012 (‘AIF Regulations’). The said amendments have been notified by the SEBI vide notification dated October 19, 2020. The following article throws some light on SEBI (AIFs) Amendment Regulations, 2020 (‘Amendment Regulations’) and tries to analyse its impact on AIFs.

Clarification on Eligibility Criteria

Regulation 4 of AIF Regulations prescribes eligibility criteria for obtaining registration as AIF with SEBI. Prior to the amendment,  Regulation 4(g), provided as follows:

“4 (g) the key investment team of the Manager of Alternative Investment Fund has adequate experience, with at least one key personnel having not less than five years experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets and has relevant professional qualification;”

The amended provision to 4 (g) extends the meaning of relevant professional qualification, the effect of which seems to add more qualitative criteria to the management team of the AIF, to be evaluated  at the time of grant of certification. The newly amended section 4(g) of the AIF Regulations reads as follow:

“(g) The key investment team of the Manager of Alternative Investment Fund has –

  • adequate experience, with at least one key personnel having not less than five years of experience in advising or managing pools of capital or in fund or asset or wealth or portfolio management or in the business of buying, selling and dealing of securities or other financial assets; and
  • at least one key personnel with professional qualification in finance, accountancy, business management, commerce, economics, capital market or banking 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 or any other qualification as may be specified by the Board:

Provided that the requirements of experience and professional qualification as specified in regulation 4(g)(i) and 4(g)(ii) may also be fulfilled by the same key personnel.”

It is apparent from the prima facie comparison of language that the key investment team of the Manager may have one key person with five years of experience (quantitative) as well as a personnel holding professional qualification (qualitative) from institutions recognised under the regulation. Further, clarity has been appended in form of proviso to the section that quantitative and qualitative requirements could be met by either one person, or it could be achieved collectively by more than one person in the fund.

With this elaboration, SEBI has harmonized the qualification requirements as that with the requirement specified for other intermediaries such as Investment Advisers, Research Analysts etc. in their respective regulations. Detailed prescription on degrees and qualifications for AIF registration by SEBI is a conferring move and is expected to aid as a clear pre-requisite on expectations of SEBI from prospective applications for registration of the fund.

Formation of Investment Committee

Regulation 20 of AIF Regulations specifies general obligations of AIFs. Erstwhile, the responsibility of making investment decisions was upon the manager of AIFs. It has been noticed by the SEBI from the disclosures made in draft Private Placement Memorandums (‘PPMs’) filed by AIFs for launch of new schemes, that generally Managers prefer to constitute an Investment Committee to be involved in the process of taking investment decisions for the AIF. However, there was no corresponding obligation in the AIF Regulations explicitly recognizing the ‘Investment Committee’ to take investment decisions for AIFs. Such Investment Committees may comprise of internal or external members such as employees/directors/partners of the Manager, nominees of the Sponsor, employees of Group Companies of the Sponsor/ Manager, domain experts, investors or their nominees etc.

These  amendments are based on the recommendations to SEBI to recognize the practice followed by AIFs to delegate decision making to the Investment Committee.[1] The rationale behind amendments to AIF Regulations is based on the following merits as proposed in the recommendations::

  1. Presence of investors or Sponsors or their nominees in an Investment Committee which may serve to improve the due diligence carried out by the Manager, as they are stakeholders in the AIF’s investments.
  2. Presence of functional resources from affiliate/group companies of the Manager (legal advisor, compliance advisor, financial advisor etc.) in the Investment Committee may be useful to ensure compliance with all applicable laws.
  3. Presence of domain experts in the committee may provide comfort to the investors regarding suitability of the investment decisions, as the investment team of the Manager may not have domain expertise in all industries/ sectors where the fund proposes to invest.

Thus, the insertion was made, giving the option to the Manager to constitute an investment committee subject to the following conditions laid down in the newly inserted sub-regulation, i.e. Regulation 20(6) of the AIF Regulations given below –

  1. The members of the Investment Committee shall be equally responsible as the Manager for investment decisions of the AIF.
  2. The Manager and members of the Investment Committee shall jointly and severally ensure that the investments of the AIF comply with the provisions of AIF Regulations, the terms of the placement memorandum, agreement made with the investor, any other fund documents and any other applicable law.
  3. External members whose names are not disclosed in the placement memorandum or agreement made with the investor or any other fund documents at the time of on-boarding investors shall be appointed to the Investment Committee only with the consent of at least seventy five percent of the investors by value of their investment in the Alternative Investment Fund or scheme.
  4. Any other conditions as specified by the SEBI from time to time.

The constitution of investment committee is a global standard practice followed by the Funds. However, funds structure in India might be altered with the new defining role of investment committee under the AIF Regulations. The investment committee generally comprises of nominees of large investors in the fund and at times other external independent professional bodies that act as a consenting body towards prospective deals of the fund. The amendment will alter the role of investors holding positions at investment committee as the new defining role might deter them from taking underlying obligations. From the funds perspective seeking external independent professionals might get costly as there is an obligation introduced by way of this amendment regulation. Further, it casts an onus on the investment committee to be involved in day to day functioning of the fund, which used to be otherwise (where members were usually involved in mere finalising the deals).  Lateral entry of the members to investment committee post placement of memorandum with the consent of investors is aimed at greater transparency in funds functioning.

Test for indirect foreign investment by an AIF

As per Clause 4 of Schedule VIII of FEMA (Non-Debt Instrument) Rules, 2019 (‘NDI Rules’) any investment made by an Investment Vehicle into an Indian entity shall be reckoned as indirect foreign investment for the investee Indian entity if the Sponsor or the Manager or the Investment Manager –

(i) is not owned and not controlled by resident Indian citizens or;

(ii) is owned or controlled by persons resident outside India.

Therefore, in order to determine whether the investment made by AIFs in Indian entity is indirect foreign investment, it is essential to identify the nature of the Manager/Sponsor/investment manager, whether he is owned or controlled by a resident Indian citizen or person resident outside India.

RBI in its reply to SEBI’s query on downstream investment had clarified that since investment decisions of an AIF are taken by its Manager or Sponsor, the downstream investment guidelines for AIFs were focused on ownership and control of Manager or Sponsor. Thus, if the Manager or Sponsor is owned or controlled by a non-resident Indian citizen or by person resident outside India then investment made by such AIF shall be considered as indirect foreign investment.

Whether an investment decision made by the Investment Committee of AIF consisting of external members who are not Indian resident citizens would amount to indirect foreign investment?

In light of the above provisions of the NDI Rules and with the introduction of the concept of an “Investment Committee”, SEBI has sought clarification from the Government and RBI vide its letter dated September 07, 2020[2].

Conclusion

With the enhancement in eligibility criteria, SEBI has ensured that the investment management team of the AIF would have relevant expertise and required skill sets.

Further, giving recognition to the concept of an investment committee will cast an obligation on investment committee fiduciary like obligations towards all the investors in the fund. . However, there exists certain ambiguity under the NDI Rules, for applications wherein external members of investment committee who are not ‘resident Indian citizens’,   which is currently on hold and pending receipt of clarification.

[1] https://www.sebi.gov.in/sebi_data/meetingfiles/oct-2020/1602830063415_1.pdf

[2] https://www.sebi.gov.in/sebiweb/about/AboutAction.do?doBoardMeeting=yes

RBI amends mode of payment and remittance norms for units of Investment vehicles

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Permits FPIs and FVCIs to use Special Non-Resident Rupee (SNRR) account 

CS Burhanuddin Dohadwala| Manager, Aanchal Kaur Nagpal| Executive

corplaw@vinodkothari.com

The Reserve Bank of India (‘RBI’) vide notification dated October 17, 2019 had  notified the Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt instrument) Regulations, 2019[1] (‘the Regulations’) governing the mode of payment and reporting of non-debt instruments consequent to the Foreign Exchange Management (Non-Debt Instrument) Rules, 2019[2] framed by the Ministry of Finance, Central Government.

RBI has recently vide its notification dated June 15, 2020 notified Foreign Exchange Management (Mode of Payment and Reporting of Non-Debt Instruments) (Amendment) Regulations, 2020[3] amending Reg. 3.1 dealing with Mode of Payment and Remittance of sale proceeds in case of investment in investment vehicles.

Let us discuss few terms to understand the recent amendments to the Regulations.

Investment Vehicles under FEMA:

According to FEMA (Non-Debt Instruments) Rules, 2019, investment vehicles mean:

Different types of account available under FEMA (Deposit) Regulations, 2016[1] (‘Deposit Regulations’)

The following are the major accounts that can be opened in India by a non-resident:

ParticularsEligible Person
Non-Resident (External) Rupee Account Scheme-NRE Account

Non-resident Indians (NRIs) and Person of Indian Origin (PIOs)

Foreign currency (Non-Resident) account (Banks) scheme – FCNR (B) account
Non-Resident ordinary rupee account scheme-NRO account

Any person resident outside India.

Special Non-Resident Rupee Account – SNRR account

Any person resident outside India.

A significant advantage of SNRR over NRO is that the former is a repatriable account while the latter is non-repatriable.

What is Special Non-Resident Rupee (‘SNRR’) Account?

Any person resident outside India, having a business interest in India, may open SNRR account with an authorised dealer for the purpose of putting through bona fide transactions in rupees. The  business  interest,  apart  from  generic  business  interest,  shall  include the  following INR transactions, namely:-

  • Investments made  in  India  in  accordance  with  Foreign  Exchange  Management  (Non-debt Instruments)  Rules,  2019  dated  October  17,  2019  and  Foreign  Exchange  Management  (Debt  Instruments)
  • Import of  goods  and  services  in  accordance  with  Section  5  of  the  Foreign  Exchange  Management  Act  1999 Regulations,   2019;
  • Export of  goods  and  services  in  accordance  with  Section  7  of  the  Foreign  Exchange  Management  Act  1999;
  • Trade credit   transactions   and   lending   under   External   Commercial   Borrowings   (ECB)   framework;
  • Business related  transactions  outside  International  Financial  Service  Centre  (IFSC)  by  IFSC  units  at  GIFT  city  like  administrative  expenses  in  INR  outside  IFSC,  INR  amount  from  sale  of  scrap,  government  incentives  in  INR,  etc;

Rationale behind the amendment:

Position under Master Direction – Foreign Investment in India by RBI

According to Annex 8 of Master Direction – Foreign Investment in India by RBI, investment made by a PROI was permitted with effect from 13th September, 2016. The provisions specify that the amount of consideration of the units of an investment vehicle should be paid out of funds held in NRE or FCNR(B) account maintained in accordance with the Deposit Regulations as one of the modes of payment.

Further it also specifies that the sale/ maturity proceeds of the units may be remitted outside India or credited to the NRE or FCNR(B) account of the person concerned.

Position under the erstwhile provisions of the Regulations

Schedule II of the Regulations (Investments by FPIs) stated earlier that of units of investment vehicles other than domestic mutual fund may be remitted outside India.

However, balances in SNRR account were permitted to be used for making investment only in units of domestic mutual fund and not in Investment Vehicles.

As discussed above, the NRO account is a non-repatriable account while the SNRR account is a repatriable account. Due to the above provisions, investment in Investment Vehicles could not be transferred to the SNRR account for repatriation resulting in ambiguity.

Owing to the above and to increase the inflow of foreign investment, the Government has amended the said provision and allowed FPIs & FVCI to invest in listed or to be listed units of Investment vehicle.

Brief comparison of the pre and post amendment is covered in our Annexure I.

Annexure-I

Comparison of the pre and post amendment

SchedulePost amendmentPrior to amendmentRemarks
Schedule II w.r.t Investments by Foreign Portfolio InvestorsA.     Mode of payment

1.       The  amount  of  consideration  shall  be  paid  as  inward  remittance  from  abroad through banking channels or out of funds held in a foreign currency account and/ or a Special Non-Resident Rupee (SNRR) account maintained in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

 

2.       Unless otherwise  specified in these regulations or the  relevant Schedules, the foreign  currency  account  and  SNRR  account  shall  be  used  only  and  exclusively for transactions under this Schedule.

 

 

 

A.     Mode of payment

1.       The amount of consideration shall be paid as inward remittance from abroad through banking channels or out of funds held in a foreign currency account and/ or a Special Non-Resident Rupee (SNRR) account maintained in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

Provided balances in SNRR account shall not be used for making investment in units of Investment Vehicles other than the units of domestic mutual fund.

2.       The foreign currency account and SNRR account shall be used only and exclusively for transactions under this Schedule.

 

 

The erstwhile provisions restricted use of SNRR account balance for making investments in investment vehicles other than mutual funds.

As a result FPIs could not use their SNRR account and had to resort to other types of accounts for investment in investment vehicles such as REITs, and InViTs. The recent amendment has removed this restriction.

The amendment has been made to provide for the amendment made in Schedule VIII dealing with Investment     by     a     person resident outside India in an Investment Vehicle.

B.     Remittance of sale proceeds

The sale proceeds (net of taxes) of equity instruments and units of REITs, InViTs and domestic mutual fund may be remitted outside India or credited to the foreign currency account or a SNRR account of the FPI.

B.     Remittance of sale proceeds

The sale proceeds (net of taxes) of equity instruments and units of domestic mutual fund may be remitted outside India or credited to the foreign currency account or a SNRR account of the FPI.

The sale proceeds (net of taxes) of units of investment vehicles other than domestic mutual fund may be remitted outside India.

To align with the amendment made in Schedule VIII dealing with Investment     by     a     person resident outside India in an Investment Vehicle.
Schedule VII w.r.t Investment by a Foreign Venture Capital Investor (FVCI)For Para A(2):

Unless otherwise specified in these regulations or the relevant Schedules, the foreign currency account and SNRR account shall be used only and exclusively for transactions under this Schedule.

For Para A(2):

The foreign currency account and SNRR account shall be used only and exclusively for transactions under this Schedule.

 

The insertion has been made to align with the amendments proposed in Schedule VIII dealing with Investment     by     a     person resident outside India in an Investment Vehicle.

Schedule VIII w.r.t Investment     by     a     person resident  outside  India  in  an Investment VehicleA.     Mode of payment:

The  amount  of  consideration  shall  be  paid  as  inward  remittance  from  abroad through  banking  channels  or  by  way  of  swap  of  shares  of  a  Special  Purpose Vehicle   or   out   of   funds   held   in   NRE   or   FCNR(B)   account   maintained   in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

Further,  for  an  FPI  or  FVCI,  amount  of  consideration  may  be  paid  out  of  their SNRR  account  for  trading  in  units  of  Investment  Vehicle  listed  or  to  be  listed (primary issuance) on the stock exchanges in India.

A.     Mode of payment:

The amount of consideration shall be paid as inward remittance from abroad through banking channels or by way of swap of shares of a Special Purpose Vehicle or out of funds held in NRE or FCNR(B) account maintained in accordance with the Foreign Exchange Management (Deposit) Regulations, 2016.

 

Further, it is clarified that the SNRR account may be used for trading in units of listed as well as to be listed units of investment vehicles and the sale/ maturity proceeds can be credited to the said account.

B.     Remittance of Sale/maturity proceeds:

The  sale/  maturity  proceeds  (net  of  taxes)  of  the  units  may  be  remitted  outside India or may be credited to the NRE or FCNR(B) or SNRR account, as applicable of the person concerned.

B.     Remittance of sale/maturity proceeds

The sale/maturity proceeds (net of taxes) of the units may be remitted outside India or may be credited to the NRE or FCNR(B) account of the person concerned.

 

 

Link to our other articles:

Introduction to FEMA (NDI) Rules, 2019 and recent amendments:

http://vinodkothari.com/2020/04/introduction-to-fema-ndi-rules-2019-and-recent-amendments/

RBI rationalises operation of Special Non-Resident Rupee A/c:

http://vinodkothari.com/wp-content/uploads/2019/11/RBI-rationalises-operation-of-SNRR-Account.pdf

 

[1] http://vinodkothari.com/wp-content/uploads/2019/11/RBI-rationalises-operation-of-SNRR-Account.pdf

[1] http://egazette.nic.in/WriteReadData/2019/213318.pdf

[2] http://egazette.nic.in/WriteReadData/2019/213332.pdf

[3] http://egazette.nic.in/WriteReadData/2020/220016.pdf